**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

| **(Mark  One)**                                       |       |                                                                                          |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| **ý**                                            | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|                                                  |       |                                                                                          |   |   |
| **For  the Fiscal Year Ended December 31, 2005** |
| ** **                                            |
| **OR**                                                |
|                                                  |       |                                                                                          |   |   |
| **o**                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                       |            |                                                                                               |  |  |  |  |

 

**FOR THETRANSITION PERIOD FROM                  TO                 .**

 

**Commission File Number 0-21321**

 

**CYMER, INC.**

(Exact name ofregistrant 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: **None**

 

Securities registered pursuant to Section 12(g) of the Act:

 

**Common Stock, $.001 par value**

(Title of class)

 

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  ýYes   o No

 

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.  oYes   ý No

 

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   o No

 

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 filer ý                                  Acceleratedfiler o                     Non-acceleratedfiler o

 

 

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Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theAct).o Yes    ý No

 

The aggregate market value of the voting stockheld by non-affiliates of the registrant, based upon the closing price of $26.35for shares of the registrant’s common stock on June 30, 2005 as reported on theNasdaq National Market, was approximately $919,917,155.  In calculating such aggregate market value,shares of common stock owned of record or beneficially by officers ordirectors, and persons known to the registrant to own more than ten percent ofthe registrant’s voting securities were excluded because such persons may bedeemed to be affiliates.  The registrantdisclaims the existence of control or any admission thereof for any otherpurpose.

 

Number of shares of common stock outstanding as of  March 8, 2006:  37,883,392.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The following document is incorporated 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 proxystatement for its annual meeting of stockholders to be held on May 18, 2006which will be filed with the Securities and Exchange Commission within 120 daysof December 31, 2005.

 

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CYMER, INC.

 

2005 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  and Executive Officers of the Registrant |   |
|     |   | 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 |   |
|     |   | Item 14. |   | Principal  Accounting Fees and Services |   |
|     |   |   |   |   |   |
| PART IV  |   |
|     |   | Item 15 |   | Exhibits  and Financial Statement Schedules |   |
|     |   |   |   |   |   |
|     |   |   |   |   |   |
|     |   | Signatures |   |

 

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#### **Forward-Looking Statements**

 

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; our competitiveposition; and our relationships with customers and third-party manufacturers ofour products, and may contain words such as “believes,” “anticipates,” “expects,” “plans,” “intends” and words of similarmeaning. These statements are predictions based on current information and our expectationsand involve a number of risks and uncertainties. The underlying information andour expectations are likely to change over time.  Actual events or results may differmaterially from those projected in the forward-looking statements due tovarious factors, including, but not limited to, those contained in Item 1A, “RiskFactors” and elsewhere in this Annual Report on Form 10-K.  Forward-looking statements herein speak onlyas of the date of this Annual Report on Form 10-K.  Unless required by law, we undertake noobligation to update or revise any forward-looking statements to reflect newinformation or future events or developments. Thus, you should not assume that our silence over time means that actualevents are bearing out as expressed or implied in such forward-lookingstatements.

 

PART I

 

### **Item 1. Business**

 

#### **Overview**

 

We arethe world’s leading supplier of excimer light sources, the essential lightsource for deep ultraviolet (“DUV”) photolithography systems. DUVphotolithography is a key enabling technology that has allowed thesemiconductor industry to meet the exacting specifications and manufacturingrequirements for volume production of today’s most advanced semiconductor chips.Our light source systems are incorporated into step-and-repeat (“steppers”) andstep-and-scan (“scanners”) photolithography systems for use in the manufactureof semiconductors with critical 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 source systems,replacement parts and service.  Wemaintain a worldwide service organization that supports our installed base oflight sources.  As of December 31, 2005this installed base totaled 2,741 light sources.  Our customers include all three manufacturersof DUV photolithography systems: ASM Lithography, 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, Intel, Matsushita, Micron, Nanya/Inotera, Powerchip, Promos, RenesasTechnology, Samsung, SMIC, Sony, ST Microelectronics, Texas Instruments,Toshiba, TSMC, and UMC.

 

In July 2005, we entered a joint venture with CarlZeiss SMT AG, a German corporation, and Carl Zeiss Laser OpticsBeteiligungsgesellschaft mbH, a German limited liability company (which werefer to together with their affiliated entities as “Zeiss”).  The joint venture, called TCZ (for Team CymerZeiss), is developing a process tool for the flat panel display manufacturingindustry, and expects to ship an evaluation model of its first productionversion of the tool, the TCZ 900X, in late 2006 or early 2007.

 

#### **OtherInformation**

 

We area Nevada corporation, incorporated on July 12, 1996. We were originally incorporatedin California in 1986 and reincorporated in Nevada in 1996.

 

Ourwebsite address is http://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

 

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reports on Form 8-K andany amendments to those reports are available free of charge through ourwebsite as soon as reasonably practicable after we electronically file suchreports or furnish them to the SEC.

 

You mayread and copy materials that we file with the SEC at the SEC’s Public ReferenceRoom at 450 Fifth Street, NW, Washington DC 20549.  Information on the operation of the PublicReference Room is available by calling the SEC at 1-800-SEC-0330.  The SEC maintains anInternet site that contains reports, proxy statements and other information wefile.  The address of the SEC website ishttp://www.sec.gov.

 

**Products and Services**

 

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

 

*Photolithography Light Sources*

 

Our excimer lightsources for photolithography produce pulsed light of extremely shortwavelengths within the DUV spectrum.  Thebandwidth of the light is further narrowed through a number of opticaltechniques.  The DUV wavelengths aremeasured 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 highly 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 2005, we sold 207 light source systems atan average selling price of $982,000.  Revenues generated from sales of light sourceswere approximately $160.3 million, $244.8 million and $207.4 million for 2003,2004 and 2005, respectively.

 

Our product development strategy has been to developnew products in rapid succession to meet continually evolving needs in themarketplace, and to obsolete our own products as quickly as possible, thus renderingour competitors’ 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.

 

Over the years, we have developed and sold a widevariety of photolithography light source products.  These products can be divided into KrF andArF product categories and include a number of current products as well as legacyproducts that we continue to service in our installed base.

 

***Current Products***

 

Our current products include our newest, mostadvanced, highest value-added ArF and KrF light sources, as well as some matureproducts that are still experiencing strong chipmaker demand as DUV lithographybecomes the prevailing light source technology in wafer fabrication.

 

***193 nm ArF Light Sources***

 

Chipmakers continue to reduce the feature sizes and shrink the CD onthe wafer, which means that the line widths of the circuitry on the waferbecome progressively smaller. At this time, chipmakers are continuing to expandtheir manufacturing capacity at 90 nm, while manufacturers of certain types ofmemory chips are in initial production at 65 nm and planning for production ofchips with even smaller CDs. In these circumstances, chipmakers need moreleading edge tools, which means they need more of the shorter wavelength ArF photolithographytools in their manufacturing facilities to pattern the critical layers on thewafer.  Growing use of 193 nm ArF lightsources at the leading edge, combined with continuing use of

 

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248 nm KrF light sources for the less critical layers, allowschipmakers to meet the rigorous performance and volume demands of high volumemanufacturing.  Our light sources aredesigned to enable chipmakers to achieve their production goals.

 

**XLA Series** – The XLA Seriesof ArF light sources is based on our dual-discharge chamber Master OscillatorPower Amplifier (“MOPA”) light source architecture.  The master oscillator creates a narrowbandwidth beam of light at low power which is referred to as “ultra-narrowed”or “highly line-narrowed”.  The beam thenis directed into the power amplifier, where the power is increasedsignificantly while maintaining the narrow bandwidth.  This combination of a narrower bandwidth andhigher power enables chipmakers to continue reducing critical circuitrydimensions and increasing processing speeds, capacity and functionality ofchips, while giving chipmakers the performance and cost advantages theyneed.  Each product in the XLA Series isbased on the XL common platform, which includes cabling and wiring harnesses, electricalinterfaces, power supplies, gas delivery systems, cooling systems, and othervarious components, all in a common enclosure. Use of a common platform enables us to develop each new product in theseries rapidly and cost-effectively. Because our customers are accustomed to working with the XLA Series, ourdirect customers can efficiently integrate a new XLA light source product intotheir advanced scanners and bring them to market quickly, while our chipmakercustomers can quickly begin using these light sources in their existingmanufacturing processes and achieve rapid time to yield.

 

**Products Based on the XL Common Platform**:

 

•                   **Next Generation XLA –**Our next generation XLA currently underdevelopment, is scheduled for initial shipment during 2006.  It will be our fifth generation ArF lightsource based on the MOPA design and XL common platform.  It will operate at a 6 kiloHertz (“kHz”)repetition rate (which means 6,000 light pulses per second) and offer up to 90watts (“W”) of output power.  We expectit to be the industry’s highest-power light source available when it isinitially shipped.  This light sourcewill enable design flexibility for lithography tools using highly sophisticatedlenses for immersion lithography applications at the 45 nm production node and below.This next generation XLA’s  high powercan support various illumination schemes, enabling tighter dose stability andmore stringent CD control.

 

•                   **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, theinitial 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.

 

•                   **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 initially shipped in the first quarter of 2004, and continues toexperience strong demand from 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.

 

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**NanoLith 7000**– The NanoLith7000 is a single-chamber ArF light source offering a 4 kHz repetition rate and20 W of output power.  Designed  to enable initial ArF process development andproduction at the 100 nm production node and below, the NanoLith 7000 is theArF twin of the ELS-7000 KrF light source (see 7000 Series below).  The NanoLith 7000 sold well from itsintroduction in mid-2001 through 2002, and was replaced by the more advanced XLA100 when that product was introduced in 2003. As of the end of 2005, we were shipping this product only sporadically,but continuing to provide consumable modules, spare parts and service for theinstalled base of NanoLith 7000s in semiconductor fabs throughout the world.

 

***248 nm KrF Light Sources***

 

We have been providing KrF light sources for volume chip productionsince 1996 when chipmakers reached the 250 nm production node.  Over the years, we have developed and sold avariety of increasingly powerful and productive KrF products.  These light sources have enabled increasingwafer throughput and continually shrinking CD.

 

**7000 Series** – The 7000Series of products offers a complete product line, encompassing both ArF andKrF light sources on a common platform, enabling chipmakers to easily “mix andmatch” these two different light source wavelengths within the manufacturingenvironment.  With a 4 kHz repetitionrate and high output power, the 7000 Series offers chipmakers high waferthroughput and lower cost of operation by reason of advanced design and materials,thus delivering improved tool availability for increased manufacturingefficiency and flexibility.

 

**Our 7000 Series 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, theELS-7010 is now our best-selling KrF light source.  This light source also offers ultra-narrowedbandwidth and a number of controls to enhance 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 2005, there was modest demand for thislight 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.

 

**6000 Series** – The 6000Series of light sources includes two KrF models and an ArF model.  When originally introduced, 6000 Series lightsources were designed for production of semiconductor devices with design rulesdown to 130 nm.

 

**Our 6000 Series 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.  Initialshipments of the ELS-6000 began in the second half of 1998, and this product continuedto sell well into 2002, and then again in 2004 when chipmakers were expanding200 mm fab capacity.  We currently sellonly a few of these light sources per year.

 

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•                   **ELS-6010A** – The ELS-6010A is the ArF model in the 6000Series of products.  It operates at a 2kHz repetition rate with 10 W of output power and was designed to meet theresolution, image contrast and wafer throughput requirements in semiconductorproduction at the 130 nm node and below. It began shipping in the second quarter of 2001, but was supersededlater that same year by the NanoLith 7000 with its higher repetition rate andpower.  We still provide consumables,spare parts and service for the ELS-6010As installed at chipmakers and otherend users.

 

***Legacy Products***

 

In general, we no longer sell our ELS-6010A or other legacylight source products because they have been superseded by our newer, moreadvanced products.  Our legacy productsare still widely used by chipmakers to pattern the circuitry on the lesscritical layers of the wafer.  They makeup a substantial portion of our installed base of light sources, and we stillprovide consumables, spare parts and service for these light sources.

 

**5000 Series** — Our 5000Series of light sources include several KrF products and one ArF product.  The 5000 Series light sources operate at a 1kHz repetition rate, and depending on the model, offer 10 W or 15 W of outputpower for use in the manufacture of semiconductors with CD of 250 nm and below.We last shipped a 5000 Series light source in early 2001, but we continue toprovide consumables, spare parts and service to the large installed base of5000 Series products throughout the world.

 

*Replacement Parts and Refurbishment Activities*

 

Certain componentsand subassemblies included in our light sources require replacement orrefurbishment following extended operation. For example, we estimate that a light source used in a semiconductorproduction environment will require one to two replacement discharge chambers,one of the core consumable modules in our light source system, per yeardepending upon the level of its usage. Similarly, certain optical components ofthe light source deteriorate with continued exposure to DUV light and requireperiodic replacement.  We provide theseand other spare and replacement parts for our photolithography light sources asneeded by our chipmaker customers.

 

Revenues generated from sales of replacement parts,excluding the receipt of reusable material, were approximately $83.2 million, $123.2million, and $130.8 million for 2003, 2004, and 2005, respectively.  Revenues from replacement parts are dependenton both the utilization of our light source systems and the size of ourinstalled base of light sources.  Thesize of our installed base increased from 2,496 light sources as of December31, 2004 to 2,741 light sources as of December 31, 2005, and the utilization ofour light source systems at chipmakers grew significantly throughout 2005. Theutilization rate grew 33% from the beginning of 2005 and reached a record high levelby the end of 2005.

 

As part of ourregular business activities, we conduct significant parts refurbishmentactivities related to some of our core assemblies.  These activities involve arrangements withour customers where we sell new parts to our customers at a reduced sales pricein exchange for these customers sending back to us the consumed assembly thatthe new part replaced.  These returnedcore assemblies contain a certain amount of material, primarily metalcomponents, that may be reused by us in future core assemblies.  Since a portion of the consideration relatedto the original sale is related to the return of consumed parts, we recordrevenue when we receive the returned assemblies from our customers.

 

Revenues generated from thereceipt of reusable material contained within consumed assemblies returned fromour customers were approximately $28.5 million for 2004 and $18.0 million for2005, 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 underValuation of Parts Used in Refurbishment Manufacturing Process and CorrectedAccounting Method in Item 7, Management’s Discussion and Analysis of FinancialCondition and Results of

 

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Operations” and in Note 1 to our consolidatedfinancial statements.

 

*Service*

 

Asthe life and usage of our installed base of light sources in production atchipmakers exceed the original warranty periods, some chipmakers requestservice contracts from us.  Additionally,we provide billable service or service contracts to the three semiconductorlithography tool manufacturers and to many of our chipmaker customers. Theseservice agreements require us to maintain and/or service these light sourceseither on an on-call or regular interval basis or both.  Some of these contracts include replacementof consumable parts and non-consumable parts.

 

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

 

Revenues generated fromservice and service contracts were approximately $21.3 million, $20.1 millionand $26.4 million for 2003, 2004 and 2005 respectively.  We expect service and service contractrevenues to remain at or exceed these higher levels as our installed base growsand the warranty period of our light source systems expires.

 

**Customers and End-Users**

 

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

 
| ASM Lithography |   | 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 ASM Lithography, Canon,and Nikon accounted for 32%, 8% and  24%,respectively, of total revenue in 2005.

 

Revenues generated from customers within the U.S. were $29.3 million, $75.8million and $60.3 million for 2003, 2004 and 2005, respectively.  Revenues generated from customers outside ofthe U.S. were $236.5 million, $342.2 million and $323.4 million for 2003, 2004and 2005, respectively.

 

Revenues generated from customers locatedin Japan were $116.5 million, $132.8 million and $119.6 million for 2003, 2004and 2005, respectively.  Revenuesgenerated from customers located in Europe were $74.6 million, $154.7 millionand $138.8 million for 2003, 2004 and 2005, respectively.  These revenues can originate from any of our locationsto customers located in these countries.

 

Long-lived assetslocated in the U.S. were $120.5 million, $114.1 million and $108.9 million as ofDecember 31, 2003, 2004 and 2005, respectively. Long-lived assets locatedoutside of the U.S. were $8.4 million, $9.4 million and $8.4 million as ofDecember 31, 2003, 2004 and 2005, respectively.

 

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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 †       |
| Arch  Chemicals               |       | Fujitsu                |       | SSMC                        |       | Samsung                        |
| Atmel                         |       | Hitachi                |       | TECH                        |       |                           |
| Clariant  Corp.               |       | JSR                    |       | UMCI  Pte Ltd.              | ** ** | **Europe**                     |
| Cypress                       |       | Kawasaki  Seitetsu     |       |                        |       | Altis  Semiconductor           |
| Freescale  Semiconductor      |       | Matsushita             | ** ** | **Taiwan/China**            |       | C-NET  †                  |
| Headway  Technologies         |       | Mitsubishi             |       | ASMC                        |       | IHP                            |
| Honeywell                     |       | NEC                    |       | ERSO                        |       | IMEC  v.z.w †             |
| HP                            |       | OKI                    |       | GSMC                        |       | Infineon  Technologies AG      |
| IBM                           |       | Renesas  Semiconductor |       | HeJian                      |       | CEA-Leti                       |
| Integrated  Device Technology |       | Rohm                   |       | Inotera                     |       | Micronas  GmbH                 |
| Intel                         |       | Sanyo                  |       | Mosel                       |       | Philips                        |
| Jazz  Semiconductor           |       | Seiko                  |       | MXIC                        |       | ST  Microelectronics           |
| LSI  Logic Corp.              |       | SELETE  †         |       | Nan-ya                      |       | Tower  Semiconductor           |
| Maxim  Integrated Products    |       | Sharp                  |       | Promos                      |       |                           |
| Microchip  Technology Inc.    |       | Sony                   |       | PSC                         |       |                           |
| Micron  Technology            |       | Tokyo  Electron Ltd.   |       | SMIC                        |       |                           |
| National  Semiconductor       |       | Tokyo  Ohka Kougyo Co. |       | TSMC                        |       |                           |
| Rohm  & Haas              |       | Toshiba                |       | UMC  Group                  |       |                           |
| Sarnoff  Corp.                |       |                   |       | VISC                        |       |                           |
| SEMATECH  †              |       |                   |       | Winbond  Group              |       |                           |
| Spansion                      |       |                   |       |                        |       |                           |
| Texas  Instruments            |       |                   |       |                        |       |                           |
| VLSI                          |       |                   |       |                        |       |                           |
| Wafertech                     |       |                   |       |                        |       |                           |

 

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†  A semiconductor industry 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, 2005, we had a backlogof approximately $90.8 million compared with a backlog of $79.1 million atDecember 31, 2004.

 

**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 manufacturing outsourcing strategy is exemplified by themodular design of our products. Substantially all manufacturing of nonproprietary subassemblies has beencontracted to third-party suppliers. As a result, we are increasingly dependentupon these contract suppliers to meet our manufacturing schedules.  The failure by one or more of these suppliersto supply us on a timely basis with sufficient quantities of components orsubassemblies that perform to our specifications could affect our ability todeliver completed light sources to our customers on schedule. We believe that thehighly outsourced content and manufacturable design of our products allows forreduced manufacturing cycle times and increased output per employee. To improvecurrent production efficiencies, control costs, and manage

 

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overall manufacturing capacity, we intend to continue to provideadditional training to manufacturing personnel, improve our assembly and testprocesses in order to reduce cycle time, invest in additional manufacturingtooling and further develop our supplier management and engineeringcapabilities.

 

In addition to the manufacturing capacity at our facilities in SanDiego, California, we completed the construction of a refurbishment facility inKorea in late 2002.  This facilityrefurbishes discharge chambers for 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. We shipped thefirst chamber to a customer from this facility in January 2003.

 

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 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. To date we have been able to obtain adequate supplies of the componentsand subassemblies used in the production of our light source systems in atimely manner from existing sources.  Ifin the future we are unable to obtain sufficient quantities of required materials,components or subassemblies, or if such items do not meet our qualitystandards, delays or reductions in product shipments could occur which could harmour business, financial condition and results of operations.

 

**Sales and Marketing**

 

Our sales and marketing efforts are designed to serve ourcustomer base consisting of both the DUV photolithography tool providers suchas ASM Lithography, Canon and Nikon as well as many of  the world’s top 20 chipmakers.  We market and sell our products through ourown worldwide direct sales and marketing channels and we have developed productand applications engineering teams to support these efforts. We believe that inorder for our sales and marketing organization to be successful, we must workclosely with and understand the requirements of both the photolithographysystems solutions providers and the end-user semiconductor 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 in somecases provide ongoing on-site technical support at the customer’s manufacturingfacility.  Prior to shipment, our supportpersonnel typically assist the customer in site preparation and inspection andprovide customers with training at our facilities or at the customer’slocation.  We also provide directcustomers and end-users with a comprehensive set of manuals, includingoperations, 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 our own logistics support organization, will be subject to the fluctuating demandsof the semiconductor industry. In order to meet these demands, we must continueto effectively manage our production of component modules which are requiredfor new systems, as well as for support and warranty requirements for installedsystems.

 

We believe that the need to provide fast and responsive service to thelevel of quality required

 

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by semiconductor manufacturers using our light sources is critical andthat we cannot depend solely on our customers to provide this service.  Therefore, we believe it is essential tomaintain, through our own personnel, a rapid response capability to service ourcustomers and end-users throughout the world. Accordingly, we seek to continuously develop and enhance our directsupport infrastructure in Europe, Japan, Korea, Singapore, the People’sRepublic of China, Taiwan and Southeast Asia and the U.S.  This task entails recruiting and trainingqualified field service personnel or identifying qualified independent firmsand maintaining effective and highly trained organizations that can provideservice to customers in various countries in their 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.

#### ** **

#### **Researchand 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 new MOPA platform.  We haveexpended development efforts to address the technology and products thatwill be based on the extreme ultraviolet (“EUV”) technology needed for futuregeneration photolithography illumination sources. While we are no longer makingdirect investments in fluorine (“F2”) light source development, we expect thecombination of our previous investment, together with continued platform andcore technology developments in our other products to enable us to acquire aleadership position should a market for F2 light sources develop. We may also invest in other product andtechnology areas in order to expand our portfolio within the semiconductorcapital equipment market sector.  In addition there are ongoing efforts toimprove existing products, reduce manufacturing costs, lower the cost of lightsource operation, enhance light source performance, develop new features forexisting light sources, and conduct research and development of non-lightsource products.

 

We have historically devoted a significant portion of our financial resourcesto research and development programs and we expect to continue to allocatesignificant resources to these efforts. Research and development expenses for2003, 2004 and 2005 were approximately $56.8 million, $58.6 million and $64.0million, respectively.

 

In the last three years, we have entered into severalresearch and development agreements related to EUV technology both withcustomers and government agencies. The largest of these research anddevelopment agreements was with Intel Corporation in January 2004. Thisagreement  provides funding to acceleratethe development of production-worthy EUV lithography light sources at theirrequest. The funding being received from Intel under this agreement ismilestone based and is netted against our total research and developmentexpenses in the period the milestone is achieved. The total funding recordedunder this agreement for 2004 and 2005 was $6.1 million and $1.9 million,respectively.

 

Revenues generated fromresearch and development contracts amounted to approximately $57,000, $783,000and $1.0 million during 2003, 2004 and 2005, respectively.  For certain of our research and developmentcontracts, our research and development expenses are offset by amounts earnedassociated with these contracts.  Theamounts offset against research and development expenses were $1.6 million, $7.6million and $2.8 million during 2003, 2004 and 2005, respectively.

 

In July 2005, we entered into a jointventure agreement with Zeiss and TCZ GmbH (“TCZ”), a Swiss limited liabilitycompany that is headquartered in San Diego and is owned 60% by us and 40% byZeiss.  TCZ is currently developing, andwill integrate, market, sell, and support, process tools for the flat paneldisplay manufacturing industry.  Thejoint venture is targeting the growing market for low-

 

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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.  TCZ currentlyexpects to ship an evaluation model of the TCZ 900X by late 2006 or early 2007.  As a majority owned subsidiary, TCZ’sresearch and development expenses are included in our consolidated research anddevelopment expenses.

 

#### **IntellectualProperty Rights**

 

While the success of our business depends more on suchfactors 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, weseek to protect our intellectual property rights in a variety of ways,including by obtaining patents.  As ofDecember 31, 2005, we owned 230 U.S. patents covering certain aspects oftechnology related to light sources and piezo techniques.  These patents will expire at various timesduring the period from January 2008 to October 2023. As of December 31, 2005,we had applied for 110 additional patents in the U.S.  As of December 31, 2005, we owned 334 foreignpatents and had 344 patent applications pending in various foreign countries.

 

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

 

Othercompanies or persons may have filed or may file in the future patentapplications that are similar or identical to ours. We may have to participatein appropriate proceedings in the courts or the patent offices to determine thepriority of inventions. 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 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 thepast, funds from research and development arrangements with third parties havebeen used to pay for a portion of our own research and development expenses. Wereceive these funds from government-sponsored programs and customers, inconnection with our designing and developing specific products. Currently,funds from lithography tool manufacturers and chipmakers are used to fund asmall portion of our research and development expenses. In providing theseresearch and development services to these manufacturers, we try to make clearwho owns the intellectual property that results from the research and developmentservices we perform. However, disputes over the ownership or rights to use ormarket this intellectual property may arise between the funding organizationsand us.

 

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

 

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Specifically,Komatsu has notified us that we may be infringing some of its Japanese patents.During our subsequent discussions with Komatsu, they also asserted that ourformer Japanese manufacturing partner, Seiko, or we may be infringing on someof Komatsu’s U.S. patents and a number of its additional Japanese patents.Komatsu has also notified one of our customers, Nikon, of its belief that ourlight sources infringe several of Komatsu’s Japanese and U.S. patents. As aresult, we started proceedings in the Japanese Patent Office to oppose certainpatents and patent applications of Komatsu. The Japanese Patent Office hasdismissed our opposition claims. Thus, litigation may result in connection withKomatsu’s Japanese patents or U.S. patents. Also, Komatsu might claim that weinfringe other or additional patents. Komatsu notified Seiko that it intends toenforce its rights against Seiko with respect to its Japanese patents if Seikocontinued to engage in manufacturing activities for us. In connection with ourformer manufacturing agreement with Seiko, we agree to pay Seiko under certainconditions for damages associated with these types of claims. Seiko may notprevail in any litigation against Komatsu, and therefore, we may be required topay Seiko for such damages.

 

We havenotified our competitor and others of our U.S. patent portfolio. Specifically,we have notified Komatsu that it may be infringing some of our U.S. patents. Wehave discussed with Komatsu our claims against each other.  Komatsu challenged one of our U.S. patents inthe United States Patent and Trademark Office (“USPTO”) but our patent wassubsequently re-issued by the USPTO. Also, Komatsu transferred its lithography light source business to ourcompetitor, Gigaphoton.  We also have haddiscussions with Lambda-Physik (a subsidiary of Coherent, Inc.) regardingallegations by each party against the other of possible patent infringement.Any of these discussions with our competitor or former competitor may not besuccessful and litigation could result.

 

In the future,patent litigation may result due to a claim of infringement by our competitoror any other third party or may be necessary to enforce patents issued tous.  Any such litigation could result insubstantial cost to us and diversion of our effort, which would have an adverseeffect on our business, financial condition and operating results. Furthermore,our customers and the end-users of our products might assert other claims forindemnification that arise from infringement claims against them. If theseassertions are successful, our business, financial condition and operatingresults may be harmed. Instead of litigation, or as a result thereof, we mayseek a license from third parties to use their intellectual property. However,we may not be able to obtain a license. Alternatively, we may design around thethird party’s intellectual property rights. Any adverse determination in a legal proceeding could result in one or more of the following, any of which could harmour 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.

 

We have granted Seiko a right of first refusal to fund our developmentof, and receive a license to, new industrial light source technologies notdeveloped with funding from other parties. In exchange for these rights, we received up-front license fees of $3.0million in aggregate during 1992 and 1993. We were also entitled to royaltiesof 5% on related product sales through September 1999, after which the royaltyrate was subject to renegotiation.  Todate no renegotiation of the royalty rate has occurred.  Through 1999, we earned no royalties underthe agreement. The license agreement also provides that

 

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product sales between us and Seiko will be at a 15% discount from therespective companies’ list prices.  The agreementterminates in August 2012.  There hasbeen no production or sales activity by Seiko associated with this contract todate and this contract does not apply to our current light source systemproducts.

 

We haveregistered the trademarks ‘‘CYMER’’ and “INSIST ON CYMER” and others in theU.S. and in some other countries. We are also trying to register additionaltrademarks in the U.S. and in other countries. We use these trademarks and manyother marks in our advertisements and other business materials, which aredistributed throughout the world. We may be subject to trademark infringementactions for using these marks and other marks on a worldwide basis and thiswould be costly to defend. If a trademark infringement action were successful,we would have to stop using the mark and possibly 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,performance efficiency and rate of quality. We believe that we competefavorably with respect to these factors.

 

Wecurrently have one significant competitor, Gigaphoton, that sells light sourcesfor DUV photolithography applications. Headquartered in Japan, Gigaphoton is ajoint venture between two large companies, Komatsu and Ushio.  We believe that Gigaphoton is aggressivelytrying to gain larger penetration in the DUV light source market. We know thatour direct customers have purchased products from Gigaphoton and have approvedits light sources for use with their products. We also know that Gigaphoton has been approved by chipmakers in Japan,the U.S. and elsewhere for producing excimer light sources.  We could lose market share and our growthcould slow or even decline if Gigaphoton gains additional market acceptance.

 

In the future, we will likelyexperience competition from other technologies, such as EUV and electronprojection lithography. To remain competitive, we believe that we will need tomanufacture 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. We might not have sufficient resources tocontinue to make the investments necessary to maintain our competitiveposition.

 

Largercompetitors with substantially greater resources, such as other manufacturersof industrial light sources for advanced lithography, may attempt to sellcompetitive products to our customers. Potential competitors may also beattracted to our growing installed base of light sources and may attempt tosupply consumables and spare parts to that installed base.

 

**Employees**

 

On December 31, 2005, we employed 879 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 workstoppages and believe that our employee relations are good.

 

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### **ExecutiveOfficers**

 

Set forth below is certain information regarding our executive officersand their ages as of March 8, 2006.

 
| **Name**           | ** ** | **Age** | ** ** | **Position**                                             |
|--------------------|------------|---------|------------|----------------------------------------------------------|
| Robert  P. Akins   |       | 54      |       | Chairman  of the Board and Chief Executive Officer       |
| Edward  J. Brown   |       | 48      |       | President  and Chief Operating Officer                   |
| Nancy  J. Baker    |       | 43      |       | Senior  Vice President, Chief Financial Officer          |
| Bill  N. Alexander |       | 49      |       | Executive  Vice President, Worldwide Customer Operations |
| Takeshi  Watanabe  |       | 51      |       | President,  Cymer Japan                                  |
| Rae  Ann Werner    |       | 41      |       | Vice  President, Controller and Chief Accounting Officer |

 

**RobertP. 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 of advisorsto the Irwin and Joan Jacobs School of Engineering at the University ofCalifornia, 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 a bachelor’sdegree in industrial studies from San Diego State University.

 

**Nancy J.Baker** has served assenior vice president and chief financial officer since January 2002.  Prior to that, she served as our vicepresident, 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 nine months.From October 1996 to June 1998 she served as director, corporate finance andtreasurer.  She joined us as corporatecontroller for worldwide operations in August 1992.  Ms. Baker’s professional career spans morethan 20 years, and prior to joining us, she held a variety of financial managementpositions with an international manufacturer in the San Diego area.  Ms. Baker received a bachelor’s degree inaccounting from the University of Texas at Austin and completed the executiveadvanced management program at Harvard Business School.

 

**Bill N.Alexander** has served as executive vice president of worldwidecustomer operations since October 2004. He joined us in October 2002 as our senior vice president of sales andfield operations for the Semiconductor Manufacturing Solutions group.  A year later, he transitioned to theLithography System Solutions group as senior vice president of sales and siteoperations. Prior to joining us, Mr. Alexander served as the president ofEurope operations for Novellus Systems, Inc. and before that, he worked as thevice president of worldwide sales and field operations at GaSonicsInternational, Inc. from August 1997 to January 2001. Throughout his career,Mr. Alexander has held various senior management positions throughout thesemiconductor industry including vice president, Asia-Pacific sales and fieldoperations at Tencor Instruments, vice president of international operations

 

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for Watkins-Johnson Company, director of Asia-Pacific regionalmarketing for Applied Materials, CVD Division, and senior manager ofAsia-Pacific strategic sales for Lam Research Corporation. Mr. Alexanderreceived a bachelor’s degree from San Jose State University and a master’sdegree in business administration from Golden Gate University.

 

**TakeshiWatanabe** has servedas president of Cymer Japan, Inc. since February 2005, and in this role isresponsible for managing our overall business in Japan, including the sales,service, and operations infrastructure for our direct customers and lithographytool manufacturers.  Prior to that, heserved as our account sales director for Canon from June 2001 to February2005.  Mr. Watanabe joined Cymer Japan,Inc. in October 2000 as finance director, and served in that position untilJune 2001.  Before joining us, Mr.Watanabe served as senior finance manager with Guidant Japan, Ltd., where hewas responsible for finance and planning and restructured the unit’s financialoperations.  Over the twenty years prior tothis, Mr. Watanabe served in a series of finance positions of increasingresponsibility with such companies as Duracell Battery Japan Ltd., StrykerJapan, Ltd., Nihon Valid Logic System, Ltd., Kulicke and Soffa (Japan), Ltd.,Sony Music Entertainment, and Measurex Japan, Ltd. Mr. Watanabe holds abachelor’s degree in accounting from Chuo University.

 

**Rae AnnWerner**has served as vice president, controller, and chiefaccounting 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 18years, 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 ourexecutive officers.

 

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

 

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

 

Ourrevenues and operating results from quarter-to-quarter have varied in the pastand our future operating results may continue to fluctuate significantly.

 

Factorsthat contribute to fluctuations in our revenues and operating results include:

 

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

•                  cyclicality in themarket for semiconductor manufacturing equipment;

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

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

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

•                  product lead timedemands from our customers and the chipmakers;

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

•                  changes in the price andprofitability of our products;

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

•                  changes in marketpenetration by our competitor;

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

•                  our ability to manageour manufacturing requirements;

 

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

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

•                  worldwide politicalinstability;

•                  changing global economicconditions, including rising energy prices; and

•                  intellectual propertyprotection.

 

We havehistorically derived a large portion of our quarterly and annual revenues fromselling a small number of light source systems. Because we sell a small numberof products, the precise time that we recognize revenue from an order may havea significant impact on our total revenue for a particular period. Ourcustomers may cancel or reschedule orders with little or no penalty. Ordersexpected in one quarter could shift to another period due to changes in theanticipated timing of customers’ purchase decisions or rescheduled deliverydates requested by our customers. Our operating results for a particularquarter or year may be adversely affected if our customers, particularly ourthree largest customers, cancel or reschedule orders, or if we cannot fillorders in time due to unexpected delays in manufacturing, testing, shipping,and product acceptance.

 

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

 

**Our businessdepends on the semiconductor and the semiconductor capital equipmentindustries, which are highly volatile and unpredictable.**

 

Wederive substantially all of our revenues from photolithography toolmanufacturers, or original equipment manufacturer (“OEM”) customers, whoincorporate 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.  Like us, our OEM customers depend on demandfor their products from the chipmakers. The capital equipment and relatedoperating expenditures of chipmakers depend on a number of factors, includingthe current and anticipated market demand for semiconductors and the manyproducts using semiconductors.  Thatdemand is highly volatile and unpredictable.

 

As aresult of the cyclicality of the semiconductor industry, the semiconductorcapital equipment industry historically has experienced periodic ups and downsand currently appears to be in flux, with industry experts uncertain about thelevel of growth to expect in 2006.  Inlate 2005 and early 2006, business indicators for our industry have become morepositive, and estimates of semiconductor capital equipment spending for thefull year of 2006 now range from an increase of at least 5% to as much as 10%to 12% over 2005 levels.  The lithographysegment of the semiconductor capital equipment industry could grow at aboutdouble the rate of the industry as a whole due to a perceived need foradditional lithography tools, with advanced lithography tools expected to havehigher average selling prices.

 

Thecyclical nature of the semiconductor and the semiconductor capital equipmentindustries affects our ability to accurately predict future revenue andtherefore our ability to manage our future expense levels. When cyclicalfluctuations result in lower than expected revenue levels, operating resultsmay be adversely affected and cost reduction measures may be necessary in orderfor us to remain competitive and financially sound.  During a down cycle or slowdown, we must bein a position to adjust our cost and expense structure to prevailing marketconditions while still being able to motivate and retain our key employees.During periods of rapid growth, we must be able to increase manufacturingcapacity and personnel to meet customer demand. We can provide no assurance that

 

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these objectives can bemet 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 semiconductorindustry often result in decreases in demand for semiconductor manufacturingequipment, including the photolithography tools that our OEM customers produce.The previous downturn in the semiconductor industry had a severe effect on thedemand for semiconductor manufacturing equipment. Fluctuating levels ofinvestment by chipmakers and resulting pricing volatility will continue tomaterially affect our aggregate bookings, revenues and operating results. Evenduring periods of reduced revenues we believe we must continue to invest inresearch and development and to maintain extensive ongoing worldwide customerservice and support capabilities to remain competitive. Continued spending infurtherance of these objectives may temporarily harm our financialresults.  Semiconductor industrydownturns and slowdowns are likely to continue to adversely affect ourbusiness, financial condition and operating results, and our operating resultsmay fall below the expectations of public market analysts or investors infuture quarters. Any failure to meet such expectations could materiallyadversely affect the price of our common stock.

 

Our OEMcustomers try to manage their inventories and production requirements toappropriate levels that reflect their expected sales to chipmakers. Marketconditions in the semiconductor industry and our OEM customers’ productionefficiency can cause them to expand or reduce their orders for new light sourcesystems as they try to manage their inventories and production requirements. Wecontinue to work with our OEM customers to better understand these issues.However, we cannot guarantee that we will be successful in understanding ourOEM customers’ inventory management and production requirements or that our OEMcustomers will not build up an excess inventory of light source systems. If ourOEM customers retain an excess inventory of light source systems, our revenuecould be reduced in future periods as the excess inventory is utilized, whichcould adversely affect our operating results, financial condition and cashflows.  If our OEM customers demandshorter product lead times to improve their inventory and cash positions, ourinventory management and cash position may be negatively impacted, which mayadversely affect our operating results, financial condition and cash flows.

 

**Asignificant percentage of our revenue is derived from sales to a few largecustomers, and if we are not able to retain these customers, or theyreschedule, reduce or cancel orders, or delay or default on payments, ourrevenues would be reduced and our financial condition and cash flows wouldsuffer.**

 

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

 
| ** **      | ** ** | **Years ended December 31,** | ** ** |
|-----------------|------------|------------------------------|------------|
| ** **      | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ASM Lithography |       | 24                           | %          | 34 | % | 32 | % |
| Canon           |       | 24                           | %          | 11 | % | 8 | % |
| Nikon           |       | 21                           | %          | 22 | % | 24 | % |
|            |       |                         |       |   |   |   |   |
| Total           |       | 69                           | %          | 67 | % | 64 | % |

 

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

 
| ** **      | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-----------------|------------|------------------|------------|------------------|------------|
| ** **      | ** ** | **2004**         | ** ** | **2005**         | ** ** |
| ASM Lithography |       | 46               | %          | 36               | %          |
| Canon           |       | 5                | %          | 5                | %          |
| Nikon           |       | 31               | %          | 25               | %          |
|            |       |             |       |             |       |
| Total           |       | 82               | %          | 66               | %          |

 

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Weexpect that sales of our light source products to these three customers willcontinue to account for a substantial majority of our revenue in theforeseeable future. None of our customers are obligated to purchase a minimumnumber of our products in the aggregate or during any particular period.  We can provide no assurance that any of ourcustomers will continue to purchase our products at past or currentlevels.  For example, revenue attributableto sales to Canon has declined by more than 50% over the last two fiscalyears.  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’scompetitive position in its industry;

•                  a customer experiencinglithography tool production problems;

•                  a decision to purchaselight sources from other suppliers;

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

•                  a decline in acustomer’s financial condition.

 

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

 

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

 

Ouronly current product line is excimer light source systems, including KrF andArF systems, and support, including consumable and spare parts and servicesupport.  We expect these light sourcesystems and the related support to continue to account for a substantialmajority of our revenues in the near term. Continued market acceptance of ourlight source system products is, therefore, critical to our future success. Theprimary market for excimer light sources is in the use of DUV photolithographyequipment for manufacturing deep-submicron semiconductor devices using smallercircuit geometries. The demand for our products depends in part on the rate atwhich chipmakers further adopt excimer light sources as the chosen light sourcefor their photolithography tools.

 

Therate with which chipmakers adopt excimer light sources may vary for a varietyof reasons, including:

 

•                  inadequate performanceof photoresists used in advanced DUV photolithography;

•                  potential shortages ofspecialized materials used in DUV optics;

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

•                  consolidation ofchipmakers.

 

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

 

•                  a decline in demand 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 newenhanced versions of our products on a timely basis.

 

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

** **

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

 

Ourmost significant product introduction in recent years consisted of a technologychange from a single-discharge-chamber excimer light source to adual-discharge-chamber design called MOPA. The MOPA design represents a paradigm shift from previously acceptedlithography technology and offers chipmakers higher power, tighter bandwidthand lower cost of operation for their current – and we expect for their future –optical lithography applications.  Asoriginally designed, the MOPA architecture was projected to provide itsbenefits across all three DUV wavelengths – 248 nm, 193 nm, and 157 nm – but atthis time, the semiconductor industry has only adopted MOPA at the 193 nmwavelength, due to the successful extension of 248 nm single chambertechnology, and the omission of 157 nm lithography from the roadmap.  There are risks inherent in the ongoingtransition to the MOPA technology, including effective execution of our productdevelopment roadmap, continuing adoption of the product by lithography toolmanufacturers and chipmakers, manufacturability, cost effectiveness, andproduct performance in the field of the new products and the development of acomparable product by our competitor.

 

Webelieve that chipmakers are currently developing a capability to producedevices that are measured at 90 nm or less, and these efforts are driving thecurrent demand for our light source products for DUV photolithography systems.After chipmakers have this capability, their demand for our light sourceproducts will depend, in part, on whether they want to expand their capacity tomanufacture these devices. This will in turn depend on whether their salesforecasts and projected manufacturing process yields justify the necessaryinvestments.

 

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

 

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

 

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

 

Webelieve it is critical for us to provide quick and responsive service directlyto the chipmakers throughout the world that use our light source products intheir photolithography systems, and that it is essential to maintain our ownpersonnel or trained third-party resources to provide these services.  Accordingly, we have an ongoing effort todevelop our direct support system with locations in Europe,

 

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Korea, Japan, thePeople’s Republic of China, Singapore, Taiwan and the U.S. This requires us todo 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.

 

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

 

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

** **

Tocontinue to grow our business, our existing light source products and theirprocess capabilities must be enhanced, and we must develop and manufacture newproducts to serve other semiconductor applications. We cannot guarantee that wewill be able to manage our business to grow effectively. Nor can we guaranteethat we will be able to accelerate the development of new enhancements to ourexisting products and create new products. Further, we may not be able toeffectively integrate new products and applications into our currentoperations. Any of these risks could materially harm our business, financialcondition and results of operations.

 

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

 

In order to respondto the business cycles of the semiconductor industry, in the past few years wehave sharply expanded and contracted the scope of our operations and the numberof employees in many of our locations and departments. As the semiconductorindustry cycle moves between growth and contraction we will need to:

 

•                  closely manage ourglobal operations;

•                  improve our process andother internal management systems;

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

•                  quickly adapt tochanging sales and marketing channels;

•                  effectively manage ourinventory levels; and

•                  attract, train, retainand manage key personnel.

 

If wefail to effectively manage changes in our business, our operating results,financial condition and cash flows will be adversely affected.

 

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

** **

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

 

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**We depend on a few key suppliersfor purchasing components and subassemblies that are included in our products.**

 

We purchase a limited number ofcomponents and subassemblies included in our light source products from asingle supplier or a small group of suppliers. For certain optical, control system and pulse power componentsand subassemblies used in our light source systems, we currently utilize asingle supplier.  To reduce the riskassociated with this single supplier, we carry a significant strategicinventory of these components.  Strategicinventories are managed as a percentage of future demand.  We have also negotiated to havevendor-managed inventory of critical components to further reduce the risk of asingle supplier.  In addition, we contract the manufacture of various subassemblies moreoften than in the past. Further, some of our suppliers have specialized insupplying equipment or manufacturing services to semiconductor equipmentmanufacturers and therefore are susceptible to industry ups and downs andsubject to the same risks and uncertainties regarding their ability to respondto changing market conditions.  Becausemany of  these suppliers reduce the sizeof their workforce in an industry downturn and increase it in an upturn, theymay not be able to meet our requirements or respond quickly enough as an upturnbegins and gains momentum.  Due to the nature of ourproduct development requirements, these key suppliers must rapidly advancetheir own technologies and production capabilities in order to support theintroduction schedule of our new products. These suppliers may not be able toprovide new modules and subassemblies when they are needed to satisfy ourproduct schedule requirements. If we cannot purchase enough of these materials,components or subassemblies, or if these items do not meet our qualitystandards, there could be delays or reductions in our product shipments, whichwould have a material adverse effect on our operating results, financialcondition and cash flows.

 

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

** **

We arecurrently aware of one significant competitor that sells light sources for DUVphotolithography applications. This competitor, Gigaphoton, is a joint venturebetween two large companies, Komatsu and Ushio, and is headquartered in Japan. Additionally, late in 2004, a formercompetitor Coherent, Inc., a U.S. company, announced that their Lambda-Physiksubsidiary would no longer pursue the excimer light source systems business forphotolithography in the semiconductor industry.

 

Webelieve that Gigaphoton is aggressively trying to gain larger marketpenetration in the excimer light source industry. We know that our customershave purchased products from this competitor and that our customers haveapproved this competitor’s light sources for use with their products.  We know that Gigaphoton has been approved bychipmakers in Japan, the U.S. and elsewhere for producing excimer lightsources.

 

Largercompanies with substantially greater resources, such as other manufacturers ofindustrial light sources for advanced lithography, may attempt to sellcompetitive products to our customers. Potential competitors may also beattracted to our growing installed base of light sources which represents asteady and significant consumable and spare parts revenue stream for us, andthey may attempt to supply consumable and spare parts to that installed base.If any existing or future competitors gain market acceptance we could losemarket share and our growth could slow or decline, which could have a materialadverse effect on our operating results, financial condition and cash flows.

 

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

** **

We are highlydependent on the services of many key employees in various areas, including:

 

•                  research anddevelopment;

•                  engineering;

•                  sales and marketing;

 

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•                  field service andsupport;

•                  manufacturing; and

•                  management.

 

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

 

•                  the continued 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

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

 

If weare unable to hire, train and retain key personnel as required, our operatingresults,  financial condition and cashflows could be adversely affected.

 

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

 

Weserve an increasingly global market.  Alarge portion of our total revenues is derived from customers located outsideof the U.S., particularly in Asian countries. We expect our international sales to continue to account for a verylarge portion of our total revenues.  Inorder to support our foreign customers, we maintain a manufacturing and fieldservice subsidiary in Korea as well as field service and support subsidiariesin Japan, the Netherlands, the People’s Republic of China, Singapore andTaiwan.

 

We maynot be able to manage our operations to address and support our globalcustomers effectively.  Further, our investmentsin these types of activities may not make us competitive in the global marketor we may not be able to meet the service, support, and manufacturing levelsrequired by our global customers.

 

Additionally,we are subject to the risks inherent in 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 complyingwith a variety of foreign laws.

 

Many of our major customers and many of thechipmakers who use our light source products in their photolithography systemsare located in Asia. Economic problems and currency fluctuations affectingthese regions in Asia could create a larger risk for us. Further, even thoughit has not been difficult for us to comply with U.S. export controls, theseexport rules could change in the future and make it more difficult orimpossible for us to export our products to many countries.  Any of these

 

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vulnerabilities could have a material adverse effect onour business, financial condition and results of operations.

 

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

** **

Therisks involved with acquiring a new company, forming a joint venture, orentering a new market include the following:

 

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

•                  failure to retain keypersonnel;

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

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

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

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

•                  failure to commercializepurchased technologies;

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

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

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

 

Mergers,acquisitions and joint ventures as well as entering new markets are inherentlysubject to multiple significant risks, and the inability to effectively managethese risks could have a material adverse effect on our business.  In July 2005, we formed a joint venture withZeiss named TCZ GmbH, to produce tools for the manufacture of flat paneldisplays.  This is a new market for bothCymer and Zeiss and may involve numerous risks. Any of these risks could materially harm our business, financialcondition and operating results. Further, any business that we acquire, jointventure that we form or new market we may enter may not achieve anticipatedrevenues or operating results.

 

**Compliance withchanging regulations of corporate governance and public disclosure may resultin additional expenses***.*

 

Changing laws, regulations andstandards relating to corporate governance and public disclosure, including theSarbanes-Oxley Act of 2002, new SEC regulations, Nasdaq Stock Market rules, andnew accounting pronouncements are creating uncertainty and additionalcomplexities for companies such as ours. In particular, the Section 404internal control requirements under the Sarbanes-Oxley Act have added and willcontinue to add complexity and costs to our business and require a significantinvestment of our time and resources to complete each year.  We take these requirements seriously and expect to continue to make every effort toensure that we receive clean attestations on our internal controls each yearfrom our outside auditors. To maintain high standards of corporate governanceand public disclosure, we intend to invest all reasonably necessary resourcesto comply with all other evolving standards. These investments may result inincreased general and administrative expenses and a diversion of managementtime and attention from strategic revenue generating and cost managementactivities.

 

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**Decreased effectiveness of equity compensation couldadversely affect our ability to attract and retain employees, and changes inaccounting for equity compensation could adversely affect earnings.**

 

We have historically usedbroad based stock option programs and other forms of equity-related incentivesas a key component of our employee compensation packages. We believe that stockoptions and other long-term equity incentives directly motivate a broader baseof employees to maximize long-term stockholder value and, through the use of long-termvesting, encourage employees to remain with us. In December 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”),“Share-Based Payment – An Amendment to Statement Nos. 123 and 95,” which wehave adopted as of January 1, 2006.  Thisnew rule requires us to record an expense to earnings for employee stock optiongrants and other equity incentives. Moreover, applicable stock exchange listingstandards relating to obtaining stockholder approval of equity compensationplans has made it more difficult and expensive for us to grant options toemployees, which has resulted in changes to our equity compensation strategy,including a reduction in the number of stock options granted to employees.  We have already developed alternative cashcompensation arrangements for our employees to replace the majority of thesestock option programs and may be required to offer additional alternative cashcompensation arrangements in the future. These and other developments in theprovision of equity compensation to employees could make it more difficult toattract, retain and motivate employees, and such a change in accounting rulesand alternative cash compensation programs may adversely impact our futureoperating results, financial condition and cash flows.

 

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

 

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

 

As ofDecember 31, 2005, we owned 230 U.S. patents covering certain aspects oftechnology related to light sources and piezo techniques. These patents willexpire at various times during the period from January 2008 to October2023.  As of December 31, 2005, we hadapplied for 110 additional patents in the U.S. As of December 31, 2005, we owned 334 foreign patents and had 344 patentapplications pending in various foreign countries.

 

Ourpending patent applications and any future applications might not be approved.Our patents might not provide us with a competitive advantage and may bechallenged by third parties. In addition, third parties’ patents might have anadverse effect on our ability to do business. As a result of cost constraints,we did not begin seeking patent protection in Japan and other countries for ourinventions that are covered by U.S. patents and patent applications until1993.  As a result we do not have theright to seek foreign 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 intellectual propertyrights to the same extent as do the laws of the U.S. Thus, the likelihood ofpiracy of our technology and products is greater in these countries. Further,third parties might independently develop similar products, duplicate ourproducts, or design around patents that are granted to us.

 

Othercompanies or persons may have filed or may file in the future patentapplications that are similar or identical to ours. We may have to participatein appropriate proceedings in the courts or the patent offices to determine thepriority of inventions. These proceedings may determine that these third-partypatent applications have priority over our patent applications. Loss ofpriority in these interference proceedings could result in substantial cost tous.

 

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We alsorely on the following to protect our confidential information and our otherintellectual property:

 

**•**                  trade secret protection;

•                  employee nondisclosureagreements;

•                  third-partynondisclosure agreements; and

•                  other intellectualproperty protection methods.

 

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

 

•                  independently developsubstantially the same proprietary information and techniques;

•                  gain access to our tradesecrets; or

•                  disclose our technology.

 

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

** **

In thepast, funds from research and development arrangements with third parties havebeen used to pay for a portion of our own research and development expenses. Wereceive these funds from government-sponsored programs and customers, inconnection with our designing and developing specific products. Currently,funds from lithography tool manufacturers and chipmakers are used to fund asmall portion of our research and development expenses. In providing theseresearch and development services to these manufacturers, we try to make clearwho owns the intellectual property that results from the research anddevelopment services we perform. However, disputes over the ownership or rightsto use or market this intellectual property may arise between the fundingorganizations and us. Any dispute over ownership of the intellectual propertywe develop could restrict our ability to market our products and have amaterial adverse effect on our business.

 

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

** **

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

 

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

 

We havenotified our competitor and others of our U.S. patent portfolio. Specifically,we have notified Komatsu that it may be infringing some of our U.S. patents. Wehave discussed with Komatsu our claims against each other.  Komatsu challenged one of our U.S. patents inthe 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 withLambda-Physik (a

 

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subsidiary of Coherent,Inc.) regarding allegations by each party against the other for possible patentinfringement. Any of these discussions with our competitor or former competitormay not be successful and litigation could result.

 

In thefuture, 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 have an adverse effect on ourbusiness, financial condition and operating results. Furthermore, our customersand the end-users of our products might assert other claims for indemnificationthat arise from infringement claims against them. If these assertions aresuccessful, our business, financial condition and operating results may bematerially affected. Instead of litigation, or as a result thereof, we may seeka license from third parties to use their intellectual property. However, wemay not be able to obtain a license. Alternatively, we may design around the third party’s intellectualproperty rights 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 harmour business, financial condition and operating results:

 

•                  loss of our proprietary rights;

•                  exposure to significant liabilities by otherthird parties;

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

•                  restriction from manufacturing or selling ourproducts.

 

Any ofthese actions could be costly and would divert the efforts and attention of ourmanagement and technical personnel, which would materially adversely affect ourbusiness, financial condition and results of operations.

 

**Trademark infringementclaims against our registered and unregistered trademarks would be expensiveand we may have to stop using such trademarks and pay damages.**

 

Weregistered the trademarks ‘‘CYMER’’ and “INSIST ON CYMER” and others in the U.S.and in some other countries. We are also trying to register additionaltrademarks in the U.S. and in other countries. We use these trademarks and many other marks in our advertisements andother business 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.

 

**We are dependenton air transport to conduct our business and disruption of domestic andinternational air transport systems could adversely affect our business.**

 

Wedepend on regular and reliable air transportation on a worldwide basis for manyof our routine business functions. If civil aviation in the U.S. or abroad isdisrupted by terrorist activities or security responses to the threat ofterrorism or for any other reason, our business could be adversely affected inthe following ways:

 

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

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

•                  we may not be able to provide timely service orsupport of installed light sources for chipmakers; and

•                  our sales and marketing efforts may be disrupted.

 

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**We areexposed to risks related to the fluctuations in the currency exchange rates forall foreign currencies in which we do business, but particularly for theJapanese yen.**

 

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

** **

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

** **

**Many foreign government standardsand regulations apply to our products. These standards and regulations are always being amended.  Although we intend to meet all foreignstandards and regulations, our products may not comply with these foreigngovernment standards and regulations. Further, it might not be cost effective for us to redesign our productsto comply with these foreign government standards and regulations.  Our inability to design products to complywith foreign standards therefore could have a material adverse effect on ourbusiness.**

 

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

 

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

 

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

 

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

 

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

** **

We areexposed to significant risks for product liability claims if personal injury ordeath results from the use of our products. We may experience material productliability losses in the future. We

 

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maintain insuranceagainst product liability claims. However, our insurance coverage may notcontinue to be available on terms that we accept. This insurance coverage alsomay not adequately cover liabilities that we incur. Further, if our productsare defective, we may be required to recall or redesign these products. Asuccessful claim against us that exceeds our insurance coverage level, or anyclaim or product recall that results in adverse publicity against us, couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

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

 

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

 

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

 

**•**                  the cyclical nature ofthe semiconductor industry;

•                  actual or anticipatedfluctuations in our operating results;

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

•                  announcements ofinnovations in technology;

•                  new products offered byus or our competitor;

•                  developments of patentsor proprietary rights;

•                  changes in financialestimates by securities analysts;

•                  general worldwidepolitical, economic, and market conditions;

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

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

 

**In addition, the stock market hasexperienced extreme price and volume fluctuations that have particularlyaffected the market price for many high technology companies. Such fluctuationshave in some cases been unrelated to the operating performance of thesecompanies. Severe price fluctuations in a company’s stock have frequently beenfollowed by securities litigation.  Anysuch litigation can result in substantial costs and a diversion of management’sattention and resources and therefore could have a material adverse effect onour business, financial condition and results of operations.**

 

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

 

None.

 

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

 

Our corporateheadquarters is located in San Diego, California and includes administrative,manufacturing, engineering, and research and development facilities.  In addition, we have field service officeslocated throughout the U.S. and internationally and have a manufacturing facilitylocated in Korea that we use to refurbish chamber assemblies.  We completed construction of a 265,000square foot building adjacent to our corporate headquarters located in SanDiego, California in the third quarter of 2003. Also in the third quarter of 2003, we transferred all manufacturingactivities and corporate services from two leased facilities in San Diego tothis company-owned manufacturing and office facility.  As of December 31, 2004 we had subleased bothof the facilities we vacated in 2003. In addition to the leased facilities inSan Diego, we also have a much smaller leased facility in Charlestown,Massachusetts.  We subleased a portion ofthis facility in the fourth quarter of 2005.

 

At December 31,2005, details on our leased and owned property 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                                                        |       |
| Portland, Oregon                               |       | April 2006            |       | 1,857                      |       | Field service office                                                      |       |
| Charlestown, Massachusetts                     |       | October 2007          |       | 21,262                     |       | 11,262 square feet subleased 12/05; 10,000 square  feet vacant            |       |
|                                           |       |                  |       |                       |       |                                                                      |       |
| Motoyawata, Japan                              |       | June 2006             |       | 13,831                     |       | Field service and sales office                                            |       |
| Osaka, Japan                                   |       | July 2006             |       | 807                        |       | Field service and sales office                                            |       |
| Hsin-Chu, Taiwan                               |       | June 2008             |       | 4,821                      |       | Field service and sales office                                            |       |
| Goldhill Plaza, Singapore                      |       | June 2007             |       | 1,866                      |       | Field service and sales office                                            |       |
| 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 2006          |       | 4,746                      |       | Field service and sales office                                            |       |

 

----

(1) Land and building are owned by us.

(2) Land leased through December 2020.

 
| **Item 3.**  | ** ** | **Legal Proceedings**                                   |
|--------------|------------|---------------------------------------------------------|
|         |       |                                                    |
|         |       | None.                                                   |
|         |       |                                                    |
| **Item  4.** | ** ** | **Submission of Matters to a Vote of Security Holders** |
|         |       |                                                    |
|         |       | None.                                                   |

 

28

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##### PARTII

 

**Item 5.****          ****Market for Registrant’s CommonEquity, Related Stockholder Matters and Issuer Purchases of Equity Securities.**

 

Our common stock is publicly traded on the Nasdaq National Market underthe symbol “CYMI”. The following table sets forth, for the periods indicated,the high and low prices of our common stock as reported by the Nasdaq NationalMarket.

 

| ** **                       | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|
| **Year ended December 31, 2004** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First quarter                    |       | $          | 50.44      |       | $          | 34.90 |   |
| Second quarter                   |       | $          | 41.99      |       | $          | 30.75 |   |
| Third quarter                    |       | $          | 37.40      |       | $          | 23.81 |   |
| Fourth quarter                   |       | $          | 35.17      |       | $          | 25.69 |   |
|                             |       |       |       |       |       |
| **Year ended December 31, 2005** |       |       |       |       |       |
| First quarter                    |       | $          | 30.00      |       | $          | 22.65 |   |
| Second quarter                   |       | $          | 29.13      |       | $          | 22.96 |   |
| Third quarter                    |       | $          | 36.43      |       | $          | 26.07 |   |
| Fourth quarter                   |       | $          | 40.43      |       | $          | 30.46 |   |

 

Theclosing sales price of our common stock on the Nasdaq National Market was $44.18on March 8, 2006 and there were 265 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 information required to be disclosed by Item 201(d) of RegulationS-K *“Securities Authorized for IssuanceUnder Equity Compensation Plans”* is incorporated herein by referenceto our Proxy Statement for our 2006 annual meeting of stockholders.

 

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**Item 6.****           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,**              | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | **2001****(1)**                           | ** ** | **2002** | ** ** | **2003** | ** ** | **2004 (4)** | ** ** | **2005** | ** ** |
| ** **                                      |       | **(in thousands, except per share data)** |       |
| **Consolidated Statements of Operations Data:** |       |                                      |       |   |   |   |   |   |   |   |   |
| Product sales                                   |       | $                                         | 267,003    |   | $ | 287,995 |   | $ | 265,816 |   | $ | 417,296 |   | $ | 382,638 |   |
| Other                                           |       | 1,948                                     |       | 871 |   | 57 |   | 783 |   | 1,010 |   |
| Total revenues                                  |       | 268,951                                   |       | 288,866 |   | 265,873 |   | 418,079 |   | 383,648 |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Costs and expenses:                             |       |                                      |       |   |   |   |   |   |   |   |   |
| Cost of product  sales                          |       | 151,340                                   |       | 162,095 |   | 187,679 |   | 243,473 |   | 227,290 |   |
| Research and  development (2)                   |       | 61,023                                    |       | 72,580 |   | 56,768 |   | 58,612 |   | 64,025 |   |
| Sales and  marketing                            |       | 19,617                                    |       | 17,153 |   | 16,966 |   | 23,369 |   | 25,143 |   |
| General and  administrative                     |       | 18,990                                    |       | 18,212 |   | 39,094 |   | 31,630 |   | 26,514 |   |
| Purchased  in-process research and development  |       | 5,050                                     |       | — |   | — |   | — |   | — |   |
| Total costs and  expenses                       |       | 256,020                                   |       | 270,040 |   | 300,507 |   | 357,084 |   | 342,972 |   |
| Operating income (loss)                         |       | 12,931                                    |       | 18,826 |   | (34,634 | ) | 60,995 |   | 40,676 |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Other income  (expense) – net              |       | (837                                      | )          | (2,077 | ) | (1,139 | ) | (421 | ) | 5,112 |   |
| Income (loss) before income tax                 |       |                                      |       |   |   |   |   |   |   |   |   |
| provision  (benefit) and minority interest      |       | 12,094                                    |       | 16,749 |   | (35,773 | ) | 60,574 |   | 45,788 |   |
| Income tax provision (benefit)                  |       | 2,871                                     |       | 2,706 |   | (21,464 | ) | 15,144 |   | 262 |   |
| Minority interest                               |       | (368                                      | )          | (447 | ) | (1,091 | ) | (2,276 | ) | 1,026 |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) before cumulative change in       |       |                                      |       |   |   |   |   |   |   |   |   |
| accounting principle                            |       | 8,855                                     |       | 13,596 |   | (15,400 | ) | 43,154 |   | 46,552 |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Cumulative change in accounting principle,      |       |                                      |       |   |   |   |   |   |   |   |   |
| net of taxes                                    |       | (370                                      | )          | — |   | — |   | — |   | — |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Net income (loss)                               |       | $                                         | 8,485      |   | $ | 13,596 |   | $ | (15,400 | ) | $ | 43,154 |   | $ | 46,552 |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic earnings (loss) per share                 |       | $                                         | 0.28       |   | $ | 0.41 |   | $ | (0.44 | ) | $ | 1.17 |   | $ | 1.29 |   |
| Weighted average common shares                  |       |                                      |       |   |   |   |   |   |   |   |   |
| outstanding                                     |       | 30,474                                    |       | 33,317 |   | 35,065 |   | 36,758 |   | 36,017 |   |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Diluted earnings (loss) per share               |       | $                                         | 0.27       |   | $ | 0.39 |   | $ | (0.44 | ) | $ | 1.15 |   | $ | 1.27 |   |
| Weighted average common and dilutive            |       |                                      |       |   |   |   |   |   |   |   |   |
| potential common  shares outstanding            |       | 31,108                                    |       | 34,712 |   | 35,065 |   | 37,584 |   | 36,544 |   |
|                                                 |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

30

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| ** **                           | ** ** | **As of December 31,** | ** ** |
|--------------------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **2001****(1)**        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004 (3)** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **(in thousands)**     | ** ** |
| **Consolidated Balance Sheet Data:** |       |                   |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents (4)        |       | $                      | 96,891     |   | $ | 92,273 |   | $ | 110,632 |   | $ | 114,246 |   | $ | 233,745 |   |
| Working capital                      |       | 257,851                |       | 351,127 |   | 397,790 |   | 452,579 |   | 499,670 |   |
| Total assets                         |       | 483,346                |       | 766,887 |   | 809,244 |   | 818,836 |   | 791,376 |   |
| Total long-term liabilities          |       | 151,772                |       | 255,154 |   | 261,627 |   | 208,035 |   | 151,304 |   |
| Treasury stock                       |       | (24,871                | )          | — |   | — |   | — |   | (50,000 | ) |
| Stockholders’ equity            |       | 254,814                |       | 412,334 |   | 453,330 |   | 517,320 |   | 538,454 |   |
|                                      |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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### **(1)**          Includes results of operations of ActiveControl Experts, Inc. (“ACX”) acquired on February 13, 2001 for the periodssubsequent to its acquisition.

 

(2)          Includes amortization ofgoodwill and intangible assets associated with the acquisition of ACX inFebruary 2001.  These amounts werepreviously shown as a separate line on the consolidated financialstatements.  Amortization of goodwill andintangible assets totaled $3.1 million for the year ended December 31, 2001.Amortization of intangible assets totaled  $160,000 for each of the years ended December31, 2002, 2003 and 2004, and $20,000 for the year ended December 31, 2005.

 

(3)          During the****fourth****quarter of 2004, we corrected our accounting treatment for ourparts refurbishment activities and all amounts associated with this correctionare included in 2004.  This adjustment resultedin a $2.9 million increase in the inventory balance as of December 31, 2004, a$28.5 million 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 further discussion on change inaccounting method for refurbishment activities under Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” underthe caption “Critical Accounting Policies and Estimates” and Item 8 “FinancialStatements and Supplementary Data” Note 1 to our consolidated financialstatements under “Parts Refurbishment”.

 

(4)             In the first quarter of 2005, we reclassifiedauction rate securities from cash and cash equivalents to short-terminvestments. Prior year-end balances were adjusted to conform to thispresentation. As of December 31, 2001, 2002, 2003 and 2004, $14.3 million,$104.4 million, $120.0 million and $86.8 million of auction rate securitieswere reclassified from cash and cash equivalents to short-term investments,respectively.

 

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

 

*The following discussion ofour financial condition and results of operations should be read in conjunctionwith our consolidated financial statements and notes thereto included in thisAnnual Report on Form 10-K.*

 

### **Overview**

 

We are the world’s leading supplier oflight source solutions for the semiconductor industry.  Our products provide the essential lightsource for DUV photolithography systems. Almost all consumer electronic devices manufactured in the last severalyears contain a semiconductor manufactured using light sources such asours.  We currently supply light sourcesto all three lithography tool manufacturers, ASM Lithography, Canon, and Nikon,who in turn supply their wafer steppers and scanners to chipmakers.  Inaddition, we sell replacement parts and services to the lithography toolmanufacturers as well as directly to the chipmakers.  Our light source systems currently constitutea substantial majority of all excimer light sources incorporated in lithographystepper and scanner tools. Our headquarters is located in San Diego, Californiawhere we develop and manufacture all of our light source systems.  As a large portion of our revenue is derivedfrom customers located outside of the U.S., we maintain a manufacturing sparesfacility and field service office in Korea and field service and supportoffices in Japan, the Netherlands, the People’s Republic of China, Singaporeand Taiwan. Japan is currently our only subsidiary office that sells excimerlight source systems. We also maintain field service offices in the U.S. toservice our installed base of light sources located in the U.S.

* *

Sincewe derive a substantial portion of our revenues from photolithography toolmanufacturers, we are subject to the volatile and unpredictable nature of thesemiconductor industry. The

 

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semiconductorindustry is highly cyclical in nature and historically has experienced periodicups and downs, and the activities of the last few years illustrate thiscyclicality.  In 2000, the semiconductorindustry experienced strong growth, which was followed by a three year declinefrom 2001 through late 2003. Growth resumed in the final quarter of 2003 andcontinued through the third quarter of 2004. In the fourth quarter of 2004, the industry declined briefly, thenleveled off early in 2005, and began to improve gradually thereafter.

 

Although 2005 started with revenue levels flat toslightly lower than 2004 levels, we began to see several positive indicatorsfor the semiconductor industry early in 2005, and certain areas of our businessincreased steadily throughout 2005.  Weexperienced sequential quarter over quarter revenue growth throughout 2005.  This revenue growth was due primarily tostrong demand for our consumables and spare parts, which is driven by our pulseusage, but also due to our ability to realize higher ASPs as we sold more ofour newest, most advanced, highest value-added light sources, and fewertrailing edge tools for capacity expansion. In addition, by the end of the year, the utilization rates of our lightsources at chipmakers, which reflect fab activity, had grown 33% over theJanuary level, and reached a record high level, as chipmakers worked to achievehigher productivity.  We saw strongutilization trends in every region. Overall semiconductor fab utilization rose to the low- to mid-90% rangeby the end of 2005, from about 90% in the third quarter of 2005.  Our most advanced technology products werethe main driver of our light source system demand throughout 2005 and shouldcontinue to be a strong driver in the future, since chipmakers must continue toshrink feature size and expand leading edge capacity.

 

Morerecently, business indicators have become more positive, with fab utilizationrates continuing to turn upward, particularly at foundries, and demand forcertain kinds of memory chips growing strongly. We are particularly encouraged by the strong and increasing demand for akind of memory chip called “NAND Flash,” which has been driven by the growingnumber of consumer video entertainment products. With these positive indicatorsthe consensus among industry forecasters is that demand for chips will continueto be strong in 2006, causing semiconductor manufacturers to buy more capitalequipment.  In fact, a number ofchipmakers have announced that they intend to increase their capital spendingin 2006.  Forecasters now expect capitalspending in the semiconductor industry to increase at least 5%, and possibly asmuch as 10% to 12%, in 2006 over 2005.  Weexpect that increasing fab utilization, growing demand for more capable flashmemory, and tight capacity for critical and mid-critical layers on siliconwafers, will drive demand for more lithography tools, particularly advancedtools.  We are strongly positioned as theleading supplier of light sources for advanced dry and immersion ArFlithography, currently the most promising growth segment of the DUVmarket.  However, there remains apossibility that macro-economic factors, such as high energy prices, risinginterest rates, or a slowing real estate market could have a negative impact onconsumer spending, including spending on electronic devices, which drives muchof the demand for chips.

 

Throughout2005, we created shareholder value through improved profitability andexecution.  We focused on and weresuccessful in improving gross margins during the year by reducing cycle times andmaterial costs, and by shifting to a product mix of higher value-added and higherASP ArF light source systems and products. We also focused on improving assetmanagement with particular emphasis on improving inventory management andincreasing operating efficiency and overall cash flows.  In 2005, we also assessed our existinginfrastructure and ability to respond to the increased activity levels that areexpected in 2006 in the semiconductor industry, and we believe we are wellpositioned to respond to these higher activity levels with our expanding ArFproduct offerings in the XLA Series, and with adequate production capacity andfield support infrastructure and personnel.  In 2006, we will continue to focus on all of theseareas, while continuing our efforts to generate a significant amount of cashand improve shareholder returns through higher returns on assets, whichincludes increasing our inventory turns and return on invested capital duringthe year.  In addition, we expect tocontinue to explore opportunities on the most effective use of our cash,including the potential additional repurchase of our own stock and convertiblesubordinated notes.

 

In July 2005, we entered into a jointventure agreement with Zeiss to form TCZ. TCZ is currently developing, and will integrate, market, sell, andsupport, process tools for the flat panel display manufacturing industry.  The joint venture is headquartered in SanDiego and is owned 60% by us and 40% by Zeiss. The joint venture is targetingthe growing market for LTPS processing used in the  manufacture of liquid crystal displays thatare brighter, have higher resolution, and consume less power

 

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than displays using today’s predominant amorphous silicon films.  We currently expect that TCZ will ship anevaluation model of its first production tool, the TCZ 900X, in late 2006 orearly 2007, and we currently expect that TCZ will break even from a financialstandpoint in 2008.

 

# **CRITICALACCOUNTING POLICIES AND ESTIMATES**

 

*General*

 

The discussion and analysis of our financial conditionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financial statements requires us to makeestimates and use judgment that may impact the reported amounts of assets,liabilities, revenues, expenses, and related disclosure of contingent assetsand liabilities.  As a part of ourongoing internal processes, we regularly evaluate our estimates and judgmentsassociated with revenue recognition, valuation of parts used in ourrefurbishment manufacturing process, inventory allowances, warranty provisions,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 that revenuerecognition, valuation of parts used in our refurbishment manufacturingprocess, inventory allowances, warranty provisions, and income taxes requiremore significant judgments and estimates in the preparation of our consolidatedfinancial statements than do other of our accounting estimates and judgments.

 

*Revenue Recognition*

 

Our revenues consistof product sales, which include sales of light source systems, consumable andspare parts, upgrades, service, service contracts and training.  Our revenues also consist of certain fundeddevelopment activities performed for our customers and under governmentcontracts and license agreements.

 

The sales of our light source systems generallyinclude training and installation services. We determined these elementsqualify 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 Staff Accounting Bulletin No. 104, werecognize revenue when the revenue recognition criteria are met for the lightsource system, and accrue the costs of providing the training and installationservices.  We recognize light sourcesystem revenue at one of following three points, depending on the terms of ourarrangement with our customer – 1) shipment of the light source system 2)delivery of the light source system or 3) receipt of an acceptance certificate.For the majority of our light source system sales, the shipping terms areF.O.B. shipping point and revenue is recognized upon shipment. For ourarrangements which include F.O.B. destination shipping terms, revenue isrecognized upon delivery of the light source system to our customer.  Lastly, one of our arrangements includes anacceptance provision, which is satisfied by the issuance of an acceptancecertificate by the customer. For these transactions, we recognize revenue uponreceipt of the acceptance certificate. In addition, we test our light source systems in environments similar tothose used by our customers prior to shipment to ensure that they meetpublished specifications.

 

Revenue from consumables and spare partssales is recognized at the point that legal title passes to the customer, whichis upon shipment from our facility.  For a significant portion of ourspare

 

33

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parts sales, our customers return the consumed assembly to usas part of the sale of the new part.  We reuse some of the material withinthese core assemblies, mainly metal components, for the future build of coreassemblies.  As a result, our revenue consists of both cash and the valueof the reusable parts received from our customers as consideration for thesespare part sales. Revenue associated with our customers’ return of coreassemblies is recognized upon receipt of the returned core assembly.  Theamount of the revenue is determined based upon the fair value of the reusableparts that we expect to yield from the returned core assembly based onhistorical experience.

 

Service and training revenue is recognized asthe services are rendered.

 

For funded development contracts, which areincluded in other revenue, funds received are accounted for on thepercentage-of-completion method based on the relationship of costs incurred tototal estimated costs. Revenues generated from these types of fundeddevelopment contracts are derived from cost sharing contracts between certaincustomers and us. If milestones on these funded development contracts requirethat specific results be achieved or reported by us, revenue is not recognizeduntil that milestone is completed.  For some of the funded developmentcontracts that we enter into with customers and government agencies, weevaluate certain criteria to determine whether recording the funds received asrevenue is appropriate.  If certain conditions are met, these funds arenot recorded as revenue but rather are offset against our own internal researchand development expenses in the period that the milestone is achieved.

 

*                 *Valuation of Parts Used in Refurbishment Manufacturing Process andCorrected Accounting Method

 

Over the last several years as part of our regularbusiness activities, we have conducted significant parts refurbishmentactivities related to some of our core assemblies, in particular our chamberassemblies. The volume of this activity significantly increased in 2004. Theseactivities involve arrangements with our customers where we sell a new part tothe customer at a reduced sales price if the customer returns the consumedassembly that the new part replaces. These returned core assemblies contain a certain amount of material,primarily metal components, that may be reused by us in future coreassemblies.  Upon receipt of theseconsumed assemblies from our customers, we record an entry to recognize theestimated fair value of the reusable components as inventory and revenue or areduction in cost of product sales sold depending on the reason for the partreplacement.  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. The costs of refurbishment are also capitalized as part ofending inventory as incurred.   As partof our normal excess and obsolete inventory analysis, these consumed assembliesare also reviewed on a quarterly basis and an inventory allowance is recordedas appropriate for these parts.  Thevalue that we assign to these core assemblies can be affected by the currentdemand for the reusable parts in our manufacturing operations and the actualyield rate 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 anychanges in the demand for the parts or the yield of the parts included in thesecore assemblies could have a material adverse effect on our financial conditionand results of operations.

 

Prior to the fourth quarter of 2004, we recorded thevalue of this material as a reduction of our cost of product sales in theperiod that the returned assembly was disassembled by our manufacturingoperations and the value of the reusable parts could be determined.  Upon further review of U.S. generallyaccepted accounting principles in the fourth quarter of 2004, we determinedthat we should instead estimate the value and record these consumed assembliesas inventory at the time that we receive the returned assembly from ourcustomer and concurrently record this amount as either revenue or as areduction to cost of product sales depending on the reason for the partreplacement.  Prior to the fourth quarterof 2004 we recorded all such transactions as a reduction to cost of productsales.  During the fourth quarter of 2004, we corrected our accounting treatmentfor these refurbishment activities and recorded the financial impact for all of2004 and prior years in our fourth quarter of 2004 financial statements. 

 

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***Inventory Allowance***

 

We perform an analysis of our inventory allowances onat least a quarterly basis to determine the adequacy of this allowance on ourfinancial statements.  The amount of theinventory allowance is determined by taking into consideration certainassumptions related to market conditions and future demands for our products,including changes to product mix, new product introductions, and/or productdiscontinuances, which may result in excess or obsolete inventory. We determinethe level of excess and obsolete inventory associated with our raw materialsand production inventory, which includes all parts on hand from our refurbishmentactivities, by comparing the on hand inventory balances and inventory on orderto the next 12 months of forecasted demand. We then adjust this calculation for inventory that has a high likelihoodof use beyond one year or can be used in other products that may have lowerdemands.  After this adjustment, wearrive at our total exposure for excess and obsolete inventory within our rawmaterials and production inventory.  Aspart of this analysis, we also determine whether there are potential amountsowed to vendors as 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 $12.7 million and $10.4million at December 31, 2004 and December 31, 2005, respectively. The decreasein this allowance from December 31, 2004 to December 31, 2005 was primarily dueto the disposal of certain obsolete materials during 2005 and an overalldecrease in inventory levels and excess parts as of December 31, 2005.

 

The methodologies used to analyze excess and obsoleteinventory and determine the inventory allowance are significantly affected byfuture demand and usage of our products. There are many factors that could potentially affect the future demandor usage of our products, including the following:

 

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

•                  Rateat which our customers take delivery of our light source systems and ourconsumable and spare parts;

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

•                  Overallmix of light source system models or consumable and spare parts and any changesto that mix required by our customers; and

•                  Utilizationrates of our light sources at chipmakers.

 

Based upon our experience, we believe that theestimates we use in calculating the inventory allowance are reasonable andproperly reflect the risk of excess and obsolete inventory.  If actual demand or the usage periods for ourinventory are substantially different from our estimates, adjustments to ourinventory allowance may be required, which could have a material adverse effecton our financial condition and results of operations.

 

###### *WarrantyProvision*

 

We maintain an accrual for the estimated cost ofproduct warranties associated with our product sales.  Warranty costs include the replacement partsand labor costs to repair our products during the warranty periods.  At the time revenue is recognized, we recorda warranty provision, which is included in cost of product sales in theaccompanying consolidated statements of operations. The warranty coverageperiod and terms for light source systems and consumable and spare parts variesby light source system model.  Thewarranty provision for our products is reviewed monthly and determined by usinga statistical financial model, which takes into consideration actual historicalexpenses, product failure rates, and potential risks associated with ourdifferent products.  This model is thenused to estimate future expenses related to warranty and the required warrantyprovision.  The risk levels andhistorical cost information and failure rates used within this model arereviewed throughout the year and updated as these inputs change over theproduct’s life cycle. Due to the highly technical nature of our light sourcesystem products, the newer model light sources and the modules contained withinthem

 

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have higher inherent warranty risks with their initial shipments andrequire higher warranty provisions until the technology becomes more mature.

 

The total balance in the warranty provision accrual asof December 31, 2004 and December 31, 2005 was $28.2 million and $30.2 million,respectively.  This increase from year toyear is primarily due to the higher level of consumables and spare parts salesthat occurred in the second half of 2005 as compared to the second half of 2004and the reserve amounts remaining in the warranty provision on December 31,2005 related to these sales.  Thisincrease in the spares and consumables portion of the warranty provision in2005 was offset by decreases in the light source systems warranty caused by theoverall mix of systems under warranty to those with lower warranty provisionrequirements and the higher number of light source systems at December 31, 2005which were at the end of the warranty period.

 

We actively engage in product improvement programs andprocesses to limit our warranty costs, but our warranty obligation is affectedby the complexity of our product, product failure rates and costs incurred tocorrect those product failures at customer sites. The industry in which weoperate is subject to rapid technological change, and as a result, weperiodically introduce newer, more complex light sources.  Although we classify these newly releasedlight source models as having a higher risk in our warranty model resulting inhigher warranty provisions, we are more likely to have differences between theestimated and actual warranty costs for these new products.  This is due to limited or no historicalproduct performance data on which to base our future warranty costs.  Warranty provisions for our older and moreestablished light source models are more predictable as we have more historicalinformation available on these products. If actual product failure rates or estimated costs to repair thoseproduct failures were to differ from our estimates, revisions to our estimatedwarranty provision would be required, which could have a material adverseeffect on our financial condition and results of operations.

 

*Income Taxes*

 

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 operations forthe current and preceding years, as well as all currently available informationabout future years should be considered.

 

Wehave considered our industry’s outlook for the future, our historicalperformance and estimated future taxable income, and ongoing tax planningstrategies in assessing the need for a valuation allowance.  Using this information, we have prepared amodel to forecast our expected taxable income in future years and to estimatewhen the benefits of our deferred tax assets are likely to be realized.  Based upon the analysis, with the exceptionof TCZ,  we believe that it is more likelythan not that the results of future operations will generate sufficient taxableincome to realize the deferred tax assets within the period allowed by currentapplicable tax law and, as such, no valuation allowance against deferred taxassets is provided.  However, in the caseof our newly-created joint venture, TCZ, we do not feel that there is sufficientevidence or operating history to conclude that TCZ’s future operating profitsare likely to allow it to utilize its NOL carryforwards and, consequently, afull valuation allowance has been provided against those loss carryforwards inthe amount of $293,000.

 

AtDecember 31, 2005 we had federal tax NOL carryforwards of $29.3 million andfederal tax credits of $19.2 million, both of which begin to expire in 2020.  At December 31, 2005, we had state tax creditcarryforwards of $15.2 million, of which $3.5 million begin to expire in 2009,and $11.7 million may be carried forward indefinitely.  At December 31, 2005 we had foreign NOL carryforwards of $1.8 millionwhich may be carried forward indefinitely.

 

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Amaterial adverse change in the outlook for worldwide lithography tool sales,the expected selling prices or profit margins for our products or our expectedshare of the global market for lithography light sources, could cause us todetermine that additional valuation allowances are needed for some or all ofour deferred tax assets, and would result in an increase to our income taxprovision in the period in which such determination is made.

 

Ourresults reflect the impact of the American Jobs Creation Act of 2004, whichrepealed the Extraterritorial Income Exclusion (“ETI”) subject to certaintransition rules. The ETI benefit is being replaced with a ManufacturingActivity deduction under Internal Revenue Code (“IRC”) Section 199, with aphase out of ETI benefits in 2005 and 2006. Our estimated ETI benefit for 2005 reflects the transition rules.

 

We have not provided for the U.S. federal income andforeign withholding taxes on $53.3 million of undistributed earnings fromnon-U.S. operations as of December 31, 2005 as it is our intention to reinvestundistributed earnings of our foreign subsidiaries and thereby indefinitelypostpone their remittance.  Accordingly,no provision has been made for foreign withholding taxes or U.S. income taxeswhich may become payable if undistributed earnings of foreign subsidiaries werepaid to us as dividends.  Currently, weare not considering the repatriation of any foreign earnings and as such, noimpact is reported in the financial statements as of December 31, 2005. It isnot practicable to estimate the amount of the deferred tax liability on suchunremitted earnings.

 

The American Jobs Creation Act of 2004 and IRC Section965 allow a temporary 85% dividends received deduction on repatriated foreignearnings if the funds are reinvested in the U.S.  We have evaluated the impact of repatriationof foreign earnings under IRC Section 965 and concluded that we will notrepatriate any foreign earnings under these provisions.

 

### **RESULTS OF OPERATIONS**

 

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

 
| ** **                                                                 | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                 | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues:                                                                  |       |                         |       |   |   |   |   |
| Product sales                                                              |       | 100.0                        | %          | 99.8 | % | 99.6 | % |
| Product sales - related  party                                             |       | —                       |       | — |   | 0.1 |   |
| Other                                                                      |       | —                       |       | 0.2 |   | 0.3 |   |
| Total revenues                                                             |       | 100.0                        | %          | 100.0 | % | 100.0 | % |
|                                                                       |       |                         |       |   |   |   |   |
| Cost and expenses:                                                         |       |                         |       |   |   |   |   |
| Cost of product  sales                                                     |       | 70.6                         |       | 58.2 |   | 59.2 |   |
| Research and  development                                                  |       | 21.4                         |       | 14.0 |   | 16.7 |   |
| Sales and  marketing                                                       |       | 6.3                          |       | 5.6 |   | 6.6 |   |
| General and  administrative                                                |       | 14.7                         |       | 7.6 |   | 6.9 |   |
| Total costs and  expenses                                                  |       | 113.0                        |       | 85.4 |   | 89.4 |   |
|                                                                       |       |                         |       |   |   |   |   |
| Operating income (loss)                                                    |       | (13.0                        | )          | 14.6 |   | 10.6 |   |
|                                                                       |       |                         |       |   |   |   |   |
| Other income (expense) – net                                          |       | (0.5                         | )          | (0.1 | ) | 1.3 |   |
|                                                                       |       |                         |       |   |   |   |   |
| Income (loss)  before income tax provision (benefit) and minority interest |       | (13.5                        | )          | 14.5 |   | 11.9 |   |
|                                                                       |       |                         |       |   |   |   |   |
| Income tax provision (benefit)                                             |       | (8.1                         | )          | 3.6 |   | 0.1 |   |
| Minority interest                                                          |       | (0.4                         | )          | (0.6 | ) | 0.3 |   |
|                                                                       |       |                         |       |   |   |   |   |
| Net income (loss)                                                          |       | (5.8                         | )%         | 10.3 | % | 12.1 | % |
| Gross margin on product sales                                              |       | 29.4                         | %          | 41.7 | % | 40.6 | % |

 

 

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### **YEARS ENDED DECEMBER31, 2004 AND 2005**

 

*Revenues*. The types of revenue that we generateand how we recognize revenue for each is explained above under the heading “CriticalAccounting Policies and Estimates.”

 

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

 

| ** **                     | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------|------------|------------------------------|------------|
| ** **                     | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2005** | ** ** |
|                           |       |                         |       |   |   |   |   |
| Light source systems:          |       |                         |       |   |   |   |   |
| Revenue                        |       | $                            | 160,302    |   | $ | 244,840 |   | $ | 207,402 |   |
| Units sold                     |       | 163                          |       | 301 |   | 207 |   |
| Average selling  price (1)     |       | $                            | 983        |   | $ | 827 |   | $ | 982 |   |
|                           |       |                         |       |   |   |   |   |
| Consumable and spare parts and |       |                         |       |   |   |   |   |
| service products               |       | $                            | 105,514    |   | $ | 172,456 |   | $ | 175,236 |   |
| Other revenue                  |       | $                            | 57         |   | $ | 783 |   | $ | 1,010 |   |
|                           |       |                         |       |   |   |   |   |
| Total revenue                  |       | $                            | 265,873    |   | $ | 418,079 |   | $ | 383,648 |   |
|                                |            |                              |            |  |  |  |  |  |  |  |  |

 

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(1)          Calculation of averageselling price includes $4.2 million deferred light source revenue during 2004and excludes $4.2 million deferred light source revenue that was recognized in2005.  We had one arrangement where aportion of the light source system fee was not payable until the system wasinstalled successfully at the end-user. This arrangement expired in March 2005.

 

Productsales decreased 8% from $417.3****million for2004 to $382.6 million for 2005.  Thisdecrease in product sales was due to lower light source system revenuespartially offset by higher consumable and spare parts and service productrevenues during 2005 as compared to 2004. Light source system revenuesdecreased 15% from $244.8 million for 2004 to $207.4 million for 2005.  A total of 301 light source systems were soldin 2004 at an average selling price of $827,000, compared to 207 systems soldin 2005 at an average selling price of $982,000.  On a foreign currency adjusted basis, theaverage selling price for 2004 was $816,000 compared to $984,000 for 2005. Theincrease in the average selling price from year to year reflected the shift inthe product mix from capacity driven lower priced KrF products in 2004 tohigher priced technology buys of advanced ArF products in 2005. The decrease inquantities of light source systems sold from year to year was due to the briefupturn 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 offset by a 2% increase in revenues associatedwith our consumable and spare parts and service products from $172.5 millionfor 2004 to $175.2 million for 2005. Revenues from funded development contracts were $783,000 for 2004,compared to $1.0 million for 2005.  Therewere no revenues recorded or earned associated with the TCZ joint venture for2005.  As a result of the current marketconditions and the anticipated semiconductor industry growth, we expect ourrevenue to increase between 15% and 18% in the first quarter of 2006 comparedto the fourth quarter of 2005.

 

Our backlog at December 31,2004 was $79.1 million compared to $90.8 million at December 31, 2005.  Bookings for the years ended December 31,2004 and December 31, 2005 were $393.3 million and $395.4 million,respectively.  The book-to-bill ratio forthe quarter ended December 31, 2004 was 0.80 compared to 1.17 for the quarterended December 31, 2005.  The increase inthe backlog  is due to the changing conditionof the semiconductor industry from year to year.  The backlog as of December 31, 2004 reflectedthe brief slowdown and flattening in the semiconductor industry that started inlate 2004, whereas the backlog as of December 31, 2005 reflects the recent startof what is anticipated to be a growth phase in the semiconductor industry.  The increase in bookings was primarily

 

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due to increased orders of light sourcesystems in the fourth quarter of 2005 as compared to the fourth quarter of2004.

 

We installed 279 lightsources at chipmakers and other end-users during 2004 as compared to 245 lightsources installed during 2005.

 

Sales to our three largestcustomers, ASM Lithography, Canon, and Nikon, amounted to 34%, 11% and 22%,respectively, of total revenue for 2004, and 32%, 8% and 24%, respectively, oftotal revenue for 2005.

 

Our sales are generated primarily by shipments tocustomers in Japan, Europe, and the U.S. Approximately 82% and 84% of our sales for 2004 and 2005, respectively,were derived from customers outside the U.S. We maintain a wholly owned Japanese subsidiary, which sells to ourJapanese customers.  Revenues fromJapanese customers, generated primarily by Cymer Japan, accounted for 32% and 31%of total revenues for 2004 and 2005, respectively. The activities of ourJapanese subsidiary are limited to sales and service of products purchased bythem from us as the parent corporation. We anticipate that international saleswill continue to account for a significant portion of our net sales.

 

*Cost of Product Sales*. Cost ofproduct sales includes direct material and labor, warranty expenses, licensefees, and manufacturing and service overhead, and foreign exchange gains andlosses on foreign currency forward exchange contracts (“forward contracts”) associatedwith purchases of our products by our Japanese subsidiary 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 and such costs are not significant.

 

The cost of productsales decreased 7% from $243.5 million for 2004 to $227.3 million for 2005. Thisdecrease in the cost of product sales was primarily due to lower light sourcesystem sales in 2005 compared to 2004.  In addition, the decrease in the cost ofproduct sales from year to year also reflects lower overall product costs as aresult of our material costs reduction efforts.

 

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 gross marginfor 2004 was favorably impacted by approximately two percentage points due to acustoms refund that was received by our Korea office and credited to cost ofproduct sales. Gross margin in the second half of 2005 was improved from thefirst half of the year due to increased factory yield and utilization and decreasedcycle times and overall material costs.  Going forward, we anticipate our gross marginwill increase due to increasing revenue levels, improved efficiencies andcontinued benefits from our product cost reduction activities.

 

*Research and Development*. Research and development expenses include costs of internally-funded andexternally-funded projects as well as continuing product development supportexpenses, which consist primarily of employee and material costs, depreciationof equipment and other engineering related costs.  Our research and development expenses areoffset by amounts associated with certain of our externally funded research anddevelopment contracts.  Research anddevelopment expenses increased 9% from $58.6 million for 2004 to $64.0 millionfor 2005 due primarily to costs associated with our LTPS product developmentefforts and EUV light source development. Research and development expenseswere offset by amounts related to our externally funded research anddevelopment contracts of $7.6 million and $2.8 million for 2004 and 2005,respectively.  In addition to ourdevelopment of EUV and LTPS technologies during 2005, we also continued tofocus on next generation ArF products based on the XL platform and nextgeneration KrF products.   As a percentage of total revenues, researchand development expenses increased from 14.0% for 2004 to 16.7% for 2005 dueprimarily to increased research and development efforts and lower revenues in2005 as compared to 2004.  As a result ofour decision to enter the flat panel display manufacturing tools market withthe formation of the TCZ joint venture, our research and development

 

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expenses going forward will also include agreater focus on LTPS product development efforts.  In addition, research and developmentexpenses will be higher in 2006 as a result of our adoption of SFAS 123R, stockoption expensing, on January 1, 2006.

 

*Sales and Marketing*. Sales and marketing expenses include theexpenses of the sales, marketing and customer support staff and other marketingexpenses.  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 reflects increasedsales expenses associated with our chipmaker customers at our foreign locationsand market development costs associated with the TCZ joint venture. Theseexpenses were offset by decreased profit sharing and bonus expenses incurred in2005 compared to 2004.  As a percentageof total revenues, such sales and marketing expenses increased from 5.6% for2004 to 6.6% for 2005.  We expect that oursales and marketing expenses will increase slightly as a result of the new stockoption expensing requirements in 2006.

 

*General and Administrative*.General and administrative expenses consist primarily of management andadministrative personnel costs, professional services and administrative operatingcosts.  General and administrativeexpenses decreased 16% from $31.6 million for 2004 to $26.5 million for 2005primarily due to the receipt of rent payments in 2005 from the tenants in twoof our San Diego facilities, which we subleased in the third and fourthquarters of 2004. General and administrative expenses in 2004 also included$3.0 million in costs associated with revisions of our estimates related to thetiming and market rates for subleasing the San Diego and Charlestownfacilities, which we exited in 2003 compared to $384,000 of such expensesrecorded in 2005. The lower general and administrative expenses in 2005 wereoffset by increased stock-based compensation expense associated withnon-employees and initial expenses associated with the TCZ joint venture duringthe year.  As a percentage of totalrevenues, general and administrative expenses decreased slightly from 7.6% for2004 to 6.9% for 2005.  We anticipate thatgeneral and administrative expense levels will increase as a result of the newstock option expensing requirements in 2006.

 

*Total Other Income (Expense) -Net.*  Net other income (expense) consistsprimarily of interest income and expense, foreign currency exchange gains andlosses associated with fluctuations in the value of the functional currenciesof our foreign subsidiaries against the U.S. dollar, and gains and lossesassociated with debt extinguishment transactions.  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 was primarily due to an increase in interestincome, a decrease in interest expense and a higher gain on debt extinguishmentrelated to our notes repurchase activities from year to year. This was offsetby a foreign currency exchange loss recorded in 2005 compared to a small foreigncurrency gain recorded in 2004. The increase in interest income from 2004 to2005 reflected higher market interest rates for our short-term and long-terminvestments on higher cash and investment balances.. The decrease in interestexpense from year to year was due to our lower debt balances as a result of therepurchase of our convertible subordinated notes that we made in the thirdquarter of 2004 and the second quarter of 2005. Foreign currency exchange gains totaled $82,000, interest income totaled$8.1 million, interest expense totaled $9.5 million and gain on debtextinguishment totaled $911,000 for 2004, compared to a foreign currencyexchange loss of $1.1 million, interest income of $10.9 million, interestexpense of $6.9 million and gain on debt extinguishment totaling $2.2 millionfor 2005.

 

*Income Tax Provision*.**The tax provision of $15.1 million and $262,000 for 2004and 2005, respectively, reflects an annual effective rate of 25% and less than1%, respectively. The change in the annual effective tax rate from period toperiod was primarily attributable to the decrease in pre-tax earnings as wellas tax benefits from U.S. export incentive programs and research credits.Included in the income tax provision for 2005 are corrections to income taxexpense that resulted from a weakness in our internal control policies andprocedures regarding the reconciliation of income tax accounts that were notdesigned with adequate precision and our process and procedures over ourforeign tax provisions did not provide for adequate review as of December 31,2005.  These corrections resulted in an$804,000 reduction in our income tax provision for the year ended December 31,2005.  Although the corrections were notconsidered material to our consolidated financial statements, we assessed amaterial weakness in our internal controls over accounting for income taxesunder the Sarbanes-Oxley section 404 requirements as of December 31, 2005.  The annual effective tax rates for bothperiods were less than the U.S. statutory rate of 35% primarily as a result ofpermanent book/tax differences and tax credits. The effective tax rate is afunction of current tax law and geographic location of pre-tax income. Duringthe fourth quarter of 2005, the expiration of certain statutes of limitationsrelated primarily to U.S. federal tax credits and deductions allowed us torelease tax reserves in the amount of $4.2 million. As a result, our fourthquarter of 2005 annualized effective tax rate was a benefit rate of 11%resulting in an annual effective tax rate of less than 1%. The decision torelease tax reserves is made each quarter based on all relevant facts andcircumstances. We do not expect the release of tax reserves to have asignificant impact on our effective tax rate in future years.

 

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The Research andExperimentation Credit was extended under the Working Families Tax Relief Actfor amounts paid or incurred after June 30, 2004 and before 2006. The ETI wasrepealed by the American Jobs Creation Act of 2004 subject to certaintransition rules. The ETI exclusion is being replaced with a ManufacturingActivity deduction under IRC Section 199 with a phase out of ETI benefits in2005 and 2006. Our estimated ETI benefit for 2005 reflects the transitionrules. We did not benefit from the Section 199 deduction in 2005 due to thetaxable income limitation. The benefit is available to us for future tax yearssubject to certain transition rules. We anticipate that the benefit availableto us under both regimes will be comparable for years in which we have taxableincome.

 

### **YEARS ENDED DECEMBER31, 2003 AND 2004**

 

*Revenues*. Productsales increased 57% from $265.8****million in2003 to $417.3 million in 2004, primarily due to a 53% increase in light sourcesystem revenue from $160.3 million in 2003 to $244.8 million in 2004.  A total of 163 light source systems were soldin 2003 at an average selling price of $983,000, compared to 301 systems soldin 2004 at an average selling price of $827,000.  On a foreign currency adjusted basis, theaverage selling price for 2003 was $963,000 compared to $816,000 for 2004. Thedecrease in the average selling price from period to period reflected the shiftin the product mix to capacity driven lower priced KrF products in 2004.  Product sales were further increased fromperiod to period due to a 63% increase in sales of consumable and spare partsand service products from $105.5 million in 2003 to $172.5 million in 2004.Included in the sales of consumable and spare parts and service revenues wererevenues associated with the receipt of reusable material contained withinconsumed core assemblies returned from our customers.  These revenues totaled $28.5 million for2004. There were no such revenues recorded in 2003. See further discussion underValuation of Parts Used in Refurbishment Manufacturing Process and CorrectedAccounting Method under Item 7 Management’s Discussion and Analysis of FinancialCondition and Results of Operations under the caption “Critical AccountingPolicies and Estimates” and Item 8 “Financial Statements and Supplementary Data”Note 1 to our consolidated financial statements under “Parts Refurbishment”.  The increase in this type of product saleswas due to increased utilization of our DUV light source by chipmakers duringmost of 2004 and an increased installed base in 2004.  Revenues from funded development contractswere $57,000 in 2003, compared to $783,000 for 2004.

 

Sales to our three largestcustomers, ASM Lithography, Canon, and Nikon, amounted to 24%, 24% and 21%,respectively, of total revenue for 2003, and 34%, 11% and 22%, respectively, oftotal revenue for 2004.

 

Approximately 88% and 82% of our sales for 2003 and2004, respectively, were derived from customers outside the U.S.  Revenues from Japanese customers, generatedprimarily by Cymer Japan, accounted for 44% and 32% of total revenues in 2003and 2004, respectively.

 

*Cost of Product Sales*. The cost of product sales increased 30%from $187.7 million for 2003 to $243.5 million for 2004. This increase in thecost of product sales was primarily due to the overall increase in productsales from year to year. Both light source system sales and sales of consumableand spare parts and service products were higher in 2004 compared to 2003. Inaddition, the increase in the cost of product sales reflects the change in ouraccounting treatment for parts used in our refurbishment manufacturing processand the reclassification of these transactions as revenue rather than a creditto cost of product sales. The increase in cost of product sales also reflectedthe reduction in force activities which took place in October 2004 and mainlyimpacted manufacturing personnel. The increase in the cost of product sales waspartially offset by the product costs associated with the shift in our productmix to lower cost KrF products and our overall material cost reduction targetson a variety of products. This increase in the cost of product sales was alsooffset by a $2.3 million Korean customs refund realized in the fourth quarterof 2004.

 

The gross margin onproduct sales was 29.4% for 2003 as compared to 41.7% for 2004.  This higher gross margin was primarily due tothe improved efficiencies and costs associated with our XL Series light sourceand the shift to our lower cost and higher margin KrF products in 2004 ascompared to 2003.  The higher grossmargin in 2004 also reflected increased factory yield and utilization,increased and improved field utilization and efficiency and significant successin our material cost

 

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reduction efforts. In addition, gross margin wasfavorably impacted in 2004 by a couple of percentage points due to the Koreancustoms refund of $2.3 million.

 

*Research and Development*. Research and development expenses increased 3% from $56.8 million for2003 to $58.6 million for 2004, due primarily to costs associated with our EUVlight source development, new business opportunity development and costsassociated with the profit sharing and bonus plans, which were earned byemployees in 2004. Research and development expenses were offset by amountsrelated to our externally funded research and development contracts of $1.6million and $7.6 million for the years ended December 31, 2003 and 2004,respectively.  In addition to ourdevelopment of EUV, we also continued to focus on next generation KrF and ArFproducts based on the XL platform.  As apercentage of total revenues, research and development expenses decreased from21.4% for 2003 to 14.0% for 2004 due primarily to lower revenues in 2003compared to 2004.

 

*Sales and Marketing*.  Salesand marketing expenses increased 38% from $17.0 million for 2003 to $23.4 millionfor 2004.  This increase in sales andmarketing expenses from year to year primarily reflected the expensesassociated with the profit sharing and bonus plans, which were earned byemployees in 2004 and increased marketing expenses associated with our internationalsubsidiaries in 2004.  As a percentage oftotal revenues, such sales and marketing expenses decreased from 6.3% for 2003to 5.6% for 2004.

 

*General and Administrative*. General and administrative expensesdecreased 19% from $39.1 million for 2003 to $31.6 million for 2004 due to anumber of factors. First of all, we incurred a $15.6 million tenant improvementwrite-off in 2003 associated with the facilities we vacated during the thirdquarter of that year. This tenant improvement write-off resulted in a decreasein depreciation expense in 2004, which is allocated among the various expenseclassifications.  Although we weresuccessful in subleasing our San Diego facilities in 2004, we did incur a lossassociated with one of the subleases. General and administrative expenses in 2004 included $3.0 million incosts associated with such subleasing activities for our San Diego andCharlestown facilities.  In addition,general and administrative expenses were higher in 2004 as compared to 2003 dueto the expenses associated with our bonus and profit sharing plans, which wereearned by employees in 2004 and significant consulting and external audit feesassociated with our compliance with the internal control reporting requirementsunder Section 404 of the Sarbanes-Oxley Act.  As a percentage of total revenues, such expenses decreased from 14.7%for 2003 to 7.5% for 2004.

 

*Total Other Income (Expense) -Net.*  Net otherexpense totaled $1.1 million and $421,000 for 2003 and 2004, respectively.  The decrease in net other expense was due toa decrease in interest expense from year to year, a gain on debt extinguishmentrelated to our notes repurchases that we made in the third quarter of 2004 anda $281,000 gain recorded for a sale of investments during 2004. Interestexpense was reduced from year to year due to our lower debt balances as aresult of the repurchases of notes made in 2004. This decrease in net otherexpense from year to year was offset by a decrease in interest income and adecrease in foreign currency gains. The decrease in interest income reflectedlower market interest rates for our short-term and long-term investments. Theforeign currency gain in 2004 was reduced by a net $1.1 million loss associatedwith the discontinuance of certain cash flow hedges during the third quarter of2004.  Foreign currency exchange gainstotaled $436,000, interest income totaled $8.9 million and interest expensetotaled $10.5 million for 2003, compared to foreign currency exchange gains of$82,000, interest income and other income of $8.1 million, interest expense of$9.5 million and a gain on debt extinguishment of $911,000 for 2004.

 

*Income Tax Provision(Benefit)*.  The tax benefit of $21.5 million and the taxprovision of $15.1 million for the years ended December 31, 2003 and 2004,respectively, reflected an annual effective rate of 60% and 25%,respectively.  The change in the annualeffective tax rate during the year ended December 31, 2004 from a benefit rateof 60% to a provision rate of 25% was primarily attributable to the increase inpre-tax earnings as well as tax benefits from U.S. export incentive programsand research and development and manufacturing investment credits. The annualeffective tax rates for both periods were less than the U.S. statutory rate of35% primarily as a result of permanent book/tax differences and tax credits.The effective tax rate is a function of current tax law and geographic location

 

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of pre-tax income.  The Research and Experimentation Credit wasextended under the Working Families Tax Relief Act for amounts paid or incurredafter June 30, 2004 and before 2006.  TheAmerican Jobs Creation Act of 2004 repealed the ETI exclusion subject tocertain transition rules.  The ETIexclusion is being replaced with a Manufacturing Activity deduction under IRCSection 199. The benefit will be available to us for tax years beginning in2005, subject to certain transition rules. We anticipate that the benefitavailable to us under both regimes is comparable for years in which we havetaxable income.

 

#### **LIQUIDITY AND CAPITAL RESOURCES**

 

Historically we have fundedour operations primarily from cash generated from operations, the proceeds ofthe note offerings in August 1997 and February 2002, bank borrowings, and theproceeds from employee stock option exercises. As of December 31, 2005, we had approximately $233.7 million in cash andcash equivalents, $130.2 million in short-term investments, $29.4 million inlong-term investments, and $499.7 million in working capital.

 

In February 2002, we issued $250.0 million in aggregateprincipal amount in a private placement of notes.  These notes are due on February 15, 2009 withinterest payable semi-annually on February 15 and August 15 of each year at3.50% per annum.  The notes areconvertible into shares of our common stock at a conversion rate of 20 sharesper $1,000 principal amount or an effective conversion price of $50.00 pershare.  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 million and $60.0 million principal amount of these notes in 2004 and2005, respectively. As of December 31, 2005, there were $140.7 millionprincipal amount of notes outstanding.

 

Netcash provided by operating activities was approximately $34.2 million and $114.0million for 2004 and 2005, respectively, compared to $3.6 million used inoperating activities for 2003. Net cash used in operating activities during2003 reflects the net loss for the year due to the downturn in thesemiconductor industry. This net loss for the year also reflects additionaloverall costs associated with our new XLA 100 light source system and itsintroduction to manufacturing in early 2003. Cash was further reduced by increases in customer accounts receivable,decreases in accounts payable, and accrued expenses and other liabilitiesoffset by a decrease in inventory from year to year.  Net cash provided by operating activitiesduring 2004 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 quarter ended December 31,2004. The increase in inventories was primarily due to our response to thegrowing light source utilizations that we experienced during the first threequarters of 2004 and higher spares inventories to support what we thought wouldbe a continued upturn in the semiconductor industry. When the industry startedto slow down in the third and fourth quarters of 2004, we took action to reduceour spares and consumables inventory.  Asa result of these actions, our inventory decreased by $10.6 million in thefourth quarter of 2004.  Net cashprovided by operating activities during 2005 reflects net income for the year,significant decreases in accounts receivable and inventory and increases in accountspayable. The decrease in accounts receivable reflects collections we made inour receivable balances that were outstanding as of December 31, 2004. Thedecrease in inventory reflects the reduction in our field and factory inventoryas a result of our ongoing initiative during 2005 to improve asset managementby reducing inventory and increasing inventory turns.

 

Netcash provided by investing activities was approximately $272,000 and $78.6million for 2004 and 2005, respectively, compared to $20.8 million used ininvesting activities for 2003. In 2003, the cash used in investing activitieswas due primarily to the continued construction of the new manufacturing andoffice facility in San Diego and purchases of required manufacturing equipmentfor the new facility. These capital acquisitions during the year were offset bythe timing of short-term and long-term investments that matured and werereinvested during the year.  Net cash providedby

 

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investingactivities during 2004 reflects the timing of short-term and long-terminvestments maturing and being reinvested during the year, purchases ofproperty and equipment, a $6.0 million payment to acquire certain patents and a$2.0 million payment to acquire an additional 6% minority interest in our CymerKorea subsidiary. Net cash provided by investing activities during 2005reflects the timing of short-term and long-term investments that matured andwere reinvested during the year, the acquisition of $18.8 million of propertyand equipment and a $2.5 million payment to acquire certain patents.

 

Net cash provided by financing activities wasapproximately $41.4 million for 2003, compared to net cash used in financingactivities of $32.0 million and $71.0 million in 2004 and 2005, respectively.In 2003, net cash provided by financing activities was primarily due toproceeds from the exercise of employee stock options of $48.2 million offset bya $6.7 million payment on our Japanese revolving loan, which occurred in June2003.  In 2004, net cash used infinancing activities reflects the repurchase of approximately $49.2 million principalamount of our convertible subordinated notes in the third quarter of 2004, at adiscount to par.  This was offset byproceeds received from the exercise of stock options totaling $15.4 millionduring 2004. Net cash used in financing activities during 2005 reflects therepurchase of shares of our stock in the market totaling $50.0 million and therepurchase of approximately $60.0 million principal amount of our convertiblesubordinated notes, at a discount to par. The treasury stock and noterepurchases were partially offset by proceeds received from the exercise ofemployee stock options totaling $25.2 million and the minority interestinvestment received from Zeiss in the TCZ joint venture of $11.1 million in2005.

 

We require substantialworking capital to fund our business, particularly to finance inventories,including purchase orders with our vendors, accounts receivable, and forcapital expenditures.  Our future capitalrequirements depend on many factors, including our manufacturing activity, thetiming and extent of spending to support product development efforts, expansionof sales and marketing and field service and support, competitive labor marketcompensation requirements, the timing of introductions of new products andenhancements to existing products, and the market acceptance of our products.We believe that cash generated from operations along with the liquidity providedby our existing cash balances and short-term investments will be sufficient tosustain operations and provide for any potential future expansion of ourbusiness for at least the next 12 months.

 

**TABULAR DISCLOSURE OF CONTRACTUALOBLIGATIONS**

 

The following summarizes our contractual obligations and othercommitments as of December 31, 2005, and the impact such obligations could haveon our liquidity and cash flow in future periods (in thousands):

 
| ** **                                 | ** ** | **Amount of Commitment Expiring by Period** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **Total**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
|                                       |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Operating lease obligations (1)            |       | $                                           | 15,693     |   | $ | 4,999 |   | $ | 3,965 |   | $ | 3,380 |   | $ | 3,278 |   | $ | 71 |   |
| Convertible subordinated notes             |       | 140,722                                     |       | — |   | — |   | — |   | 140,722 |   | — |   |
| Interest on convertible subordinated notes |       | 17,238                                      |       | 4,925 |   | 4,925 |   | 4,925 |   | 2,463 |   | — |   |
| Purchase orders                            |       | 48,215                                      |       | 48,215 |   | — |   | — |   | — |   | — |   |
|                                       |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total commitments                          |       | $                                           | 221,868    |   | $ | 58,139 |   | $ | 8,890 |   | $ | 8,305 |   | $ | 146,463 |   | $ | 71 |   |

 

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(1)                We currentlysublease all or a portion of our leased facilities, and the payments receivedunder these are direct offsets to our operating lease obligations. The amountsin the table above represent the gross lease amounts and the following tablesummarizes amounts to be received under these non-cancelable subleaseagreements (in thousands):

 

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| ** **                | ** ** | **Future Sublease Payments** | ** ** |
|---------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **Total**                    | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
|                      |       |                         |       |   |   |   |   |   |   |   |   |
| Total sublease agreements |       | $                            | 9,725      |   | $ | 3,471 |   | $ | 3,604 |   | $ | 1,526 |   | $ | 1,124 |   |
|                           |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

**SUBSEQUENTEVENTS**

 

On January 2, 2006, we acquired the remaining 19%minority interest in our majority-owned subsidiary, Cymer Korea.  We paid a total of $7.0 million for this 19%interest. This transaction increased our total interest in Cymer Korea from 81%to 100%.

 

In the ordinary course of business, we maintain lifeinsurance policies on certain executives as a means of funding our executivedeferred compensation plan.  In January2006, one of our senior executives for whom we held such a policy passedaway.  As a result, we received a net$3.2 million in insurance proceeds in the first quarter of 2006.  These net proceeds will be included in otherincome on our statement of operations for the quarter ending March 31, 2006.

 

# **RECENT ACCOUNTINGPRONOUNCEMENTS**

 

In November 2004, the FASB issuedStatement of Financial Accounting Standards No. 151 (“SFASNo. 151),  “Inventory Costs, an amendment of ARB 43, Chapter 4”. This statement amends Accounting Research Bulletin No. 43 (“ARBNo. 43”), Chapter 4, to clarify accounting for abnormal amounts of idlefacility expense, freight, handling costs and wasted material.  SFASNo. 151 requires that those items be recognized as current-periodcharges.  SFAS No. 151 is effective for fiscal years beginning afterJune 15, 2005.  We have adopted SFAS No. 151 on January 1, 2006 andwe do not believe that its adoption will have a significant impact on ourconsolidated financial statements.

 

In December 2004, the FASB issued SFASNo. 123R, “Share-Based Payment - An Amendment to Statement Nos. 123 and95,” that addresses the accounting for share-based payment transactions inwhich an enterprise receives employee services in exchange for (a) equityinstruments of the enterprise or (b) liabilities that are based on thefair value of the enterprise’s equity instruments or that may be settled by theissuance of such equity instruments. This statement will eliminate the abilityto account for share-based compensation transactions using Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,”and will require instead that such transactions be accounted for using afair-value-based method.  On April 14, 2005, the SEC announced thedeferral of the effective date of SFAS No. 123R. The deferral allowscompanies to adopt the provisions of SFAS No. 123R beginning on the firstannual period beginning after June 15, 2005. Based on the new requiredadoption date, we have adopted SFAS No. 123R as of January 1, 2006.

 

We have evaluated the impact and implementation ofSFAS No.123R and how this new pronouncement will effect our consolidatedfinancial statements. We anticipate that the adoption of SFAS No. 123Rwill have a significant impact on our consolidated statements of operations,although it will have no impact on our cash position.  Our evaluationincluded a determination on how future stock awards will be valued based on anappropriate fair value model upon adoption of SFAS No. 123R as

 

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well as the impact of stock compensation expenseassociated with unvested stock options outstanding as of December 31,2005.  In addition, as a result of the amendment to our employee stockpurchase plan, effective May 1, 2005, our employee stock purchase plan isa non-compensatory plan under SFAS No. 123R, and, therefore, no stockcompensation expense will be recorded under the employee stock purchase planupon the adoption of SFAS No. 123R.  As of December 31, 2005, theunamortized compensation expense related to outstanding unvested options wasapproximately $12.7 million. We expect to amortize this expense over theremaining vesting period of these stock options. In addition, we will recordadditional expense for any new awards as they are granted in 2006 and in futureyears.  We are also required to elect thetransition method that we will use as part of the adoption of SFASNo. 123R. The allowed transition methods include prospective andretroactive adoption alternatives. The prospective method requires thatcompensation expense be recorded for all unvested stock options and awardsprospectively beginning with the first quarter adoption of SFAS No. 123R,while the retroactive method would require us to record compensation expensefor all unvested stock options and awards beginning with the first periodrestated. We will use the prospective transition method upon our adoption ofSFAS No. 123R effective January 1, 2006.

 

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

 

In November 2005, theFASB issued FASB Staff Position FAS 115-1 and FAS 124-1 (“FSP 115-1 and 124-1”),  “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments”. FSP 115-1 and 124-1applies to debt and equity securities accounted for under  Statement of Financial Accounting StandardsNo. 115, “Accounting for Certain Investments in Debt and Equity Securities”.  The objective of FSP 115-1 and 124-1 is toprovide guidance for identifying other-than-temporarily impaired investments.FSP 115-1 and 124-1 also provides new disclosure requirements for investmentsthat are deemed to be temporarily impaired. The disclosure requirements are effective in annual financialstatements for fiscal periods beginning after December 15, 2005.  We do not believe that the implementation ofFSP FAS 115-1 and FAS 124-1 will have a material impact on our consolidatedfinancial statements.

 

In February 2006, the FASB issued Statement ofFinancial Accounting Standards No. 155 (“SFAS No. 155”), ”**Accounting for CertainHybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140**”. SFAS No. 155 allows financial instruments that have embedded derivatives to beaccounted for as a whole (eliminating the need to bifurcate the derivative fromits host) if the holder elects to account for the whole instrument on a fairvalue basis. SFAS No. 155 is effective for all financial instruments acquired,issued, or subject to a remeasurement event occurring after the beginning of anentity’s first fiscal year that begins after September 15, 2006.  We arestill assessing the impact that the adoption of SFAS No. 155 will have on ourconsolidated financial statements.

 

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#### **Item 7A.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

# **Foreign Currency Risk**

 

We conduct business in severalinternational currencies through our global operations. Due to the large volumeof our business that we conduct in Japan, the Japanese operation poses thegreatest foreign currency risk.  We usefinancial instruments, principally forward contracts, to manage our foreigncurrency exposures. We enter into forward contracts in order to reduce theimpact of currency fluctuations related to purchases of our inventories byCymer Japan in U.S. dollars for resale under firm third-party sales commitmentsdenominated in Japanese yen, as well as other foreign currency exposuresincluding exposures related to intercompany debt.  We do not enter into forward contracts forspeculative purposes.

 

As of December 31, 2005, we hadoutstanding forward contracts to buy U.S. $46.2 million for 5.2 billion yenunder foreign currency exchange facilities with contract rates ranging from 105.8yen to 118.3****yen per U.S. dollar.  These contracts expire on various datesthrough June 2006.

 

Ourforward contracts generally qualify for hedge accounting treatment per theprovisions of Statement of Financial Accounting Standards No. 133, “Accountingfor Derivative Instruments and Hedging Activities”. As a result, we deferchanges in the fair value for the effective portion of these hedges and recordthe amount in other comprehensive income (loss) and subsequently reclassify thegain or loss to cost of product sales in the same period that the related saleis made to the third party. The fair value of all of our forward contracts andthe deferred loss (net of tax) for those that qualify for hedge accountingtreatment totaled $1.8 million and $70,000, respectively, as of December 31,2005.

 

Thefair value of these forward contracts as of December 31, 2005 would havefluctuated by $4.6 million if the foreign currency exchange rate for theJapanese yen to the U.S. dollar on these forward contracts had changed by 10%.

 

# **Investment and Debt Risk**

 

We maintain an investment portfolioconsisting primarily of government and corporate fixed income securities,certificates of deposit and commercial paper. While it is our general intent to hold such securities until maturity, wewill occasionally sell certain securities for cash flow purposes. Therefore,our investments are classified as available-for-sale and are carried on thebalance sheet at fair value.  Due to theconservative nature of the investment portfolio, a sudden change in interestrates would not have a material effect on the value of the portfolio.

 

In February 2002, we issued $250.0 million principalamount of unsecured fixed rate 3.50% Convertible Subordinated Notes dueFebruary 15, 2009.  Interest on thesenotes is payable on February 15 and August 15 of each year.  The notes are convertible into shares of ourcommon stock at a conversion rate of 20 shares per $1,000 principal amountsubject to adjustment under certain conditions. We may redeem the notes afterFebruary 20, 2005 at certain redemption prices expressed as a percentage of theprincipal 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 atface value on the consolidated balance sheets. In the third quarter of 2004 andthe second quarter of 2005, we repurchased, at a discount to par, approximately$49.2 million and $60.0 million principal amount, respectively, of thesenotes.  As of December 31, 2005, $140.7million principal amount of the notes were outstanding.  The fair value of such debt based on quotedmarket prices on December 31, 2005 was $136.5 million.

 

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

 

The information required by this Item is included in Part IV Items15(a)(1) and (2) of this Annual Report on Form 10-K.

 

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

 

None.

 

#### **Item 9A.  Controls and Procedures**

 

1.              Evaluation ofDisclosure Controls and Procedures.  Ourchief executive officer and our chief financial officer, after evaluating theeffectiveness of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of December 31, 2005, have concluded that our disclosurecontrols and procedures were not effective as of such date because weidentified a material weakness in our internal control over financial reportingrelated to our accounting for income taxes, as described below. Due to thismaterial weakness, in preparing our financial statements at and for the yearended December 31, 2005, we performed additional analysis and otherpost-closing procedures related to our accounting for income taxes toreasonably assure that such financial statements were stated fairly in allmaterial respects in accordance with U.S. generally accepted accountingprinciples.

 

2.             Changes in InternalControl Over Financial Reporting. There were no changes in our internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) identified in connection with the evaluation of our internalcontrols performed during the last fiscal quarter that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

3.             Management's Reporton Internal Control Over Financial Reporting. Our management is responsible forestablishing and maintaining adequate internal control over our financialreporting.  

 

We assessed the effectiveness of our internal controlover financial reporting as of December 31, 2005 using the criteria establishedin Internal Control – Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO).  Based upon this assessment, we have concludedthat, as of December 31, 2005, our internal control over financial reportingwas not effective due to the identification of a material weakness. A materialweakness is a significant deficiency, or combination of significantdeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.

 

Management’s assessment identified the followingmaterial weakness in its internal control over financial reporting as ofDecember 31, 2005:

 

We did not maintain effective internal controls overour accounting for income taxes. Specifically, our policies and procedures overthe reconciliation of income tax accounts were not designed with adequateprecision and our policies and procedures over foreign tax provisions did notprovide for adequate review. These deficiencies resulted in errors in ourconsolidated tax provision. Such errors were corrected prior to the issuance ofour consolidated financial statements at and for the year ended December 31,2005. These deficiencies also resulted in a more than remote likelihood that amaterial misstatement to our consolidated financial statements would not beprevented or detected.   

 

Management's assessment of the effectiveness of ourinternal control over financial reporting as of December 31, 2005, has beenaudited by KPMG LLP, an independent registered public accounting firm.  Their report appears on page F-2 of thisAnnual Report on Form 10-K.

 

4.             Management’sRemediation Efforts. Subsequent to December 31, 2005, we have taken thefollowing steps to improve our internal controls over our accounting for incometaxes:

 
| • |   | Improved the procedures  for reviewing our consolidated tax provisions and reconciling all subsidiary  office tax; and                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                            |
| • |   | Increased the level of  communication with our subsidiary accountants over the preparation of our  foreign quarterly and annual tax provisions. |

 

We will monitor the effectiveness of these new processes, proceduresand controls and will make any changes management determines 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.

 

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

 

None.

 

##### PARTIII

 

**Item 10.  Directors and ExecutiveOfficers of the Registrant.**

 

The information regarding the identification and business experience ofour directors under the caption “Proposal 1 - Election of Directors” in ourProxy Statement for the annual meeting of stockholders to be held on May 18,2006 to be filed with the SEC within 120 days after the end of our fiscal yearended December 31, 2005, is incorporated herein by reference. For informationregarding the identification and business experience of our executive officers,see “Executive Officers” at the end of Item 1 in Part I of this Annual Reporton Form 10-K. Information concerning filing requirements applicable to ourexecutive officers and directors under the caption “Section 16(a) BeneficialOwnership Reporting Compliance” in our Proxy Statement is incorporated hereinby reference.

 

In2003, we adopted a code of ethics that applies to our principal executiveofficer, principal financial officer, principal accounting officer orcontroller, or persons performing similar functions.  We have posted the text of the code of ethicson our website which can be accessed at 

 

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http://www.cymer.comunder “Investor Relations.”  In addition,we will promptly disclose on our website (1) the nature of any amendment to thecode of ethics that applies to our principal executive officer, principalfinancial officer, principal accounting officer or controller, or personsperforming similar functions and (2) the nature of any waiver, including animplicit waiver, from a provision of the code of ethics that is granted to oneof these specified officers, and the name of such person who is granted thewaiver on our website in the future.

 

**Item11.  Executive Compensation**

 

Theinformation under the caption “Compensation of Executive Officers” in our ProxyStatement is incorporated herein by reference.

 

**Item 12. SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters**

 

The information under the captions “Security Ownership of CertainBeneficial Owners and Management” and “Equity Compensation Plan Information” inour Proxy Statement is incorporated herein by reference.

 

### **Item 13.  Certain Relationships and Related Transactions**

 

The information under the caption “Certain Transactions” in our ProxyStatement is incorporated herein by reference.

 

With the exception of the information specifically incorporated byreference from our Proxy Statement in this Annual Report on Form 10-K, ourProxy Statement shall not be deemed to be filed as part of this Report.  Without limiting the foregoing, theinformation under the captions “Report of the Audit Committee of the Board ofDirectors,”  “Report of the CompensationCommittee of the Board of Directors” and “Performance Measurement Comparison”in our Proxy Statement is not incorporated by reference in this Annual Reporton Form 10-K.

#### ** **

#### **Item 14.  Principal Accounting Fees and Services**

 

Theinformation under the caption “Independent Registered Public Accounting Firm Fees”in our Proxy Statement is incorporated herein by reference.

 

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PART IV

 

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

 

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

 

(1)(2)       Financial Statements and Reports of FinancialStatement Schedule. Thefollowing Consolidated Financial Statements of Cymer, Inc., FinancialStatement Schedule and Reports of Independent Registered Public AccountingFirm are included in a separate section of this Annual Report on Form 10-Kbeginning on page F-1:

 
| ** ** | **Description**                                                                                                                                  | ** ** |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|       |                                                                                                                                             |       |
|       | Report of Independent  Registered Public Accounting Firm                                                                                         |       |
|       | Report of Independent  Registered Public Accounting Firm                                                                                         |       |
|       | Consolidated Balance Sheets as of  December 31, 2004 and 2005                                                                               |       |
|       | Consolidated Statements of  Operations for the Years Ended December 31, 2003, 2004 and 2005                                                 |       |
|       | Consolidated Statements of  Stockholders’ Equity and Comprehensive Income (Loss) For the Years Ended  December 31, 2003, 2004 and 2005 |       |
|       | Consolidated Statements of  Cash Flows for the Years Ended December 31, 2003, 2004 and 2005                                                 |       |
|       | Notes to  Consolidated Financial Statements                                                                                                      |       |
|       | Financial  Statement Schedule:                                                                                                                   |       |
|       | Schedule II  – Valuation and Qualifying Accounts and Reserves                                                                          |       |

 

All other financial statement schedules have beenomitted because the required information is not applicable or not present inamounts sufficient to require submission of the schedule, or because theinformation required is included in our consolidated financial statements orthe notes thereto.

 

(3)           Exhibits.  The exhibits listed under Item15(c) hereof are filed with, or incorporated by reference into, thisAnnual Report on Form 10-K.  Eachmanagement contract or compensatory plan or arrangement is identifiedseparately in item 15(c) hereof.

 

(b)                           Exhibits.  The following exhibits arefiled 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 August 23, 2004).                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                        |
| 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). |
|   |   |                                                                                                                                                                                                                                                                                                                        |
| 4.2    |   | Indenture, dated as of  February 15, 2002, between Cymer and State Street                                                                                                                                                                                                                                              |

 

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|   |   | 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   |   | Standard Industrial  Lease – Multi-Tenant, dated August 19, 1991, by and between Lepercq  Corporate Income Fund L.P. and Cymer** **(originally  between Frankris** **Corporation  and Cymer) (incorporated herein by reference to Exhibit 10.15 to Cymer’s  Registration Statement on Form S-1,  Reg. No. 333-08383). |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.3   |   | 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).                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.4   |   | 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).                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.5   |   | Contract Manufacturing  Agreement - Lithography Laser, dated August 28, 1992, by and between  Cymer and Seiko Instruments Inc. (the “Seiko Agreement”) (incorporated herein  by reference to Exhibit 10.16 to Cymer’s Registration Statement on  Form S-1, Reg. No. 333-08383).                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
|   |   | Addendum No. 2 to  the Seiko Agreement, dated February 21, 2000 (incorporated herein by  reference to Exhibit 10.5 to Cymer’s Annual Report on Form 10-K for  the year ended December 31, 1999).                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
|   |   | Termination of Seiko  Contract Manufacturing Agreement - Lithography Laser, dated March 31,  2003 (incorporated herein by reference to Exhibit 10.5 to Cymer’s Annual  Report on Form 10-K for the year ended December 31, 2002).                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.6#  |   | 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).                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.7#  |   | 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).                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.8#  |   | 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  February 23, 2005).                                                                                                                                                                     |

 

51

----

 
| 10.9#  |   | 1996 Director Option  Plan (incorporated herein by reference to Exhibit 10.5 to Cymer’s  Registration Statement on Form S-1, Reg. No. 333-08383).                                                                                       |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                        |
| 10.10# |   | 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).               |
|   |   |                                                                                                                                                                                                                                                        |
| 10.11# |   | 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).             |
|   |   |                                                                                                                                                                                                                                                        |
| 10.12# |   | 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)                                                                                             |
|   |   |                                                                                                                                                                                                                                                        |
| 10.13# |   | 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).                           |
|   |   |                                                                                                                                                                                                                                                        |
| 10.14  |   | 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).         |
|   |   |                                                                                                                                                                                                                                                        |
| 10.15# |   | Employment Agreement,  effective as of April 1, 2002, by and between Robert P. Akins and Cymer  (incorporated herein by reference to Exhibit 10.1 to Cymer’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 2002). |
|   |   |                                                                                                                                                                                                                                                        |
| 10.16# |   | Employment Agreement,  effective as of March 1, 2004, by and between Nancy J. Baker and Cymer  (incorporated herein by reference to Exhibit 10.13 to Cymer’s Annual  Report on 10-K for the year ended December 31, 2003).              |
|   |   |                                                                                                                                                                                                                                                        |
| 10.17# |   | 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).     |
|   |   |                                                                                                                                                                                                                                                        |
| 10.18# |   | 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).                     |
|   |   |                                                                                                                                                                                                                                                        |
| 10.19# |   | 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).     |
|   |   |                                                                                                                                                                                                                                                        |
| 10.20# |   | 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).                   |
|   |   |                                                                                                                                                                                                                                                        |
| 10.21# |   | Employment Agreement,  effective as of October 21, 2004, by and between Bill N. Alexander and Cymer.                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                        |
| 10.22# |   | 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 April 1, 2005).                                          |
|   |   |                                                                                                                                                                                                                                                        |
| 10.23# |   | 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).                                                           |
|   |   |                                                                                                                                                                                                                                                        |
| 10.24# |   | Cymer Inc. Deferred  Compensation Plan, as amended and restated (incorporated herein by reference  to Exhibit 99.1 to Cymer’s Current Report on Form 8-K filed on for  the quarter ended September 30, 2005).                           |

 

52

----

 
| 10.25* |   | Joint Venture  Agreement, dated July 15, 2005, among TCZ GmbH, Cymer, Inc., Carl  Zeiss SMT AG and Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH.  (incorporated herein by reference to Exhibit 10.1 to Cymer’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2005).                                                          |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.26  |   | Amendment No. 1  to Joint Venture Agreement of TCZ GmbH, dated September 16, 2005, among  TCZ GmbH, Cymer, Inc., Carl Zeiss SMT AG and Carl Zeiss Laser  Optics Beteiligungsgesellschaft mbH (incorporated herein by reference to  Exhibit 10.2 to Cymer’s Quarterly Report on Form 10-Q filed for the  quarter ended September 30, 2005). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.27* |   | 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).                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.28  |   | 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).                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.29  |   | 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).                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.30# |   | 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).                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.31# |   | 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).                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.32* |   | 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).                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.33* |   | 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).                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                    |
| 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.                                                                                                                                                                                                                                                                                                                                                                  |

 

53

----

 
| 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. |
|   |   |                                                                                                    |

----

|   |   | #      | Indicates management  contract or compensatory plan or arrangement.                                                                           |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                          |
|   |   | *      | Confidential treatment  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

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf 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:March 14, 2006

 

KNOWALL PERSONS BY THESE PRESENTS, that each person whose signature appears belowconstitutes and appoints Nancy J. Baker and Rae Ann Werner, and each of them,as his true and lawful attorneys-in-fact and agents, with full power ofsubstitution and resubstitution, for him and in his name, place, and stead, inany and all capacities, to sign any and all amendments to this Annual Report onForm 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,          |   | March 14, 2006 |
|--------|-----------------------|--------|-----------------------------------|--------|---------------------|
|   | Robert P. Akins       |   | and Chairman of the Board         |   |                |
|   |                  |   | (*Principal Executive  Officer*)  |   |                |
|   |                  |   |                              |   |                |
|   | /s/ NANCY J. BAKER    |   | Senior Vice President        |   | March 14, 2006 |
|   | Nancy J. Baker        |   | and Chief Financial Officer       |   |                |
|   |                  |   | (*Principal Financial  Officer*)  |   |                |
|   |                  |   |                              |   |                |
|   | /s/ RAE ANN WERNER    |   | Vice President, Controller        |   | March 14, 2006 |
|   | Rae Ann Werner        |   | and Chief Accounting Officer      |   |                |
|   |                  |   | (*Principal Accounting  Officer*) |   |                |
|   |                  |   |                              |   |                |
|   | /s/ CHARLES J. ABBE   |   | Director                          |   | March 14, 2006 |
|   | Charles J. Abbe       |   |                              |   |                |
|   |                  |   |                              |   |                |
|   | /s/ EDWARD H. BRAUN   |   | Director                          |   | March 14, 2006 |
|   | Edward H. Braun       |   |                              |   |                |
|   |                  |   |                              |   |                |
|   | /s/ MICHAEL R. GAULKE |   | Director                          |   | March 14, 2006 |
|   | Michael R. Gaulke     |   |                              |   |                |
|   |                  |   |                              |   |                |
|   | /s/ WILLIAM G. OLDHAM |   | Director                          |   | March 14, 2006 |
|   | William G. Oldham     |   |                              |   |                |
|   |                  |   |                              |   |                |
|   | /s/ PETER J. SIMONE   |   | Director                          |   | March 14, 2006 |
|   | Peter J. Simone       |   |                              |   |                |
|   |                  |   |                              |   |                |
|   | /s/ YOUNG K. SOHN     |   | Director                          |   | March 14, 2006 |
|   | Young K. Sohn         |   |                              |   |                |
|   |                  |   |                              |   |                |
|   | /s/ JON D. TOMPKINS   |   | Director                          |   | March 14, 2006 |
|   | Jon D. Tompkins       |   |                              |   |                |

 

55

----

 

#### **Report of Independent Registered Public AccountingFirm**

 

The Board ofDirectors and Stockholders

Cymer, Inc.:

 

We have auditedthe accompanying consolidated balance sheets of Cymer, Inc. and subsidiaries asof December 31, 2005 and 2004, and the related consolidated statements ofoperations, stockholders’ equity and comprehensive income (loss), and cashflows for each of the years in the three-year period ended December 31,2005. In connection with our audits of the consolidated financial statements,we also have audited financial statement Schedule II. These consolidatedfinancial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Cymer, Inc. and subsidiaries as ofDecember 31, 2005 and 2004, and the results of their operations and theircash flows for each of the years in the three-year period endedDecember 31, 2005, in conformity with U.S. generally accepted accountingprinciples. Also, in our opinion, the related financial statement Schedule II,when considered in relation to the basic consolidated financial statementstaken as a whole, presents fairly, in all material respects, the informationset forth therein.

 

We also haveaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2005, based oncriteria established in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), andour report dated March 8, 2006 expressed an unqualified opinion onmanagement’s assessment of, and an adverse opinion on the effective operationof, internal control over financial reporting.

 

 
|   | /s/ KPMG LLP |   |
|--------|--------------|--------|

 

San Diego, CaliforniaMarch 8, 2006

 

F-1

----

 

#### **Report of Independent Registered Public AccountingFirm**

 

The Board ofDirectors and Stockholders

Cymer, Inc.:

 

We have audited management’s assessment, included in the accompanyingManagement’s Report on Internal Control Over Financial Reporting (Item 9A.3),that Cymer, Inc. and subsidiaries (the Company) did not maintain effectiveinternal control over financial reporting as of December 31, 2005, because ofthe effect of the material weaknessidentified in management’s assessment, based on criteria established in Internal Control-Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO).The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of theCompany’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that(1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (2) provide reasonable assurance that transactions are recordedas necessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures ofthe company are being made only in accordance with authorizations of managementand directors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

 

A material weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. The following material weakness has been identified andincluded in management’s assessment:

 

The Company did not maintain effective internalcontrols over their accounting for income taxes. Specifically, the Company’s policies and procedures overthe reconciliation of income tax accounts were not designed with adequateprecision and their policies and procedures over foreign tax provisions did notprovide for adequate review. These deficiencies resulted in errors in theCompany’s consolidated tax provision. Management has concluded that thesedeficiencies resulted in a more than remote likelihood that a materialmisstatement of the annual or interim financial statements would not beprevented or detected.

** **

**Inour opinion, management’s assessment that the Company did not maintaineffective internal control over financial reporting as of December 31, 2005, isfairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO).Also, in our opinion, because of the effect of the material weakness describedabove on the achievement of the objectives of the control criteria, the Companyhas not maintained effective internal control over financial reporting as ofDecember 31, 2005, based on criteriaestablished in Internal Control-Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO).**

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets of the Company as of December 31, 2005 and 2004, and the relatedconsolidated statements of operations, stockholders’ equity and comprehensiveincome (loss), and cash flows for each of the years in the three-year periodended December 31, 2005. This material weakness was considered in determiningthe nature, timing, and extent of audit tests applied in our audit of the 2005 consolidated financial statements,and this report does not affect our report dated March 8, 2006, which expressedan unqualified opinion on those consolidated financial statements.

 

 
|   | /s/ KPMG LLP |   |
|--------|--------------|--------|

 

San Diego, CaliforniaMarch 8, 2006

 

F-2

----

 

**CYMER, INC.**

**CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                                                                                  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **2004**              | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                                                  |       |                  |       |                  |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| CURRENT ASSETS:                                                                                                                                                                             |       |                  |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                  |       | $                     | 114,246    |                  | $          | 233,745 |   |
| Short-term  investments                                                                                                                                                                     |       | 175,866               |       | 130,204               |       |
| Accounts  receivable - net                                                                                                                                                                  |       | 110,680               |       | 89,818                |       |
| Accounts  receivable - related party                                                                                                                                                        |       | —                |       | 588                   |       |
| Foreign currency  forward exchange contracts                                                                                                                                                |       | —                |       | 1,776                 |       |
| Inventories                                                                                                                                                                                 |       | 110,022               |       | 89,046                |       |
| Deferred income  taxes                                                                                                                                                                      |       | 23,337                |       | 33,338                |       |
| Prepaid expenses  and other assets                                                                                                                                                          |       | 5,726                 |       | 6,497                 |       |
| Total current  assets                                                                                                                                                                       |       | 539,877               |       | 585,012               |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| PROPERTY AND EQUIPMENT - NET                                                                                                                                                                |       | 123,548               |       | 117,251               |       |
| LONG-TERM INVESTMENTS                                                                                                                                                                       |       | 84,561                |       | 29,395                |       |
| DEFERRED INCOME TAXES                                                                                                                                                                       |       | 44,913                |       | 34,429                |       |
| GOODWILL                                                                                                                                                                                    |       | 8,358                 |       | 8,358                 |       |
| INTANGIBLE ASSETS - NET                                                                                                                                                                     |       | 10,394                |       | 10,474                |       |
| OTHER ASSETS                                                                                                                                                                                |       | 7,185                 |       | 6,457                 |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                |       | $                     | 818,836    |                  | $          | 791,376 |   |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                               |       |                  |       |                  |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| CURRENT LIABILITIES:                                                                                                                                                                        |       |                  |       |                  |       |
| Accounts payable                                                                                                                                                                            |       | $                     | 13,949     |                  | $          | 17,710 |   |
| Accounts payable  - related party                                                                                                                                                           |       | —                |       | 4,975                 |       |
| Accrued warranty  and installation                                                                                                                                                          |       | 28,546                |       | 30,775                |       |
| Accrued payroll  and benefits                                                                                                                                                               |       | 16,284                |       | 12,461                |       |
| Accrued patents,  royalties and other fees                                                                                                                                                  |       | 6,318                 |       | 7,180                 |       |
| Foreign currency  forward exchange contracts                                                                                                                                                |       | 1,901                 |       | —                |       |
| Income taxes  payable                                                                                                                                                                       |       | 10,397                |       | 7,268                 |       |
| Unearned income                                                                                                                                                                             |       | 6,152                 |       | 1,726                 |       |
| Other current  liabilities                                                                                                                                                                  |       | 3,751                 |       | 3,247                 |       |
| Total current  liabilities                                                                                                                                                                  |       | 87,298                |       | 85,342                |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| CONVERTIBLE SUBORDINATED NOTES                                                                                                                                                              |       | 200,753               |       | 140,722               |       |
| OTHER LIABILITIES                                                                                                                                                                           |       | 7,282                 |       | 10,582                |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| Total  liabilities                                                                                                                                                                          |       | 295,333               |       | 236,646               |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| MINORITY INTEREST                                                                                                                                                                           |       | 6,183                 |       | 16,276                |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                               |       |                  |       |                  |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                  |       |                  |       |                  |       |
| Preferred stock -  authorized 5,000,000 shares; $.001 par value, no shares issued or outstanding                                                                                            |       | —                |       | —                |       |
| Common stock -  $.001 par value per share; 100,000,000 shares authorized; 36,993,000 and 38,036,000  shares outstanding at December 31, 2004 and December 31, 2005,  respectively |       | 37                    |       | 38                    |       |
| Additional  paid-in capital                                                                                                                                                                 |       | 378,414               |       | 407,549               |       |
| Treasury stock  at cost (1,943,000 common shares) at December 31, 2005                                                                                                                 |       | —                |       | (50,000               | )          |
| Unearned  compensation                                                                                                                                                                      |       | (16                   | )          | —                |       |
| Accumulated  other comprehensive loss                                                                                                                                                       |       | (4,455                | )          | (9,025                | )          |
| Retained  earnings                                                                                                                                                                          |       | 143,340               |       | 189,892               |       |
| Total  stockholders’ equity                                                                                                                                                            |       | 517,320               |       | 538,454               |       |
|                                                                                                                                                                                        |       |                  |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                             |       | $                     | 818,836    |                  | $          | 791,376 |   |

 

See Notes to Consolidated Financial Statements.

 

F-3

----

 

**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
| ** **                                                                 | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                 | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                                       |       |                              |       |   |   |   |   |
| REVENUES:                                                                  |       |                              |       |   |   |   |   |
| Product sales                                                              |       | $                                 | 265,816    |   | $ | 417,296 |   | $ | 382,238 |   |
| Product sales -  related party                                             |       | —                            |       | — |   | 400 |   |
| Other                                                                      |       | 57                                |       | 783 |   | 1,010 |   |
| Total revenues                                                             |       | 265,873                           |       | 418,079 |   | 383,648 |   |
|                                                                       |       |                              |       |   |   |   |   |
| COSTS AND  EXPENSES:                                                       |       |                              |       |   |   |   |   |
| Cost of product  sales                                                     |       | 187,679                           |       | 243,473 |   | 227,290 |   |
| Research and  development                                                  |       | 56,768                            |       | 58,612 |   | 64,025 |   |
| Sales and  marketing                                                       |       | 16,966                            |       | 23,369 |   | 25,143 |   |
| General and  administrative                                                |       | 39,094                            |       | 31,630 |   | 26,514 |   |
|                                                                       |       |                              |       |   |   |   |   |
| Total costs and  expenses                                                  |       | 300,507                           |       | 357,084 |   | 342,972 |   |
|                                                                       |       |                              |       |   |   |   |   |
| OPERATING INCOME  (LOSS)                                                   |       | (34,634                           | )          | 60,995 |   | 40,676 |   |
|                                                                       |       |                              |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                   |       |                              |       |   |   |   |   |
| Foreign currency  exchange gain (loss) - net                               |       | 436                               |       | 82 |   | (1,115 | ) |
| Gain on debt  extinguishment                                               |       | —                            |       | 911 |   | 2,220 |   |
| Interest and  other income                                                 |       | 8,928                             |       | 8,079 |   | 10,943 |   |
| Interest and  other expense                                                |       | (10,503                           | )          | (9,493 | ) | (6,936 | ) |
|                                                                       |       |                              |       |   |   |   |   |
| Total other  income (expense) - net                                        |       | (1,139                            | )          | (421 | ) | 5,112 |   |
|                                                                       |       |                              |       |   |   |   |   |
| INCOME (LOSS)  BEFORE INCOME TAX PROVISION (BENEFIT) AND MINORITY INTEREST |       | (35,773                           | )          | 60,574 |   | 45,788 |   |
|                                                                       |       |                              |       |   |   |   |   |
| INCOME TAX  PROVISION (BENEFIT)                                            |       | (21,464                           | )          | 15,144 |   | 262 |   |
| MINORITY  INTEREST                                                         |       | (1,091                            | )          | (2,276 | ) | 1,026 |   |
| NET INCOME  (LOSS)                                                         |       | $                                 | (15,400    | ) | $ | 43,154 |   | $ | 46,552 |   |
|                                                                       |       |                              |       |   |   |   |   |
| EARNINGS (LOSS)  PER SHARE:                                                |       |                              |       |   |   |   |   |
| Basic earnings  (loss) per share                                           |       | $                                 | (0.44      | ) | $ | 1.17 |   | $ | 1.29 |   |
| Weighted average  common shares outstanding                                |       | 35,065                            |       | 36,758 |   | 36,017 |   |
|                                                                       |       |                              |       |   |   |   |   |
| Diluted earnings  (loss) per share                                         |       | $                                 | (0.44      | ) | $ | 1.15 |   | $ | 1.27 |   |
| Weighted average  common and dilutive potential common shares outstanding  |       | 35,065                            |       | 37,584 |   | 36,544 |   |

 

See Notes to Consolidated FinancialStatements.

 

F-4

----

 

**CYMER, INC.**

CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE 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  (Loss)** | ** **  |
|                                                               |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       |               |        |
| **BALANCE,  JANUARY 1, 2003**                                 | ** ** | **34,227**        | ** ** | **$**       | **34**     | ** **          | **$**      | **302,501**  | ** ** | **—**        | ** ** | **$**            | **—**  | ** **             | **$**      | **(2,358**        | **)**      | **$**       | **(3,429** | **)**              | **$**       | **115,586** | ** ** | **$** | **412,334** |   |   |   |
|                                                               |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       |               |        |
| Exercise of  common stock options and warrants                     |       | 1,899             |       | 2           |       | 44,083              |       |         |       |              |       |             |        |                   |       |              |       | 44,085      |       |               |        |
| Issuance of  employee stock purchase plan shares                   |       | 217               |       |        |       | 4,072               |       |         |       |              |       |             |        |                   |       |              |       | 4,072       |       |               |        |
| Amortization of  unearned compensation                             |       |              |       |        |       |                |       |         |       |              |       | 737              |        |                   |       |              |       | 737         |       |               |        |
| Reversal of  unearned compensation                                 |       |              |       |        |       | (1,475              | )          |         |       |              |       | 1,475            |        |                   |       |              |       | —      |       |               |        |
| Non-employee  stock options granted                                |       |              |       |        |       | 235                 |       |         |       |              |       |             |        |                   |       |              |       | 235         |       |               |        |
| Employee stock  options – change in status                    |       |              |       |        |       | 1,102               |       |         |       |              |       |             |        |                   |       |              |       | 1,102       |       |               |        |
| Employee stock  awards                                             |       | 2                 |       |        |       | 22                  |       |         |       |              |       |             |        |                   |       |              |       | 22          |       |               |        |
| Income tax  benefit from stock options exercises                   |       |              |       |        |       | 8,448               |       |         |       |              |       |             |        |                   |       |              |       | 8,448       |       |               |        |
| Net loss                                                           |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       | (15,400           | )          | (15,400     | )          | $                  | (15,400     | ) |
| Other  comprehensive loss:                                         |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       |               |        |
| Translation  adjustment                                            |       |              |       |        |       |                |       |         |       |              |       |             |        | 799                    |       |              |       | 799         |       | 799                |        |
| Net unrealized  loss on available-for-sale investments, net of tax |       |              |       |        |       |                |       |         |       |              |       |             |        | (894                   | )          |              |       | (894        | )          | (894               | )           |
| Net unrealized  loss on derivatives, net of tax                    |       |              |       |        |       |                |       |         |       |              |       |             |        | (2,210                 | )          |              |       | (2,210      | )          | (2,210             | )           |
| Total  comprehensive loss                                          | ** ** | ** **        |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       | **$**              | **(17,705** | **)** |
|                                                               |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       |               |        |
| **BALANCE,  DECEMBER 31, 2003**                               | ** ** | **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 income                                                         |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       | 43,154            |       | 43,154      |       | $                  | 43,154      |   |
| Other  comprehensive income:                                       |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       |               |        |
| 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 option exercises                    |       |              |       |        |       | 2,899               |       |         |       |              |       |             |        |                   |       |              |       | 2,899       |       |               |        |
| Net income                                                         |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       | 46,552            |       | 46,552      |       | $                  | 46,552      |   |
| Other  comprehensive income (loss):                                |       |              |       |        |       |                |       |         |       |              |       |             |        |                   |       |              |       |        |       |               |        |
| 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** |   |   |   |

 

SeeNotes to Consolidated Financial Statements.

 

F-5

----

 

**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                                           | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                           | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                                                                 |       |                              |       |   |   |   |   |
| OPERATING  ACTIVITIES:                                                                               |       |                              |       |   |   |   |   |
| Net income  (loss)                                                                                   |       | $                                 | (15,400    | ) | $ | 43,154 |   | $ | 46,552 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                              |       |   |   |   |   |
| Gain on debt  extinguishment                                                                         |       | —                            |       | (911 | ) | (2,220 | ) |
| Depreciation and  amortization                                                                       |       | 30,938                            |       | 28,364 |   | 28,280 |   |
| Non-cash  stock-based compensation                                                                   |       | 1,359                             |       | 345 |   | 1,019 |   |
| Amortization of  unearned compensation                                                               |       | 737                               |       | 130 |   | 16 |   |
| Minority  interest                                                                                   |       | 1,091                             |       | 2,276 |   | (1,026 | ) |
| Provision for  deferred income taxes                                                                 |       | (23,669                           | )          | 13,035 |   | (1,680 | ) |
| Loss on disposal  and impairment of property and equipment                                           |       | 18,106                            |       | 131 |   | 55 |   |
| Change in assets  and liabilities:                                                                   |       |                              |       |   |   |   |   |
| Accounts  receivable - net                                                                           |       | (10,478                           | )          | (47,861 | ) | 20,862 |   |
| Accounts  receivable - related party                                                                 | ** ** | **—**                        | ** ** | **—** |   | (588 | ) |
| Foreign currency  forward exchange contracts                                                         |       | 1,749                             |       | (679 | ) | (3,002 | ) |
| Inventories                                                                                          |       | 7,107                             |       | (17,010 | ) | 20,976 |   |
| Prepaid expenses  and other assets                                                                   |       | 59                                |       | (884 | ) | (1,936 | ) |
| Accounts payable                                                                                     |       | (7,400                            | )          | (5,150 | ) | 3,761 |   |
| Accounts payable  - related party                                                                    | ** ** | **—**                        | ** ** | **—** |   | 4,975 |   |
| Accrued expenses  and other liabilities                                                              |       | (8,036                            | )          | 16,270 |   | 2,634 |   |
| Unearned income                                                                                      |       | —                            |       | 5,399 |   | (4,426 | ) |
| Income taxes  payable                                                                                |       | 242                               |       | (2,439 | ) | (230 | ) |
|                                                                                                 |       |                              |       |   |   |   |   |
| Net cash  provided by (used in) operating activities                                                 |       | (3,595                            | )          | 34,170 |   | 114,022 |   |
|                                                                                                 |       |                              |       |   |   |   |   |
| INVESTING ACTIVITIES:                                                                                |       |                              |       |   |   |   |   |
| Acquisition of  property and equipment                                                               |       | (62,783                           | )          | (19,485 | ) | (18,750 | ) |
| Purchases of  investments                                                                            |       | (471,968                          | )          | (641,674 | ) | (290,728 | ) |
| Proceeds from  sold or matured investments                                                           |       | 514,091                           |       | 669,421 |   | 390,580 |   |
| Acquisition of  patents                                                                              |       | —                            |       | (5,990 | ) | (2,500 | ) |
| Acquisition of  minority interest                                                                    |       | (180                              | )          | (2,000 | ) | — |   |
|                                                                                                 |       |                              |       |   |   |   |   |
| Net cash  provided by (used in) investing activities                                                 |       | (20,840                           | )          | 272 |   | 78,602 |   |
|                                                                                                 |       |                              |       |   |   |   |   |
| FINANCING  ACTIVITIES:                                                                               |       |                              |       |   |   |   |   |
| Net borrowings  under revolving loan and security agreements                                         |       | (6,667                            | )          | — |   | — |   |
| Proceeds from  issuance of common stock                                                              |       | 48,157                            |       | 15,446 |   | 25,218 |   |
| Redemption of  convertible subordinated notes                                                        |       | —                            |       | (47,407 | ) | (57,336 | ) |
| Cash investment  received from minority shareholder                                                  |       | —                            |       | — |   | 11,120 |   |
| Payments on capital  lease obligations                                                               |       | (50                               | )          | (48 | ) | (20 | ) |
| Repurchase of  common stock into treasury                                                            |       | —                            |       | — |   | (50,000 | ) |
|                                                                                                 |       |                              |       |   |   |   |   |
| Net cash  provided by (used in) financing activities                                                 |       | 41,440                            |       | (32,009 | ) | (71,018 | ) |
|                                                                                                 |       |                              |       |   |   |   |   |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS                                        |       | 1,354                             |       | 1,181 |   | (2,107 | ) |
|                                                                                                 |       |                              |       |   |   |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                                           |       | 18,359                            |       | 3,614 |   | 119,499 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF THE YEAR                                                  |       | 92,273                            |       | 110,632 |   | 114,246 |   |
|                                                                                                 |       |                              |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS AT END OF THE YEAR                                                        |       | $                                 | 110,632    |   | $ | 114,246 |   | $ | 233,745 |   |

 

F-6

----

 
| ** **                                                                                                       | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                       | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                                       | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                               |       |                              |       |   |   |   |   |
| Interest paid                                                                                                    |       | $                                 | 9,004      |   | $ | 9,033 |   | $ | 6,914 |   |
| Income taxes  paid, net                                                                                          |       | $                                 | 1,325      |   | $ | 3,515 |   | $ | 2,613 |   |
|                                                                                                             |       |                              |       |   |   |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:                                         |       |                              |       |   |   |   |   |
| Reversal of  unearned compensation related to cancelled stock options previously issued  for the ACX acquisition |       | $                                 | 1,475      |   | $ | — |   | $ | — |   |
| Intangible  assets included in accrued liabilities                                                               |       | $                                 | 5,990      |   | $ | — |   | $ | — |   |
| Reversal of  deferred tax asset valuation allowance against goodwill                                             |       | $                                 | 2,950      |   | $ | — |   | $ | — |   |

 

SeeNotes to Consolidated Financial Statements.

 

F-7

----

 

**1.**       SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES

 

***Nature of Operations*** – Cymer, Inc.and its wholly owned and majority-owned subsidiaries, are engaged primarily inthe development, manufacturing and marketing of excimer light sources for saleto manufacturers of photolithography tools in the semiconductor equipmentindustry.  We sell our product tocustomers primarily in Japan, Asia, Europe and the U.S.  In addition, we formed a joint venture with CarlZeiss SMT AG and Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH calledTCZ (for Team Cymer Zeiss) in July 2005. TCZ is developing a process toolfor the flat panel display manufacturing industry.

 

***Principles of Consolidation*****– The accompanyingconsolidated financial statements include our accounts and the accounts of ourwholly owned subsidiaries – Cymer Japan, Inc. (“Cymer Japan”), CymerSingapore Pte Ltd. (“Cymer Singapore”), Cymer B.V. in the Netherlands (“CymerB.V.”), Cymer Southeast Asia, Ltd, in Taiwan (“Cymer SEA”), Cymer SemiconductorEquipment Shanghai Co., Ltd, in the People’s Republic of China (“Cymer PRC”),and our majority-owned subsidiaries, Cymer Korea, Inc. (“Cymer Korea”) andTCZ GmbH, a Swiss limited liability company. We own 81% of Cymer Korea and 60% of TCZ.  See Note 18 for additional information onCymer Korea.  Cymer Japan is currently ouronly subsidiary office that sells excimer light source systems.  Cymer Japan also provides field service tocustomers in the Japan region. Cymer Singapore, Cymer B.V., Cymer SEA, andCymer PRC are field service offices for customers in those respectiveregions.  Cymer Korea providesrefurbishment manufacturing, field service, and administrative activities forthat region and the Asia-Pacific region. TCZ is currently developing, and willintegrate, market and sell, and support tools employing an excimer laser beamto induce crystallization of low-temperature poly-silicon (“LTPS”) processingfor the manufacture of flat panel displays. All significant intercompany balances and transactions have beeneliminated in consolidation.

 

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

 

***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, 2004 and 2005 we had$75.4 million and $143.0 million of cash equivalents, respectively.

 

***Investments***– We maintain an investmentportfolio consisting primarily of government and corporate fixed incomesecurities, auction rate securities 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.  In September 2004 we sold approximately$20.3 million of corporate debt securities that resulted in a $281,000 gain onthe sale.  The cost of securities soldwas determined by a specific identification method.

 

***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 reviewthe components of our inventory on a regular basis for excess or obsoleteinventory and make appropriate allowances and dispositions in the period thatsuch inventory is identified.

 

F-8

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***Parts Refurbishment***– As part of our regular business activities, we conduct parts refurbishmentactivities related to some of our core assemblies, in particular our chamberassemblies, that wear out with use. The volume of this activity significantlyincreased in 2004.  These activitiesinvolve arrangements with our customers where we sell a new part to thecustomer at a reduced sales price in exchange for the return of the consumedassembly from the customer.  Thesereturned core assemblies contain a certain amount of material, primarily metalcomponents, that may be reused by us in future core assemblies.  Upon receipt of these consumed assembliesfrom our customers, we record an entry to recognize the estimated fair value ofthe reusable components as inventory and revenue or a reduction in cost ofproduct sales sold depending on the reason for the part replacement. The valueof the reusable parts contained within the consumed assembly is determinedbased upon historical data of the value of the reusable parts that we typicallyyield from a consumed assembly. The costs of refurbishment are also capitalizedas part of ending inventory as incurred. As part of our normal excess andobsolete inventory analysis, these consumed assemblies are also reviewed on aquarterly basis and an inventory allowance is recorded as appropriate for theseparts.  The value that we assign to thesecore assemblies can be affected by the current demand for the reusable parts inour manufacturing operations and the actual yield rate achieved for partswithin these consumed core assemblies.

 

Prior to the fourth quarter of 2004, we recorded thevalue of this material as a reduction of our cost of product sales in theperiod that the returned assembly was disassembled by our manufacturingoperations and the value of the reusable parts could be determined.  Upon further review of U.S. generallyaccepted accounting principles in the fourth quarter of 2004, we determinedthat we should instead estimate the value and record these consumed assembliesas inventory at the time that we receive the returned assembly from our customerand concurrently record this amount as revenue rather than as a reduction ofcost of product sales.  During the fourth quarter of 2004, wecorrected our accounting treatment for these refurbishment activities andrecorded the financial impact for all of 2004 and prior years in our fourthquarter of 2004 financial statements. As a result of this analysis, wedetermined that although there was a financial impact due to this accountingcorrection, the amounts were not material to years prior to 2004 or to thefiscal year ended December 31, 2004. This adjustment resulted in a $2.9million increase in the inventory balance as of December 31, 2004, a $28.5million increase in 2004 product revenue, a $25.6 million increase in 2004 costof product sales and a $2.0 million increase in 2004 net income.

 

***Property and Equipment*** – Property and equipment are stated at costless accumulated depreciation. Additionsand improvements are capitalized and maintenance and repairs are expensed asincurred.  Depreciation is computed using the straight-line method over theestimated useful lives of the assets (generally one to five years).  The buildings that we own are depreciatedover a useful life of twenty years. Leasehold improvements and equipment heldunder capital leases are amortized using the straight-line method over theshorter of the life of the asset or the remaining lease term. Equipment acquired under capital leases is stated atthe present value of the future minimum lease payments.  Amortizationof equipment obtained under capital leases is included in depreciation expensein the accompanying consolidated financial statements.  Light source systems built for internal useare capitalized and depreciated using the straight-line method over threeyears.

 

***Goodwill****/**Intangible Assets** –*We account for our goodwill and other intangibleassets in accordance with Statement of Financial Accounting Standards No. 142(“SFAS No. 142”), “Goodwill and Other Intangible Assets*”*. SFAS No. 142 includes provisions that discontinued theamortization of goodwill and intangible assets with indefinite useful livesassociated with purchase business combinations. Under SFAS No. 142,our goodwill is subject to an annual impairment test. We conduct this test in the fourth quarter ofeach fiscal year, or whenever events or circumstances occur indicatingpotential impairment.

 

Intangibleassets consist primarily of acquired patents. Intangible assets with finitelives are recorded at cost and are amortized using the straight-line methodover their expected useful lives.  Theexpected useful life can vary depending upon the nature of the technology, butcurrently, it 

 

F-9

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rangesfrom four to fifteen years. We review the carrying value and remaining usefullife of intangibles for impairment whenever events or circumstances indicatethat the carrying amount may not be recoverable. The amount of impairment, ifany, is measured based on the projected discounted future operating cash flowsusing a discount rate reflecting our average cost of funds.  The assessment of the recoverability ofintangible assets will be impacted if estimated future operating cash flows arenot achieved.

 

***Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of***– Long-lived assets and certainidentifiable intangibles are reviewed for impairment whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of the assets to future net cash flows(undiscounted and without interest) expected to be generated by the asset.  If such assets are considered to be impaired,the impairment to be recognized is measured by the amount by which the carryingamount of the assets exceeds the fair value of the assets.  Assets to be disposed of are reported at thelower of the carrying amount or fair value less costs to sell.

 

***AssetRetirement Obligation*****–We currently account for ourasset retirement obligations in accordance with Statement of Financial Accounting Standards No. 143(“SFAS No. 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 a lease agreement for ourfacility in Japan which includes an obligation for us to restore the facilityto its original condition when we vacate it. We have estimated the fair valueof this asset retirement obligation to be approximately $665,000 and have recordedit in accrued patents, royalties and other fees on the accompanyingconsolidated balance sheet. The total accretion expense that we recordedrelated to this obligation for the year ended December 31, 2005 was $200,000.

 

***Fair Value of Financial Instruments***– We used the following methods and assumptions to estimate the fair value ofeach class of financial instruments for which it is suitable to estimate thatvalue:

 

Cashand cash equivalents, accounts receivable, accounts receivable – related party,accounts payable, accounts payable – related party, accrued warranty andinstallation, accrued payroll and benefits, accrued patents, royalties andother fees, income tax payable, unearned income, and other current liabilities– the carrying amount reported in the consolidated balance sheets for thesebalances approximates fair value due to the short maturities of theseinstruments.

 

Investments– Investments are recorded at fair value, which is based on quoted marketprices for such securities.

 

ForwardContracts – The fair value of forward contracts are recorded at fair valuewhich is based on the quoted exchange rates for such instruments (see “DerivativeInstruments” below).

 

ConvertibleSubordinated Notes – Convertible Subordinated Notes are recorded at their facevalue of $200.8 million and $140.7 million at December 31, 2004 and 2005,respectively. The fair value of such debt, based on quoted market prices at December 31,2004 and 2005, was $199.7 million and $136.5 million, respectively.

 

***Lease LossAccrual*****–**Inaccordance with Statement of Financial Accounting Standards No. 146 (“SFASNo. 146”), “Accounting for Costs Associated with Exit or DisposalActivities”, our costs associated with exit or disposal activities arerecognized when they are incurred or when we cease using a property.  To date, our exit or disposal activities haveconsisted of lease obligations net of expected sublease income for our SanDiego, California and Charlestown, Massachusetts facilities which were vacatedby us prior to the end of their leases. The total liability is included withinOther Current Liabilities on the accompanying consolidated balance sheet.

 

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The following table summarizes informationrelated to our accrued lease loss liability for the years ended December 31,2004 and 2005 (in thousands):

 
| ** **                | ** ** | **2004** | ** ** | **2005** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
|                      |       |     |       |     |       |
| Balance, January 1   |       | $        | —     |     | $          | 2,230 |   |
| Lease loss accruals       |       | 2,958    |       | 384      |       |
| Rent payments             |       | (728     | )          | (1,980   | )          |
| Balance, December 31 |       | $        | 2,230      |     | $          | 634 |   |

 

***Guarantees/Warranties***– In the ordinary course of business, we are not subject topotential obligations under guarantees that fall within the scope of FinancialAccounting Standards Board Interpretation No. 45 (“FIN 45”), “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others”, except for standard warranty provisionsassociated with product sales and indemnification provisions related tointellectual property that are contained within many of our customer agreements.All of these provisions give rise only to the disclosure requirementsprescribed by FIN 45.

 

(a) ProductWarranties – Warranty provisions contained within our customer 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 determined usinga 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 as informationchanges over the product’s life cycle. If actual warranty expenditures differsubstantially from our estimates, revisions to the warranty provision would berequired.  Actual warranty expendituresare recorded against the warranty provision as they are incurred.

 

The following table summarizes informationrelated to our warranty provision for the years ended December 31, 2003, 2004and 2005 (in thousands):

 
| ** **                                                                                      | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                            |       |     |       |     |       |     |       |
| Balance,  January 1                                                                        |       | $        | 29,600     |     | $          | 26,200   |       | $ | 28,200 |   |
| Liabilities  accrued for warranties issued during the year, net of adjustments and  expirations |       | 15,505   |       | 23,595   |       | 26,331   |       |
| Warranty  expenditures incurred during the year                                                 |       | (18,905  | )          | (21,595  | )          | (24,340  | )          |
| Balance,  December 31                                                                      |       | $        | 26,200     |     | $          | 28,200   |       | $ | 30,191 |   |

 

(b)   IntellectualProperty Indemnifications – We include intellectual property indemnificationclauses within our general terms and conditions with our customers and thegeneral purchase agreements with our three major customers, ASM Lithography,Canon, and Nikon.  In general, theseindemnification provisions provide that we will defend our customers againstany infringement claims that arise related to our products.  Under the indemnification clauses, we willpay all costs and damages, including attorney’s fees, associated with suchsettlements or defenses, provided that the customer follows specific proceduresfor notifying us of such claims and allows us to manage the settlementproceedings. Due to the nature of these indemnification provisions, they areindefinite and extend beyond the term of the actual customer agreements.

 

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An indemnification provision was also included in the contractmanufacturing agreement with Seiko Instruments, Inc. (“Seiko”), which wasterminated effective March 31, 2003. As with our indemnification provisions on intellectual property, wecontinue to honor this indemnification clause within the agreement even afterits termination. Seiko and at least one Japanese customer have been notifiedthat our light source systems in Japan may infringe certain Japanesepatents.  We believe, based upon theadvice of counsel, that our products do not infringe any valid claim of theasserted patents or that we are entitled to prior use claims in Japan.  Due to the nature of these indemnificationprovisions, they are indefinite and extend beyond the term of the actualcustomer agreements.

 

As part of the research and development agreement signed with IntelCorporation (“Intel”) in 2004, we also agreed to provide Intel with indemnityagainst any infringement of the intellectual property rights of any third partyarising from Intel’s purchase and/or use of our EUV source systems.  Details of such indemnity will be negotiatedas part of a purchase agreement related to potential future products.

 

As part of thesupply agreement signed with TCZ in September 2005, we agreed to indemnifyTCZ against any infringement of the intellectual property rights of a thirdparty arising from TCZ’s purchase of our products.  We will defend such actions at our own expenseand will pay the cost and damage awarded in any such action provided that TCZgrants us sole control of the defense and settlement of such action and alsoprovides us with information required for the defense and settlement of suchaction.  Due to the nature ofthese indemnification provisions, they are indefinite and extend beyond the termof the actual customer agreements.

 

***Comprehensive Income******(Loss)*–**Comprehensive income (loss) includes net income (loss), unrealized gains andlosses on forward contracts, foreign currency translation adjustments, andunrealized gains and losses on available-for-sale securities, which we recordas short-term and long-term investments in the accompanying consolidatedbalance sheets.

 

***Revenue Recognition***– We recognize revenue inaccordance with Staff Accounting Bulletin No. 104 (“SAB 104”), “RevenueRecognition”.  We recognize revenue whenpersuasive evidence of an arrangement exists, delivery has occurred or serviceshave been rendered, our price is fixed or determinable, and collectibility isreasonably assured. Our revenues consist of product sales, which include salesof light source systems, consumable and spare parts, upgrades, service, servicecontracts and training.  Our revenues also consist of certain fundeddevelopment activities performed for our customers and under governmentcontracts and license agreements.

 

Our light source system sales generally includetraining and installation services. We determined these elements qualify as oneunit of accounting under EITF No. 00-21, “Revenue Arrangements withMultiple Deliverables” as we do not have evidence of fair value for theundelivered training and installation elements. Furthermore, we determined thatthe undelivered training and installation elements are perfunctory performanceobligations and are not essential to the functionality of our light sourcesystems. Therefore, in accordance with the provisions of SAB 104, we recognizerevenue when the revenue recognition criteria are met for the light sourcesystem, and accrue the costs of providing the training and installationservices.  We recognize light sourcesystem revenue at one of following three points, depending on the terms of ourarrangement with our customer – 1) shipment of the light source 2) delivery ofthe light source or 3) receipt of an acceptance certificate. For the majorityof our light source 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 our lightsource systems in environments similar to those used by our customers prior toshipment to ensure that they meet published specifications.

 

Revenue from consumables and spare partssales is recognized at the point that legal title passes to the customer, whichis upon shipment from our facility.  For a significant portion of ourspare parts 

 

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sales, our customers return the consumedassembly to us as part of the sale of a new part.  We reuse some of thematerial within these core assemblies, mainly metal components, for the futurebuild of core assemblies.  As a result, our revenue consists of both cashand 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 asthe services are rendered.

 

For funded development contracts, which areincluded in other revenue, funds received are accounted for on the percentage-of-completionmethod based on the relationship of costs incurred to total estimated costs.Revenues generated from these types of funded development contracts are derivedfrom cost sharing contracts between certain customers and us. If milestones onthese funded development contracts require that specific results be achieved orreported by us, revenue is not recognized until that milestone iscompleted.  For some of the 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.

 

***Research and Development*****– We expense research and development costs, which includecosts associated with funded development contracts, in the period incurred. Fundeddevelopment contracts are generally cost sharing contracts between us and acustomer 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 anddevelopment expenses also include offsets for amounts we receive from certainof our externally funded research and development contracts.

 

***Income Taxes*** – Income taxesare accounted for under the asset and liability method.  Deferred tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenthe financial statement carrying amounts of existing assets and liabilities andtheir respective tax bases.  Deferred taxassets and liabilities are measured using enacted tax rates that are expectedto apply in the periods in which the deferred tax asset or liability isexpected to be realized or settled.  Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date.

 

***Stock-Based Compensation*** – Weapply the intrinsic value-based method of accounting prescribed by AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and relatedinterpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, “Accountingfor Certain Transactions involving Stock Compensation, an interpretation of APBOpinion No. 25”**to account forour stock option plans.  Under thismethod, employee-based stock compensation expense is measured on the date ofgrant only if the then current market price of the underlying stock exceeds theexercise price.  Statement of FinancialAccounting Standards No. 123 (“SFASNo. 123”) “Accounting forStock-Based Compensation”, established accounting and disclosurerequirements using a fair value-based method of accounting for stock-basedemployee compensation plans.  As allowed by SFAS No. 123, we have elected tocontinue to apply the intrinsic value-based method of accounting describedabove, and have adopted the disclosure requirements of SFAS No. 123, asamended by Statement of Financial Accounting Standards No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure”*.*For thepro-forma disclosure, employee-based stock compensation expense is recorded on a straight-linebasis over the applicable vesting period.

 

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

 

We account for options granted to non-employees underSFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, “Accountingfor Equity Instruments that are Issued to other than Employees for Acquiring orin Conjunction with Selling Goods or Services”. We measure the fair value of such options using the Black-Scholesoption-pricing model at each financial reporting date.  We account for changes in fair values betweenreporting dates in accordance with FASB Interpretation No. 28.  Stock-based compensation expense for optionsgranted to non-employees and for those employees who changed status during the yearsended December 31, 2003, 2004 and 2005 was $1.3 million,  $326,000 and $1.0 million, respectively.

 

UnderSFAS No. 123, the weighted average per share fair value of the optionsgranted for the years ended December 31, 2003, 2004 and 2005 was $19.20,$21.76 and $17.39, respectively, on the date of grant.  Fair value under SFAS No. 123 isdetermined using the Black-Scholes option-pricing model with the weightedaverage assumptions noted below. In the fourth quarter of 2005, we refinedthe computation of the expected volatility assumption used in ouroption-pricing model. We determined that the volatility calculated using ablend of publicly traded options or implied volatility and our historicalvolatility was more reflective of expected volatility than using onlyhistorical volatility. We used this updated expected volatility, which waslower than the expected volatility used in previous quarters in 2005, for stockoptions granted in the fourth quarter of 2005. Because we had a low volume ofstock option grants in the fourth quarter of 2005 compared to the optionsgranted in the first nine months of 2005, the weighted average expectedvolatility for 2005 was only slightly lower than the volatility in the firstthree quarters of 2005. For the riskfree interest rate, we use the then currently available rate on zero couponU.S. Government issues with a remaining life of five years for valuing optionsand one year for valuing employee stock purchase plan (“ESPP”) shares.

 
| ** **               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------|------------|-----------------------------------|------------|
| ** **               | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
|                     |       |                              |       |   |   |   |   |
| Dividend yield           |       | None                              |       | None |   | None |   |
| Volatility rate:         |       |                              |       |   |   |   |   |
| Options                  |       | 79%                               |       | 75% |   | 74% |   |
| ESPP                     |       | 79%                               |       | 75% |   | 75% |   |
| Risk free interest rate: |       |                              |       |   |   |   |   |
| Options                  |       | 3.16%                             |       | 3.40% |   | 3.97% |   |
| ESPP                     |       | 1.26%                             |       | 2.30% |   | 3.33% |   |
| Expected life:           |       |                              |       |   |   |   |   |
| Options                  |       | 4.26 years                        |       | 4.36 years |   | 4.19 years |   |
| ESPP                     |       | .5 years                          |       | .5 years |   | .5 years |   |

 

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Thefollowing table compares earnings (loss) 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,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                                                                                                              |       |                              |       |   |   |   |   |
| Net income  (loss), as reported                                                                                                                   |       | $                                 | (15,400    | ) | $ | 43,154 |   | $ | 46,552 |   |
| Add: Stock-based  employee compensation expense included in reported net income (loss), net of  related tax effects                               |       | 544                               |       | 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 |       | (10,933                           | )          | (17,112 | ) | (22,911 | ) |
|                                                                                                                                              |       |                              |       |   |   |   |   |
| Pro forma net  income (loss)                                                                                                                      |       | $                                 | (25,789    | ) | $ | 26,301 |   | $ | 24,654 |   |
|                                                                                                                                              |       |                              |       |   |   |   |   |
| Earnings (loss)  per share:                                                                                                                       |       |                              |       |   |   |   |   |
| Basic – as  reported                                                                                                                         |       | $                                 | (0.44      | ) | $ | 1.17 |   | $ | 1.29 |   |
| Basic – pro  forma                                                                                                                           |       | $                                 | (0.74      | ) | $ | 0.72 |   | $ | 0.68 |   |
|                                                                                                                                              |       |                              |       |   |   |   |   |
| Diluted – as  reported                                                                                                                       |       | $                                 | (0.44      | ) | $ | 1.15 |   | $ | 1.27 |   |
| Diluted – pro  forma                                                                                                                         |       | $                                 | (0.74      | ) | $ | 0.70 |   | $ | 0.67 |   |

 

As of December 31,2005, the unamortized compensation expense related to outstanding unvestedoptions was approximately $12.7 million with a weighted average remaining vestingperiod of 1.2 years. We expect to amortize this expense over the remainingvesting period of these stock options. In addition, we will record additionalexpense for any new awards that are granted in 2006 and in future years.

 

InFebruary 2005, our board of directors approved the acceleration of thevesting of stock options that had exercise prices of $30.50 per share or higherheld by employees. This acceleration of stock options excluded directors,executive officers and certain vice presidents. The purpose of thisacceleration of vesting was to enable us to eliminate the recognition in ourstatement of operations of the compensation expense associated with these “outof the money” stock options in future periods, upon our adoption of Statementof Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-BasedPayment – An Amendment to Statement Nos. 123 and 95,” on January 1, 2006.  The acceleration of vesting of these stockoptions in the year ended December 31, 2005 contributed approximately$10.4 million of pro forma stock-based compensation expense during the yearended December 31, 2005.

 

***Foreign Currency Translation*** – Thefinancial statements of our foreign subsidiaries where the functional currencyhas been determined to be the local currency are translated into U.S. dollarsusing current rates of exchange for assets and liabilities and rates ofexchange that approximate the rates in effect at the transaction date forrevenues, expenses, gains and losses. Gains and losses resulting fromforeign currency translation are accumulated as a separate component ofconsolidated stockholders’ equity as accumulated other comprehensive income(loss). Gains and losses resulting from foreign currency transactions areincluded in the consolidated statements of operations. The net gainsfrom foreign currency transactions totaled $436,000 and $82,000 for the yearsended December 31, 2003 and 2004, respectively. Net losses from foreigncurrency transactions totaled $1.1 million for the year ended December 31,2005. Such amounts are recorded in other income (expense) in the accompanyingconsolidated statements of operations.

 

***Derivative Instruments*****– We conductbusiness in several international currencies through our global operations. Wemaintain a foreign exchange risk management policy with the goals of 

 

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protecting productmargins and minimizing the volatility of reported earnings due to foreigncurrency exposure.  In accordance with ourpolicy, we use financial instruments, principally foreign currency forwardexchange contracts (“forward contracts”), to manage our foreign currencyexposures. We enter into forward contracts in order to reduce the impact ofcurrency fluctuations related to purchases of our inventories by Cymer Japan inU.S. dollars for resale under firm third-party sales commitments denominated inJapanese yen, as well as other foreign currency exposures including exposuresrelated to intercompany debt.  We do notenter into forward contracts 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 risk managementobjective and strategy for undertaking the hedge, including identification ofthe hedging instrument, the hedged transaction, the nature of the risk beinghedged, and how the hedging instrument’s effectiveness will be assessed.  Furthermore, the hedging relationship must behighly effective in achieving offsetting cash flows attributable to the hedgedrisk during the term of the hedge.

 

In accordance with theprovisions of SFAS No. 133, we defer changes in the fair value for theeffective portion of these hedges and record the amount in other comprehensiveincome (loss), and subsequently reclassify the gain or loss to cost of productsales in the same period that the related sale is made to the third party.  For forward contracts entered into after May 1,2004, interest charges or “forward points” on our forward contracts areexcluded from the assessment of hedge effectiveness, and are recorded currentlyin foreign currency exchange gain (loss) in the consolidated statements ofoperations. In the event that an anticipated, hedged transaction is no longerlikely to occur within a certain time period, the derivative gain or lossreported in accumulated other comprehensive income is immediately reclassifiedinto foreign currency exchange gain (loss).

 

The fair value of allforward contracts and the associated deferred loss in other comprehensiveincome (loss) totaled $1.8 million and $70,000, respectively, as of December 31,2005. It is expected that 100% of the deferred loss will be reclassified intoearnings within the next 12 months.  Theexcluded component of our forward contracts amounted to a gain of $181,000 and$809,000 for the years ended December 31, 2004 and 2005, respectively.  In the third quarter of 2004, we recorded aloss of $1.1 million as a result of the discontinuance of certain cash flowhedges. This loss is included in foreign currency exchange gain (loss) on ourconsolidated statements of operations.

 

Asof December 31, 2005, we had outstanding forward contracts to buy U.S.$46.2 million for 5.2 billion yen under foreign currency exchange facilitieswith contract rates ranging from 105.8 yen to 118.3****yenper U.S. dollar. These contracts expire on various dates through June 2006. Werecognized a net loss through cost of product sales from the forward contractsof $2,484,000 and  $2,317,000 for theyears ended December 31, 2003 and 2004, respectively, and a net gainthrough cost of product sales of $1,375,000 for the year ended December 31,2005.

 

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

 

*Cashand cash equivalents* – We invest ourexcess cash in an effort to preserve capital, provide liquidity, maintaindiversification and generate returns relative to our corporate investmentpolicy and prevailing market conditions. We have not experienced any material losses in our cash and investmentaccounts.  The cash balances that we hold in financial institutions are in excess offederally insured limits. We perform periodic evaluations of the relativecredit standing of financial institutions and limit the amount of risk byselecting financial institutions with a strong relative credit standing.  At December 31, 2004 and 2005, we had $113.8million and $233.3 million respectively, in deposits with major financialinstitutions that exceeded the federally insured limit of $100,000.

 

F-16

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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, securitydeposits, 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 supplier forcertain 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:

 
| ** **      | ** ** | **Years ended December 31,** | ** ** |
|-----------------|------------|-----------------------------------|------------|
| ** **      | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **      | ** ** | **(in thousands)**                | ** ** |
| **Customer**    |       |                              |       |   |   |   |   |
| ASM Lithography |       | $                                 | 63,793     |   | $ | 140,828 |   | $ | 121,156 |   |
| Canon           |       | 64,459                            |       | 45,597 |   | 29,957 |   |
| Nikon           |       | 55,107                            |       | 90,972 |   | 93,203 |   |
|                 |            |                                   |            |  |  |  |  |  |  |  |

 

Accountsreceivable balances for these same major customers are detailed as follows:

 
| ** **      | ** ** | **December 31,** | ** ** |
|-----------------|------------|-----------------------|------------|
| ** **      | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ** **      | ** ** | **(in thousands)**    | ** ** |
| **Customer**    |       |                  |       |   |   |
| ASM Lithography |       | $                     | 48,946     |   | $ | 31,846 |   |
| Canon           |       | 4,812                 |       | 4,079 |   |
| Nikon           |       | 33,173                |       | 22,303 |   |
|                 |            |                       |            |  |  |  |  |

 

Revenuesfrom Japanese customers, generated primarily by Cymer Japan,  amounted to 44%, 32% and 31% of total revenuefor the years ended December 31, 2003, 2004, and 2005, respectively.Revenues from ASM Lithography in the Netherlands accounted for 24%, 34% and 32%of revenues for the years ended December 31, 2003, 2004, and 2005,respectively.

 

Theloss of business of any of these major customers would have a material adverseeffect on our operating results, financial condition, and cash flows.

 

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

 

F-17

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The following table sets forth the computation of dilutedweighted average common and potential common shares outstanding for the yearsended December 31, 2003, 2004, and 2005 (in thousands):

 
| ** **                                                               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                               | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                               | ** ** | **(in  thousands )**                        | ** ** |
| Basic weighted  average common shares outstanding                        |       | 35,065                                      |       | 36,758 |   | 36,017 |   |
|                                                                     |       |                                        |       |   |   |   |   |
| Effect of  dilutive securities:                                          |       |                                        |       |   |   |   |   |
| Warrants                                                                 |       | —                                      |       | 14 |   | — |   |
| Options                                                                  |       | —                                      |       | 812 |   | 527 |   |
|                                                                     |       |                                        |       |   |   |   |   |
| Diluted weighted  average common and potential common shares outstanding |       | 35,065                                      |       | 37,584 |   | 36,544 |   |

 

For the years ended December 31, 2003,2004 and 2005, weighted average options and warrants to purchase 3,943,000, 3,326,000and 4,500,000 shares of common stock, respectively, were outstanding but notincluded in the computation of diluted earnings per share as their effect wasanti-dilutive.  In addition, for theyears ended December 31, 2003, 2004 and 2005, weighted average commonshares attributable to convertible subordinated notes of 5,000,000, 4,645,000and 3,820,000, respectively, were not included in the computation of dilutedearnings per share as their effect was also anti-dilutive.

 

***Accounting Pronouncements Adopted***

 

In March 2005, the FASB issued FASBInterpretation No. 47 (“FIN 47”), “Accounting for Conditional AssetRetirement Obligations, an Interpretation of FASB Statement No. 143”. FIN 47 clarifies that an entity must record a liability for a “conditional”asset retirement obligation if the fair value of the obligation can bereasonably estimated. FIN 47 is effective no later than the end of fiscal yearsending after December 15, 2005.  The adoption of FIN 47 has not had amaterial impact on our consolidated financial statements.

 

***Recent Accounting Pronouncements***

 

In December 2004, the FASB issued SFASNo. 123R, “Share-Based Payment - An Amendment to Statement Nos. 123 and95,” that addresses the accounting for share-based payment transactions inwhich an enterprise receives employee services in exchange for (a) equityinstruments of the enterprise or (b) liabilities that are based on thefair value of the enterprise’s equity instruments or that may be settled by theissuance of such equity instruments. This statement will eliminate the abilityto account for share-based compensation transactions using AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and will require instead that such transactions be accounted forusing a fair-value-based method.  On April 14, 2005, the SECannounced the deferral of the effective date of SFAS No. 123R. Thedeferral allows companies to adopt the provisions of SFAS No. 123Rbeginning on the first annual period beginning after June 15, 2005. Basedon the new required adoption date, we will adopt SFAS No. 123R as of January 1,2006.

 

We have evaluated theimpact and implementation of SFAS No.123R and how this new pronouncement willeffect our consolidated financial statements. We anticipate that the adoptionof SFAS No. 123R will have a significant impact on our consolidatedstatements of operations, although it will have no impact on our cashposition.  Our evaluation included a determination on how future stockawards will be valued based on an appropriate fair value model upon adoption of

 

F-18

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SFAS No. 123R aswell as the impact of stock compensation expense associated with unvested stockoptions outstanding as of December 31, 2005.  In addition, as aresult of the amendment to our employee stock purchase plan, effective May 1,2005, our employee stock purchase plan is a non-compensatory plan under SFAS No. 123R,and, therefore, no stock compensation expense will be recorded under theemployee stock purchase plan upon the adoption of SFAS No. 123R.  Asof December 31, 2005, the unamortized compensation expense related tooutstanding unvested options was approximately $12.7 million. We expect toamortize this expense over the remaining vesting period of these stock options.In addition, we will record additional expense for any new awards as they aregranted in 2006 and in future years.  Weare also required to elect the transition method that we will use as part ofthe adoption of SFAS No. 123R. The allowed transition methods includeprospective and retroactive adoption alternatives. The prospective methodrequires that compensation expense be recorded for all unvested stock optionsand awards prospectively beginning with the first quarter adoption of SFAS No. 123R,while the retroactive method would require us to record compensation expensefor all unvested stock options and awards beginning with the first periodrestated. We will use the prospective transition method upon our adoption ofSFAS No. 123R effective January 1, 2006.

 

***Reclassifications****–*Certain amounts in the prior yearconsolidated financial statements have been reclassified to conform to currentperiod presentation.  As of December 31,2004, $86.8 million of auction rate securities were reclassified from cash andcash equivalents to short-term investments.

 

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

 

In July 2005, Cymerentered into a Joint Venture Agreement (the “JV Agreement”) with (i) CarlZeiss SMT AG, a German corporation (“SMT”); (ii) Carl Zeiss Laser OpticsBeteiligungsgesellschaft mbH, a German limited liability company (“LOB”); and (iii) TCZGmbH, the Swiss limited liability company that was formed as part of the JVAgreement. TCZ is currently developing and will integrate, market and sell, andsupport tools employing an excimer laser beam to induce crystallization of low-temperaturepoly-silicon (“LTPS”) processing for the manufacture of flat paneldisplays.  LOB and SMT, together with their affiliated entities, arecollectively referred to as “Zeiss”.

 

TCZ is owned 60% by usand 40% by Zeiss and earnings and losses will be distributed according to thesame percentages.  As an initial capitalcontribution to TCZ, we contributed certain intellectual property andapproximately $14.2 million in cash in the third quarter of 2005.  We consolidate the financial position and resultsof operations of TCZ and reflect Zeiss’ interest in TCZ as minority interest inour consolidated financial statements. If TCZ is dissolved, the intellectual property owned by TCZ will bedistributed to the members as joint owners, and the remaining assets, net ofliabilities, will be distributed to the members in accordance with theirpercentage interests.

 

As a result of theformation of TCZ, we entered into various agreements with TCZ.  Included in these agreements was a long-termsupply agreement which requires us to provide TCZ with components for TCZ’sproducts and an intellectual property agreement which controls the use of anyintellectual property developed by us for the joint venture (“JV”).

 

We determined TCZ qualifiesas a separate operating segment.  SeeNote 16.

 

F-19

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

 

The consolidated balance sheets detail is as follows as of December 31,2004 and 2005 (in  thousands):

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ACCOUNTS RECEIVABLE:                            |       |                  |       |   |   |
| Trade                                           |       | $                     | 105,662    |   | $ | 88,404 |   |
| Other                                           |       | 5,638                 |       | 2,170 |   |
|                                            |       | 111,300               |       | 90,574 |   |
| Less allowance  for doubtful accounts           |       | (620                  | )          | (756 | ) |
| Total                                           |       | $                     | 110,680    |   | $ | 89,818 |   |
|                                            |       |                  |       |   |   |
| INVENTORIES:                                    |       |                  |       |   |   |
| Raw materials                                   |       | $                     | 52,245     |   | $ | 42,482 |   |
| Work-in-progress                                |       | 24,344                |       | 18,408 |   |
| Finished goods                                  |       | 46,093                |       | 38,601 |   |
| Allowance for  excess and obsolete inventory    |       | (12,660               | )          | (10,445 | ) |
| Total                                           |       | $                     | 110,022    |   | $ | 89,046 |   |
|                                            |       |                  |       |   |   |
| UNEARNED INCOME:                                |       |                  |       |   |   |
| Light source  systems                           |       | $                     | 4,169      |   | $ | — |   |
| Funded  development contracts                   |       | 1,699                 |       | 796 |   |
| Service  contracts                              |       | 221                   |       | 880 |   |
| License  agreement                              |       | 63                    |       | 50 |   |
|                                            |       | $                     | 6,152      |   | $ | 1,726 |   |
|                                            |       |                  |       |   |   |
| PROPERTY AND EQUIPMENT:                         |       |                  |       |   |   |
| Land                                            |       | $                     | 9,080      |   | $ | 9,080 |   |
| Building                                        |       | 89,546                |       | 89,852 |   |
| Building  improvements                          |       | 5,498                 |       | 6,687 |   |
| Furniture and equipment                         |       | 83,587                |       | 85,804 |   |
| Capitalized  light sources                      |       | 37,041                |       | 41,739 |   |
| Leasehold  improvements                         |       | 3,024                 |       | 3,473 |   |
| Construction in  process                        |       | 2,546                 |       | 1,552 |   |
|                                            |       | 230,322               |       | 238,187 |   |
| Less accumulated  depreciation and amortization |       | (106,774              | )          | (120,936 | ) |
| Total                                           |       | $                     | 123,548    |   | $ | 117,251 |   |

** **

**Depreciation expense totaled $28.0 million, $24.7 million and $24.8million for the years ended December 31, 2003, 2004 and 2005,respectively.**

 

F-20

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**4.**                    INVESTMENTS

** **

Investments at December 31,2004 consist of the following (in thousands):

 
| ** **                | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Market** | ** ** |
| ** **                | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
| Short-term:               |       |          |       |           |       |           |       |       |       |
| Corporate debt securities |       | $             | 49,972     |           | $          | 80             |       | $          | (7         | ) | $ | 50,045 |   |
| U.S. government agencies  |       | 1,997         |       | —         |       | (2             | )          | 1,995      |       |
| Commercial paper          |       | 33,124        |       | 25             |       | (98            | )          | 33,051     |       |
| Auction rate securities   |       | 90,775        |       | —         |       | —         |       | 90,775     |       |
| Total                     |       | $             | 175,868    |           | $          | 105            |       | $          | (107       | ) | $ | 175,866 |   |
|                      |       |          |       |           |       |           |       |       |       |
| Long-term:                |       |          |       |           |       |           |       |       |       |
| Corporate debt securities |       | 14,726        |       | —         |       | (158           | )          | 14,568     |       |
| U.S. government agencies  |       | 67,680        |       | —         |       | (387           | )          | 67,293     |       |
| Auction rate securities   |       | 2,700         |       | —         |       | —         |       | 2,700      |       |
| Total                     |       | $             | 85,106     |           | $          | —         |       | $          | (545       | ) | $ | 84,561 |   |

 

Investments at 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 |   |

 

As of December 31,2005, the contractual maturities of debt securities were as follows (inthousands):

 
| ** **  | ** ** | **Less than** | ** ** | **One to**      | ** ** | ** ** | ** ** |
|-------------|------------|---------------|------------|-----------------|------------|------------|------------|
| ** **  | ** ** | **One Year**  | ** ** | **Three Years** | ** ** | **Total**  | ** ** |
|        |       |          |       |            |       |       |       |
| Short-term: |       | $             | 130,204    |            | $          | —     |       | $ | 130,204 |   |
| Long-term:  |       | —        |       | 29,395          |       | 29,395     |       |
|        |       |          |       |            |       |       |       |
| Total       |       | $             | 130,204    |            | $          | 29,395     |       | $ | 159,599 |   |

 

F-21

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The following tableshows the gross unrealized losses and fair value of our investments that arenot deemed to be other-than-temporarily impaired grouped by investment categoryat December 31, 2005:

 
| ** **                 | ** ** | ** ** | ** ** | **Gross**      | ** ** |
|----------------------------|------------|------------|------------|----------------|------------|
| ** **                 | ** ** | **Market** | ** ** | **Unrealized** | ** ** |
| ** **                 | ** ** | **Value**  | ** ** | **Loss**       | ** ** |
|                       |       |       |       |           |       |
| Corporate debt  securities |       | $          | 16,900     |           | $          | (179 | ) |
| U.S. government  agencies  |       | 105,495    |       | (1,373         | )          |
| Commercial paper           |       | 4,609      |       | (2             | )          |
| Total                      |       | $          | 127,004    |           | $          | (1,554 | ) |

 

At December 31, 2005,we did 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 31,2005 represent a temporary condition and will not result in realized losses onsale or maturity of the securities.  Wereview our investment portfolio to identify and evaluate investments that haveindications of possible impairment. Factors considered in determining whether a loss is temporary includethe length of time and extent to which fair value has been less than the costbasis, the financial condition and near-term prospects of the investee, creditquality and our ability to hold the investment for a period of time sufficientto allow for any anticipated recovery in market value.

 

**5.       REPORTINGCOMPREHENSIVE INCOME**

 

Comprehensive income includes net income, effective unrealized gainsand losses on forward contracts, foreign currency translation adjustments, andunrealized gains and losses on available-for-sale securities, which arerecorded as short-term and long-term investments in the accompanyingconsolidated balance sheets.

 

See the Consolidated Statements of Stockholders’ Equity for the impactof the components of comprehensive income (loss) to our net income (loss).

 

The following table summarizes the change in each component ofaccumulated other comprehensive loss for the years ended December 31, 2003,2004 and 2005 (in thousands):

 
| ** **        | ** ** | ** **        | ** ** | ** **      | ** ** | **Total unrealized**   | ** ** | **Total unrealized**      | ** ** | ** **        | ** ** |
|-------------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|---------------------------|------------|-------------------|------------|
| ** **        | ** ** | ** **        | ** ** | ** **      | ** ** | **gains (losses) on**  | ** ** | **losses on**             | ** ** | **Accumulated**   | ** ** |
| ** **        | ** ** | ** **        | ** ** | ** **      | ** ** | **available-for-sale** | ** ** | **foreign currency**      | ** ** | **other**         | ** ** |
| ** **        | ** ** | ** **        | ** ** | **Translation** | ** ** | **investments,**       | ** ** | **forward exchange**      | ** ** | **comprehensive** | ** ** |
| ** **        | ** ** | ** **        | ** ** | **adjustment**  | ** ** | **net of tax**         | ** ** | **contracts, net of tax** | ** ** | **loss**          | ** ** |
|              |       |              |       |            |       |                   |       |                      |       |              |       |
| January 1, 2003   |       | Balance           |       | $               | (5,272     | )                      | $          | 2,342                     |       | $                 | (499       | ) | $ | (3,429 | ) |
|              |       | Period net change |       | 799             |       | (894                   | )          | (2,210                    | )          | (2,305            | )          |
| December 31, 2003 |       | 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 | ) |

 

F-22

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** **

**6.       DEVELOPMENT AGREEMENT ANDINTELLECTUAL PROPERTY LICENSE AGREEMENT**

 

In January 2004,we entered into a research and development agreement with Intel. Under thisagreement, Intel will provide us a total of $20.0 million over a three-yearperiod to accelerate the development of production-worthy extreme ultraviolet (“EUV”)lithography light sources. The funding from Intel under this agreement ismilestone based and is netted against our total research and developmentexpenses in the period that the milestone is achieved.  Due to the complexity of the EUV technology, wehave regular communications with Intel on the milestones under the contract andthe timing and requirements for their completion.  As a result of these discussions, onlycertain milestones were planned for and achieved in 2005.  We will continue to work with Intel in 2006 tofurther refine the milestones and work to be performed under the contract. Thetotal funded amounts recorded under this agreement for the years ended December 31,2004 and 2005 were $6.1 million and $1.9 million, respectively.

 

In February 2004, weentered into an intellectual property license agreement with Intel for the useof certain Intel patents and trade secrets related to EUV technology. Under theterms of this agreement, we will pay license fees to Intel if we are successfulin commercializing an EUV lithography light source capable of high volumemanufacturing by the end of the second quarter of 2008. The license paymentsunder this agreement are triggered in the quarter in which we successfully shipthe first complete high volume manufacturing EUV source system.  Commencing with shipment of this first unit, wewill pay Intel $1.25 million in license fees per quarter for a period ofsixteen quarters.  The quarterly licenseamounts paid to Intel, if any, will be related to our sale of EUV light sourcesystems and, as a result, will be recorded as cost of product sales. Themethodology and amounts that we will record to cost of product sales will bedetermined when the high volume manufacturing production unit sales or aforecast of sales can be made.  Noamounts have been earned under this arrangement as of December 31, 2005.

 

**7.       GOODWILLAND INTANGIBLE ASSETS**

 

We account for our goodwill and otherintangible assets in accordance with SFAS No. 142. Under SFAS No. 142,our goodwill is subject to an annual impairment test. During thefourth quarter of 2005, we completed our annual impairment test of goodwill andintangible assets, and concluded that no impairment of goodwill existed.  The carrying amount of goodwill was $8.4million as of December 31, 2004 and 2005.

 

Included in intangibleassets – net on the accompanying balance sheets are amounts associated withpatents that were acquired in 2001, 2003 and 2005.  As of December 31, 2004 and 2005, thenet carrying amount of these patents was $10.4 million and $10.5 million,respectively.  The accumulatedamortization for these patents at December 31, 2004 and 2005 was $5.9million and $8.3 million, respectively.  Amortizationexpense for these patents was $1.5 million, $2.4 million and $2.4 million forthe years ended December 31, 2003, 2004 and 2005, respectively.

 

As of December 31,2005, future estimated amortization expense for the next five years for thesepatents is expected to be as follows for (in thousands):

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

 

F-23

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** **

**8.**                    CREDIT FACILITIES

** **

***Margin Facility –***During 2004 and 2005, we maintained arevolving credit facility referred to as a “margin facility” with a large U.S.financial institution.  The facilitycarries a preferred interest rate which is tied to the U.S. Federal Funds rate,and is secured by certain investment securities which we hold at the samefinancial institution.   The applicablerate of interest on this facility at December 31, 2004 and 2005 wasapproximately 2.45% and 4.95%, respectively. No amounts were outstanding under this facility as of December 31,2004 and 2005.

 

***Foreign Currency ExchangeFacilities*** – During 2004 and 2005, we maintained foreigncurrency exchange facilities with five financial institutions in the U.S.  See also “Derivative Instruments” in Note1.  The foreign currency exchangefacilities provided up to $100 million in 2004 and 2005 to be utilized for spotand futures foreign currency exchange contracts for periods of up to one year.As of December 31, 2004 and 2005, $49.1 million and $46.2 million wasutilized under the foreign currency exchange facilities, respectively.

 

**9.**                    IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS

** **

During the year ended December 31,2003 the impairment loss of $17.7 million included impairment associated withtenant improvements, $15.6 million of which resulted from two leased facilitiesin San Diego which were vacated in the third quarter of 2003 and certain testequipment used within manufacturing and research and development.  The loss of $17.7 million was recorded ingeneral and administrative, cost of product sales and research and developmentexpenses, as appropriate, in the accompanying consolidated statements ofoperations.  Impairment losses for 2004and 2005 were immaterial.

 

**10.**             CONVERTIBLE SUBORDINATED NOTES

** **

InFebruary 2002, we issued $250.0 million principal amount of unsecuredfixed rate 3.50% convertible subordinated notes due February 15, 2009 withinterest payable on February 15 and August 15 of each year. Thesenotes are convertible into shares of our common stock at a conversion rate of20 shares per $1,000 principal amount or an effective conversion price of$50.00 per share. We may redeem the notes after February 20, 2005 atcertain redemption prices expressed as a percentage of the principal amount. The notesare subordinated to our existing and future senior indebtedness and effectivelysubordinated to all indebtedness and other liabilities of our subsidiaries.  In the third quarter of 2004 and the secondquarter of 2005, we repurchased, at a discount to par, $49.2 million and $60.0million principal amount of these notes, respectively.  As a result of these repurchases, werecognized a gain on debt extinguishment of $911,000 in 2004 and $2.2 millionin 2005 .  Asof December 31, 2004 and 2005, we had $200.8 million and $140.7 millionprincipal amount of convertible subordinated notes outstanding, respectively.

 

**11.    STOCKHOLDERS’EQUITY**

 

***Common Stock Warrants*** – During fiscal 2001, we issuedwarrants to purchase 200,000 shares of our common stock at a weighted averagepurchase price of $31.43 per share in conjunction with the acquisition ofcertain patents (See Note 14).  During fiscal 2003, 2004 and 2005, no warrantswere granted and no warrants were exercised. The warrants expire in May 2006.

 

***Stockholder Rights Plan***– In February 1998, our board of directors adopted a stockholder rights plan.  The stockholder rights plan was intended to assure that all of our stockholders would receive fair and equal treatment in the event of any proposed takeover of Cymer and to guard against partial tender offers and other abusive tactics to gain control of Cymer without paying all of our stockholders the fair value of their shares, including a control premium. In August 2004, our board of directors 

 

F-24

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amended the stockholder rights plan to change the final expiration date from February 13, 2008 to September 1, 2004.  As a result of this amendment, the stockholder rights plan terminated on September 1, 2004.

 

***Stock Repurchase Program****–** *In January 2005, we announced that ourboard of directors had authorized us to repurchase up to $50 million**of our common stock in the open market or in privatelynegotiated transactions.  Through May 31,2005, we had repurchased 1,942,959 shares for $50 million, thereby completingthe program.

 

***StockOption and Purchase Plans***– We have thefollowing stock option and stock purchase plans:

 

*2005 Equity Incentive Plan (the “2005Plan”)*****– In May 2005, at our annual meetingof stockholders, our stockholders approved the 2005 Plan. The 2005 Planprovides for the grant or award of various equity incentives to our employees,directors and consultants. Upon approval of the 2005 Plan by the stockholders,we discontinued the use of our 1996 Stock Option Plan and 2000 Equity IncentivePlan for future equity awards.  Optionsissued under 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.  A total of 1,000,000 *shares* of common stock are reserved for issuance under the2005 Plan and it provides for the issuance of incentive stock options,nonstatutory stock options, stock appreciation rights, stock bonus awards,stock purchase awards, stock unit awards and other stock awards. Options topurchase 336,800 shares are outstanding and 663,064 shares remain available forgrant under this plan as of December 31, 2005.

 

*1996 Stock Option Plan (the“1996 Plan”)* – The 1996 Plan provided for the grant of incentivestock options to our employees and nonqualified stock options to our employees,directors and consultants.  The exerciseprices of stock options granted under the 1996 Plan were at least equal to thefair market value of our common stock on the dates of grant. Options issuedunder the 1996 Plan expire five to ten years after the options were granted andgenerally vest and become exercisable ratably over a four-year period followingthe date of grant. The 1996 Plan was terminated in May 2005 with the approvalof the 2005 Plan. A total of 7,900,000 shares of common stock were reserved forissuance under the 1996 Plan.  Of theseshares, options to purchase 3,706,460 shares are outstanding as of December 31,2005.

 

*2000 Equity Incentive Plan (the “2000 Plan”)*– In August 2000, our board of directors adopted the 2000 Plan whichprovides for the grant of options to our employees or consultants who areneither directors nor officers. The exercise prices of the options grantedunder the 2000 Plan were equal to the quoted market value of our common stockat the date of grant.  Options issuedunder the 2000 Plan expire ten years after the options were granted and generallyvest and become exercisable ratably over a four year period following the dateof grant.  The 2000 Plan was amended in2002 to increase the shares reserved for issuance under the plan from 1,850,000to 4,950,000.  The plan was terminated inMay 2005 with the approval of the 2005 Plan. A total of 4,950,000 sharesof common stock were reserved for issuance under the 2000 Plan. Of theseshares, options to purchase 2,846,039 shares are outstanding as of December 31,2005.

 

*1996Employee Stock Purchase Plan (the “ESPP”)*– The ESPPis intended to qualify under Section 423 of the Internal Revenue Code.  Under the ESPP, eligible employees maypurchase shares of our common stock through payroll deductions of up to 15% ofhis or her compensation (as defined in the plan), at a price per share equal to95% of the fair market value of our common stock at the end of the purchaseperiod.  This plan was amended in 2001 byour shareholders to establish two year offering periods with six-month purchaseperiods and to increase the plan shares issuable from 500,000 to 800,000.  This plan was amended again in 2004 toincrease the plan shares issuable to 1,200,000 shares. InFebruary 2005, our board of directors approved an amendment to our ESPPwhich became effective May 1, 2005. The amendment: a) changed the durationof offering periods under the plan from two years to six months b) reduced thediscount to market price used to determine purchase price for shares of ourcommon stock under the plan from 15% to 5%, 

 

F-25

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andc) eliminated the “lookback” feature that allowed the purchase price to bedetermined as of the beginning of an offering period, or enrollment date, ifthe market price as of the enrollment date was lower than the market price atthe end of the offering period.  Thenumber of shares issuable under the ESPP as of December 31, 2005 was94,723, and 1,105,277 shares have been previously issued.

 

*ACX 1993 Stock Option Plan**(the “ACX Plan”)*– We assumed the ACX Stock Option Plan uponcompletion of the acquisition of ACX in February 2001.  Outstanding options may be exercised solelyfor shares of our common stock, according to the conversion ratio establishedin the terms of the acquisition.  Theoutstanding ACX options were converted to options to purchase 336,109 of ourshares, at exercise prices ranging from $2.08 to $38.71 per share.  The ACX Plan provided for the grant ofincentive and nonstatutory options to purchase shares of common stock toemployees, directors and consultants at exercise prices not less than 100% ofthe fair market value of common stock on the dates the options weregranted.  Options issued under the ACXPlan expire five to ten years after the options were granted and generally vestand become exercisable ratably over a four-year period following the date ofgrant.  No further options will be issuedunder the ACX Plan.  As of December 31,2005, options to purchase 14,360 shares are outstanding under the ACX Plan.

 

In 1996, we adopted a *1996 Director Option Plan (the “Director Option Plan”)*whereby 200,000 shares were reserved for option grants to our directors.  There were 80,000 options issued under theDirector Option Plan in 1997.  TheDirector Option Plan was terminated in October 1997; however, 20,000 ofthese options remain outstanding as of December 31, 2005.

 

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

 
| ** **                            | ** ** | ** **         | ** ** | **Options Outstanding** | ** ** |
|---------------------------------------|------------|--------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **Stock Options**  | ** ** | ** **              | ** ** | **Weighted Average** | ** ** |
| ** **                            | ** ** | **Available**      | ** ** | **Number of**           | ** ** | **Exercise Price** | ** ** |
| ** **                            | ** ** | **for Grant** | ** ** | **Shares**              | ** ** | **Per Share** | ** ** |
|                                  |       |               |       |                    |       |   |   |
| Balance at January 1, 2003       |       | 2,650              |       | 8,122                   |       | $ | 28.20 |   |
| Granted                               |       | (1,496             | )          | 1,496                   |       | $ | 32.01 |   |
| Exercised                             |       | —             |       | (1,899                  | )          | $ | 23.22 |   |
| Cancelled                             |       | 493                |       | (493                    | )          | $ | 27.38 |   |
| Expired                               |       | (53                | )          | —                  |       | $ | — |   |
|                                  |       |               |       |                    |       |   |   |
| Balance at December 31, 2003     |       | 1,594              |       | 7,226                   |       | $ | 30.36 |   |
| Granted                               |       | (1,053             | )          | 1,053                   |       | $ | 36.73 |   |
| Exercised                             |       | —             |       | (502                    | )          | $ | 23.34 |   |
| Cancelled                             |       | 315                |       | (315                    | )          | $ | 32.97 |   |
| Expired                               |       | (4                 | )          | —                  |       | $ | — |   |
|                                  |       |               |       |                    |       |   |   |
| 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                |       | (342                    | )          | $ | 36.62 |   |
| Expired                               |       | (799               | )          | —                  |       |   |   |
|                                  |       |               |       |                    |       |   |   |
| Balance at December 31, 2005     |       | 663                |       | 6,924                   |       | $ | 32.15 |   |
| Exercisable at December 31, 2005 |       |               |       | 5,603                   |       | $ | 32.63 |   |

 

F-26

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Thefollowing table summarizes information as of December 31, 2005 concerningcurrently outstanding and exercisable options (number of shares in thousands):

 
| **Options Outstanding** | ** **  | **Options Exercisable** | ** ** |
|-------------------------|-------------|-------------------------|------------|
| ** **              | ** **  | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** **  | ** **              | ** ** | **Weighted Average** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** **  | ** **              | ** ** | **Remaining** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| **Range of**            | ** **  | **Number**              | ** ** | **Contractual Life** | ** ** | **Average** | ** ** | **Number** | ** ** | **Average** | ** ** |
| **Exercise Prices**     | ** **  | **Outstanding**         | ** ** | **(years)** | ** ** | **Exercise Price** | ** ** | **Exercisable** | ** ** | **Exercise Price** | ** ** |
|                    |        |                    |       |   |   |   |   |   |   |   |   |
| $                       | 11.65  | -                       | $          | 15.50 |   | 24 |   | 1.67 |   | $ | 12.56 |   | 24 |   | $ | 12.56 |   |
| $                       | 16.32  | -                       | $          | 23.25 |   | 1,132 |   | 4.55 |   | $ | 20.35 |   | 1,025 |   | $ | 20.42 |   |
| $                       | 23.38  | -                       | $          | 34.87 |   | 3,014 |   | 7.08 |   | $ | 29.38 |   | 1,981 |   | $ | 29.29 |   |
| $                       | 34.94  | -                       | $          | 52.31 |   | 2,733 |   | 5.59 |   | $ | 40.10 |   | 2,552 |   | $ | 40.13 |   |
| $                       | 54.00  | -                       | $          | 60.00 |   | 21 |   | 4.25 |   | $ | 54.42 |   | 21 |   | $ | 54.42 |   |
| $                       | 11.65  | -                       | $          | 60.00 |   | 6,924 |   | 6.05 |   | $ | 32.15 |   | 5,603 |   | $ | 32.63 |   |

 

InFebruary 2005, our board of directors approved the acceleration of thevesting of stock options that had exercise prices of $30.50 per share or higherheld by employees. This acceleration of stock options excluded directors,executive officers and certain vice presidents. The purpose of thisacceleration of vesting was to enable us to eliminate the recognition in ourstatement of operations of the compensation expense associated with these stockoptions in future periods upon the adoption of SFAS No. 123R which will be effective for us on January 1,2006. As the result of the acceleration of the vesting of these stock options,approximately 709,000 shares of our common stock became immediately exercisableas of February 17, 2005.

 

**12.**             INCOME TAXES

** **

Total income taxes forthe years ended December 31, 2003, 2004 and 2005 were allocated as follows(in thousands):

 
| ** **                                | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                      |       |                              |       |   |   |   |   |
| To income on continuing operations        |       | $                                 | (21,464    | ) | $ | 15,144 |   | $ | 262 |   |
| To stockholder’s equity and goodwill |       | (13,005                           | )          | (2,748 | ) | (736 | ) |
| Total income taxes                        |       | $                                 | (34,469    | ) | $ | 12,396 |   | $ | (474 | ) |

 

F-27

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Thebreakdown of income (loss) before income tax provision (benefit) and minorityinterest and the components of the provision (benefit) for income taxes oncontinuing operations on U.S. and foreign pre-tax income are summarized asfollows (in thousands):

 
| ** **                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| U.S. pre-tax  income            |       | $                                           | (46,536    | ) | $ | 48,369 |   | $ | 43,002 |   |
| Foreign pre-tax  income         |       | 10,763                                      |       | 12,205 |   | 2,786 |   |
|                            |       |                                        |       |   |   |   |   |
| Total                           |       | $                                           | (35,773    | ) | $ | 60,574 |   | $ | 45,788 |   |
|                            |       |                                        |       |   |   |   |   |
| Current income  taxes:          |       |                                        |       |   |   |   |   |
| Federal                         |       | $                                           | (4,082     | ) | $ | (794 | ) | $ | 1,576 |   |
| State                           |       | (714                                        | )          | 78 |   | (11 | ) |
| Foreign                         |       | 3,989                                       |       | 1,838 |   | 1,032 |   |
|                            |       |                                        |       |   |   |   |   |
| Total                           |       | (807                                        | )          | 1,122 |   | 2,597 |   |
|                            |       |                                        |       |   |   |   |   |
| Deferred income  taxes:         |       |                                        |       |   |   |   |   |
| Federal                         |       | (14,904                                     | )          | 16,455 |   | 328 |   |
| State                           |       | (4,418                                      | )          | (1,226 | ) | (2,338 | ) |
| Foreign                         |       | (1,335                                      | )          | (1,207 | ) | (325 | ) |
|                            |       |                                        |       |   |   |   |   |
| Total                           |       | (20,657                                     | )          | 14,022 |   | (2,335 | ) |
|                            |       |                                        |       |   |   |   |   |
| Income tax  provision (benefit) |       | $                                           | (21,464    | ) | $ | 15,144 |   | $ | 262 |   |

 

Theincome tax provision (benefit) is different from that which would be obtainedby applying the statutory federal income tax rate (35%) to income before incometax expense.  The items causing thisdifference for each period are as follows (in thousands):

 
| ** **                                                         | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                         | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                               |       |                                        |       |   |   |   |   |
| Provision at  statutory rate                                       |       | $                                           | (12,520    | ) | $ | 21,201 |   | $ | 16,026 |   |
| Foreign  provision in excess of (less than) federal statutory rate |       | 312                                         |       | 2,958 |   | (1,443 | ) |
| State income  taxes, net of federal benefit                        |       | (2,903                                      | )          | (135 | ) | (2,035 | ) |
| Extraterritorial  income exclusion benefit                         |       | (4,108                                      | )          | (7,305 | ) | (7,571 | ) |
| Federal tax  credits                                               |       | (2,123                                      | )          | (1,139 | ) | (3,896 | ) |
| Change in cash  surrender value of life insurance                  |       | —                                      |       | — |   | (883 | ) |
| Change in  valuation allowance                                     | ** ** | **—**                                  | ** ** | **—** |   | 293 |   |
| Other                                                              |       | (122                                        | )          | (436 | ) | (229 | ) |
|                                                               |       |                                        |       |   |   |   |   |
| Provision  (benefit) at effective tax rate                         |       | $                                           | (21,464    | ) | $ | 15,144 |   | $ | 262 |   |

 

F-28

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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,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                       | ** ** | **2004**              | ** ** | **2005** | ** ** |
|                                                             |       |                  |       |   |   |
| Deferred tax  assets:                                            |       |                  |       |   |   |
| Reserves and  accruals not currently deductible                  |       | $                     | 20,045     |   | $ | 19,216 |   |
| Difference  between book and tax basis of inventory              |       | 3,390                 |       | 5,667 |   |
| Tax  carryforwards                                               |       | 46,175                |       | 39,363 |   |
| Tax effect of  foreign transactions                              |       | 2,138                 |       | 6,192 |   |
| Foreign deferred  tax assets                                     |       | 3,444                 |       | 3,731 |   |
| Total gross  deferred tax assets                                 |       | 75,192                |       | 74,169 |   |
| Valuation  allowance                                             |       | —                |       | (293 | ) |
| Net deferred tax  assets                                         |       | 75,192                |       | 73,876 |   |
| Deferred tax  liabilities:                                       |       |                  |       |   |   |
| Difference  between book and tax basis of property and equipment |       | (6,237                | )          | (5,986 | ) |
| Reserves and  accruals not currently taxable                     |       | (706                  | )          | (123 | ) |
| Total deferred  tax liabilities                                  |       | (6,943                | )          | (6,109 | ) |
| Net deferred tax  assets                                         |       | $                     | 68,249     |   | $ | 67,767 |   |

 

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 the net operating loss (“NOL”) carryforwards of ourjoint venture, TCZ, we believe there is insufficient evidence to conclude thatrealization of the benefit is more likely than not, and therefore we haveprovided a full valuation allowance of $293,000 against this asset.  With regard to all other deferred tax assets,we believe that it is more likely than not that the results of futureoperations will generate sufficient taxable income to realize the benefit, andtherefore no valuation allowance has been provided for these assets.

 

At December 31,2005, we had federal tax NOL carryforwards of $29.3 million and federal taxcredits of $19.2 million, both of which begin to expire in 2020.  At December 31, 2005, we had state taxcredit carryforwards of $15.2 million, of which $3.5 million begin to expire in2009, and $11.7 million may be carried forward indefinitely.  At December 31, 2005, we had foreign NOLcarryforwards of $1.8 million which may be carried forward indefinitely.

 

During the fourth quarter of 2005, the expiration ofcertain statutes of limitations related primarily to U.S. federal tax creditsand deductions allowed us to release tax reserves in the amount of $4.2million. As a result, our fourth quarter of 2005 annualized effective tax ratewas a benefit rate of 11% resulting in an annual effective tax rate of lessthan 1%. See Note 17.

 

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 $3.0 million.

 

We have notprovided U.S. federal income and foreign withholding taxes on $53.3 million ofundistributed earnings from non-U.S. operations as of December 31, 2005 asit is our intention to reinvest undistributed earnings of our foreignsubsidiaries and thereby indefinitely postpone their remittance.  Accordingly, no provision has been made forforeign withholding taxes or U.S. income taxes which may become payable ifundistributed earnings of foreign subsidiaries were paid to us asdividends.  Currently, we are notconsidering the repatriation of any foreign earnings and as such, no impact isreported in the financial statements as of December 31, 2005.  It is not practicable to estimate the amountof the deferred tax liability on such unremitted earnings.

 

F-29

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**13.    CONTINGENCIESAND COMMITMENTS**

 

***Leases*** – We leasecertain facilities under non-cancelable operating leases.  The lease terms on these facilities arethrough January 1, 2010 and provide for certain rent abatements andminimum annual 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 fromlease payments because the building meets certain investment and operationalcriteria of the Korean government.  Wealso lease certain equipment under capital and short-term operating leaseagreements. These capital leases expired in 2005.  The net book value of assets under capitalleases at December 31, 2004 was approximately $12,000, which is net ofaccumulated amortization of approximately $135,000.

 

Rentexpense under operating leases net of sublease rental income is recognized on astraight-line basis over the life of the related leases, and totaledapproximately $4,773,000, $6,495,000 and $679,000 for the years ended December 31,2003, 2004 and 2005, respectively.  Rentexpenses for 2004 and 2005 include $3.0 million and $384,000 in costs recordedfor lease losses associated with our subleasing activities for our San Diegoand Charlestown facilities, respectively. Sublease rental income totaled $972,000, $1,085,000 and $4,044,000 forthe years ended December 31, 2003, 2004 and 2005, respectively.

 

Totalfuture minimum lease commitments under operating leases are as follows (inthousands):

 
| **Years ending December 31,** | ** ** | **Operating** | ** ** |
|----------------------------------------------|------------|---------------|------------|
|                                         |       |          |       |
| 2006                                         |       | $             | 4,999      |   |
| 2007                                         |       | $             | 3,965      |   |
| 2008                                         |       | $             | 3,380      |   |
| 2009                                         |       | $             | 3,278      |   |
| 2010                                         |       | $             | 71         |   |
| Total                                        |       | $             | 15,693     |   |

 

The following representsfuture minimum rentals to be earned under our noncancelable subleases (inthousands). These amounts are directly offset to the operating lease amountsabove.

 
| ** **                                   | ** ** | **Sublease** | ** ** |
|----------------------------------------------|------------|--------------|------------|
| **Years ending December 31,** | ** ** | **Payments** | ** ** |
|                                         |       |         |       |
| 2006                                         |       | $            | 3,471      |   |
| 2007                                         |       | $            | 3,604      |   |
| 2008                                         |       | $            | 1,526      |   |
| 2009                                         |       | $            | 1,124      |   |
| Total                                        |       | $            | 9,725      |   |

 

F-30

----

 

***Employee Savings Plan*** – We have a401(k) plan that allows participating employees to contribute a percentage oftheir salary, subject to annual limits. The plan is available to substantially all full-time U.S. employees.  Beginning January 1, 2000 we made amatching contribution of up to 4% of each participating employee’scompensation, not to exceed $4,000 per year. Effective January 1, 2004, our board of directors amended the401(k) plan to increase our maximum matching contribution to 5% of eachparticipating employee’s compensation, not to exceed $5,000 per year. Under thePlan, we contributed $1,558,000, $2,811,000 and $2,440,000 for the years ended December 31,2003, 2004 and 2005, 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$310,000, $182,000 and $222,000 for the years ended December 31, 2003,2004 and 2005, respectively.  Ourliability for deferred compensation totaled $2,958,000 and $4,126,000 as of December 31,2004 and 2005, respectively, and is included in other liabilities.  The cash surrender value of the lifeinsurance policies totaled $1,455,000 and $2,523,000 as of December 31,2004 and 2005, respectively, and is included in other assets.

 

***Executive Option and Group HealthCoverage 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. One former executiveparticipated in this program in 2005. The cost for this program was notmaterial in 2003, 2004 or 2005.

 

***Retirement Plans*** –Cymer Japan has a Retirement Allowance and Pension Plan (“pension plan”) forall Cymer Japan employees, as well as a retirement allowance for Japanesedirectors (“directors’ plan”).  Expenseunder these plans totaled approximately $526,000, $536,000 and $321,000 for theyears ended December 31, 2003, 2004 and 2005, respectively.   The expenses for the pension plan arerecorded pursuant to the accounting requirements under Statements of FinancialStandards No. 87, 88 and 132R. We use November 30 as the measurementdate. Our liability for both plans totaled approximately $1.5 million and $1.4million as of December 31, 2004 and 2005, respectively. Although the totalexpenses and liability balances provided above include both plans, thedirectors’ plan is immaterial to all amounts and years provided.  The projected benefit obligation at December 31,2004 and 2005 was approximately $1.3 million for both years.  The accumulated benefit obligation at December 31,2004 and 2005 was approximately $928,000 and $1.0 million, respectively. Theactuarial loss was approximately $69,000 at December 31, 2005.

 

Thepension plan is an unfunded plan and includes no plan assets. The net periodicpension costs for the year 2006 are estimated at $225,000, and the projectedbenefit obligation is estimated at $1.4 million as of December 31, 2006.Estimated future benefit payments expected under the pension plan from 2006through 2010, and thereafter are $80,000, $90,000, $101,000, $109,000, $179,000and $709,000, respectively.  Thefollowing assumptions were used in the actuarial calculations for both 2004 and2005: salary increases 4.0% per year, and mortality rates using the Japanese 19thLife Table. The discount rates used in the actuarial calculations were 1.25%and 1.50% for 2004 and 2005, respectively.

 

***Korea CustomsInvestigation*****–**The****customs agency in Korea had asserted thatparts being imported into Korea from our corporate office in San Diego wereclassified improperly for customs and duties purposes and some used items,which were returned to San Diego, were valued improperly during the period from1997 through July 2003.  Although wedid not agree with these 

 

F-31

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assertions, Koreancustoms assessed and required us to pay additional duties related to shipmentsduring this time period.  As a result ofthese assertions and discussions that we had with the customs agency in Korea,we accrued a liability of $4.7 million through December 31, 2003. Theexpense resulting from this recorded liability was included in cost of productsales in the accompanying consolidated statements of operations. Payments madeto the customs agency in Korea were $2.5 million and $1.9 million during 2003and 2004, respectively. The 2004 payment was net of a $289,000 refund receivedfrom the Korea customs agency.  In 2004,we received notification from the Korean customs agency that we would receive arefund of a portion of duties previously paid. As a result, we recorded a $2.3million reduction to cost of product sales and $100,000 to interest income inthe accompanying consolidated statements of operations for the year ended December 31,2004 related to this refund. The accrual for this refund was recorded inaccounts receivable-net in the accompanying consolidated balance sheet as of December 31,2004. No balances related to this refund were outstanding as of December 31,2005.

 

***Contingencies*****– We are party to legal actions in the normal course of business.  Based in part on the advice of legal counsel,our management does not expect the outcome of legal action in the normal courseof business to have a material impact on our financial position, liquidity, orresults of operations.

 

Our former Japanesemanufacturing partner, Seiko, and one of our Japanese customers have beennotified that our light source systems in Japan may infringe certain Japanesepatents held by another Japanese company. We have agreed to indemnify our former Japanese manufacturing partnerand our customers against patent infringement claims under certain circumstances,even after the termination date of the contract manufacturing agreement.  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.

 

**14.    PATENTLICENSE AGREEMENTS**

 

In May 2001,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 life of the patentspurchased under the agreement. The amortization of these patents is included incost of product sales on the accompanying statements of operations since theyare used in products which are currently being shipped to customers.

 

In November 2003,we acquired the rights to the same list of patents as in the May 2001agreement but for a different field of use, for a total amount of $6.0 millionin cash.  This license agreement allowsus to use the patents for EUV and other future applications.  The total value of these patents are beingamortized over a period of 5.5 years which represents the remaining life of thepatents purchased under the agreement. The amortization of these patents isincluded in research and development expenses on the accompanying statements ofoperations since the field of use involves applications which are still in theresearch and development stages.

 

In November 2005,we acquired certain patents for use in our DUV light source applications in mask based lithography for a total of $2.5million in cash.  The total value ofthese patents are being amortized over a period of 14.65 years which representsthe average remaining life of the patents purchased under the agreement. Theamortization of these patents is included in cost of product sales on theaccompanying statements of operations since they are mainly being used inproducts which are currently being shipped to customers.

 

F-32

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As of December 31,2004 and 2005, the net carrying amount related to all of these patent licenseagreements was $10.4 million and $10.5 million, respectively.

 

**15.   **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. Thegeneral provisions of these agreements are as follows:

 

*Product License Agreement**–* We granted to the stockholder the exclusive right in Japanand the non-exclusive right outside Japan to manufacture and sell one of ourproducts and any subsequent enhancements. We also granted the stockholder theright of first refusal to license and fund the development of new technologiesnot developed with funding from other parties. In exchange for these rights, we received up-front license fees and wereentitled to royalties of 5% on related product sales through September 1999,after which the royalty rate was subject to renegotiation.  To date there has been no renegotiation ofthe royalty rate.  The license agreementalso provides that product sales between us and the stockholder will be at a15% discount from the respective companies’ list price. The agreementterminates in August 2012.  Therewas no activity under this agreement in 2003, 2004 and 2005.

 

*Contract Manufacturing Agreement**–* The stockholder agreed to manufacture certain products forus and we were required to purchase from the stockholder a specified percentageof our total annual product, as defined. We mutually agreed to the termination of this contract effective March 31,2003. We made $351,000 in purchases under this agreement in 2003 prior to itstermination.

 

*Joint Venture Agreement**–*  As a result of the TCZ jointventure which was formed in July 2005, Zeiss is now a related party.  In addition to transactions that occur amongus, Zeiss and TCZ related to the joint venture, we also purchase certainoptical parts directly from Zeiss and sell our light source system products toZeiss periodically.  We had an accountsreceivable balance of $588,000 and an accounts payable balance of $5.0 millionas of December 31, 2005 and recorded revenue of $400,000 for the yearended December 31, 2005, all of which were associated with these relatedparty transactions with Zeiss.

 

**16.    SEGMENTINFORMATION**

 

Ourprimary business is to design, manufacture and sell excimer light sourcesystems, replacement parts, and support services for use in photolithographysystems used in the manufacture of semiconductors.  In addition, as discussed in Note 2, weentered into a JV Agreement in July 2005 with Zeiss and formed TCZGmbH. TCZ is currently developing a process tool for use in the manufacture offlat panel displays. TCZ is owned 60% by us and 40% by Zeiss and we consolidatethe financial position and results of operations of TCZ into our consolidatedfinancial statements.

 

In accordance withStatement of Financial Accounting Standards No. 131 (“SFAS No, 131”), “Disclosureabout Segments of an Enterprise and Related Information”, we determined thatour business consists of two operating segments.  Although the TCZ business is one of ouroperating segments, we have not provided separate segment disclosures for TCZfor the year ended December 31, 2005 since its assets and results ofoperations for 2005 were below the established quantitative thresholds includedin SFAS No. 131.

 

F-33

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**GeographicInformation**

 

Presentedbelow is information regarding sales to unaffiliated customers, long-livedassets, all other identifiable assets and total identifiable assets, classifiedby operations located in the U.S., Japan, Korea, Taiwan, Singapore, the People’sRepublic of China, the Netherlands, and Switzerland.  Long-lived assets include net property, plantand equipment attributed to the geographic location in which they are located.Intercompany sales to our subsidiaries are generally priced between 90% to 95%of the price of products sold to outside customers.

 

Salesto unaffiliated customers consist of sales generated from each of thegeographic locations as detailed below. These sales exclude export sales to other geographic locations.  All significant intercompany balances areeliminated in consolidation. 

 
| ** **                           | ** ** | **Year ended December 31, 2003** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                    | ** ** |
|                                 |       |                                  |       |
| ** **                           | ** ** | ** **                            | ** ** | ** ** | ** ** | **Asia** | ** ** | **Europe** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | ** **                            | ** ** | ** ** | ** ** | **(Korea, Taiwan,** | ** ** | **(the Netherlands and** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **U.S.**                              | ** ** | **Japan** | ** ** | **Singapore and China)** | ** ** | **Switzerland)** | ** ** | **Consolidated** | ** ** |
|                                 |       |                                  |       |   |   |   |   |   |   |   |   |
| **Sales  to unaffiliated customers** |       | $                                     | 90,986     |   | $ | 116,530 |   | $ | 45,225 |   | $ | 13,132 |   | $ | 265,873 |   |
|                                 |       |                                  |       |   |   |   |   |   |   |   |   |
| **Long  lived assets**               |       | 120,452                               |       | 1,918 |   | 5,727 |   | 752 |   | 128,849 |   |
| **All  other identifiable assets**   |       | 587,953                               |       | 46,649 |   | 33,884 |   | 11,909 |   | 680,395 |   |
|                                 |       |                                  |       |   |   |   |   |   |   |   |   |
| **Total  identifiable assets**       |       | $                                     | 708,405    |   | $ | 48,567 |   | $ | 39,611 |   | $ | 12,661 |   | $ | 809,244 |   |
|                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                           | ** ** | **Year ended December 31, 2004** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                              | ** ** |
|                                 |       |                                                 |       |
| ** **                           | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Asia** | ** ** | **Europe** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | ** **                                           | ** ** | ** ** | ** ** | **(Korea, Taiwan,** | ** ** | **(the Netherlands and** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **U.S.**                                             | ** ** | **Japan** | ** ** | **Singapore and China)** | ** ** | **Switzerland)** | ** ** | **Consolidated** | ** ** |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Sales  to unaffiliated customers** |       | $                                                    | 212,283    |   | $ | 132,512 |   | $ | 53,623 |   | $ | 19,661 |   | $ | 418,079 |   |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Long  lived assets**               |       | 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 |   |

 

F-34

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| ** **                           | ** ** | **Year ended December 31, 2005** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                              | ** ** |
|                                 |       |                                                 |       |
| ** **                           | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Asia** | ** ** | **Europe** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | ** **                                           | ** ** | ** ** | ** ** | **(Korea, Taiwan,** | ** ** | **(the Netherlands and** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **U.S.**                                             | ** ** | **Japan** | ** ** | **Singapore and China)** | ** ** | **Switzerland)** | ** ** | **Consolidated** | ** ** |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Sales  to unaffiliated customers** |       | $                                                    | 180,804    |   | $ | 118,563 |   | $ | 63,612 |   | $ | 20,669 |   | $ | 383,648 |   |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Long  lived assets**               |       | 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 |   |
|                                      |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-35

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

** **
| ** **                      | ** ** | **QUARTERLY RESULTS OF OPERATIONS**                          | ** ** |
|---------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **(in thousands, except for per share data)** | ** ** |
| ** **                      | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Year ended December 31, 2004**                        | ** ** |
| ** **                      | ** ** | **1st**                                                                     | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th (2)** | ** ** |
|                            |       |                                                                        |       |   |   |   |   |   |   |
| Revenues                        |       | $                                                                           | 87,921     |   | $ | 94,907 |   | $ | 107,140 |   | $ | 128,111 |   |
|                            |       |                                                                        |       |   |   |   |   |   |   |
| Operating income                |       | $                                                                           | 10,905     |   | $ | 16,027 |   | $ | 22,093 |   | $ | 12,881 |   |
|                            |       |                                                                        |       |   |   |   |   |   |   |
| Net income                      |       | $                                                                           | 7,156      |   | $ | 10,201 |   | $ | 15,421 |   | $ | 10,376 |   |
|                            |       |                                                                        |       |   |   |   |   |   |   |
| Basic earnings  per share (1)   |       | $                                                                           | 0.20       |   | $ | 0.28 |   | $ | 0.42 |   | $ | 0.28 |   |
|                            |       |                                                                        |       |   |   |   |   |   |   |
| Diluted earnings  per share (1) |       | $                                                                           | 0.19       |   | $ | 0.27 |   | $ | 0.41 |   | $ | 0.28 |   |

 
| ** **                      | ** ** | **QUARTERLY RESULTS OF OPERATIONS**                          | ** ** |
|---------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **(in thousands, except for per share data)** | ** ** |
| ** **                      | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Year ended December 31, 2005**                        | ** ** |
| ** **                      | ** ** | **1st**                                                                     | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th(3)** | ** ** |
|                            |       |                                                                        |       |   |   |   |   |   |   |
| 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 |   |

 

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(1)  Earnings per share are computed separately for each quarter and thefull year using the respective weighted average shares. Therefore, the sum ofthe quarterly earnings per share amounts may not equal the annual amountsreported.

 

(2)  During thefourth quarter of 2004, we corrected our accounting treatment for our partsrefurbishment activities and all amounts associated with this correction wererecorded in the quarter ended December 31, 2004.  This adjustment resulted in a $28.5 millionincrease in 2004 product revenue, a $25.6 million increase in 2004 cost ofproduct sales and a $2.0 million increase in 2004 net income. See further discussion on change in accountingmethod for refurbishment activities under Item 7 “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” under “CriticalAccounting Policies and Estimates” and Item 8 “Financial Statements andSupplementary Data” Note 1 to our consolidated financial statements under “PartsRefurbishment”.

 

(3)  Includesadditional net income of approximately $804,000 due to the correction of our income tax provision 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.

 

**18.    SUBSEQUENTEVENTS**

 

On January 2, 2006,we acquired the remaining 19% minority interest in our majority-ownedsubsidiary, Cymer Korea.  We paid a totalof $7.0 million for this 19% interest. This transaction increased our total interest in Cymer Korea from 81% to100%.

 

In the ordinary course of business, we maintain lifeinsurance policies on certain executives as a means of funding our executivedeferred compensation plan. In January 2006, one of our senior executivesfor whom we hold such a policy passed away. As a result, we received a net $3.2 million in insurance proceeds in thefirst quarter of 2006.  These netproceeds will be included in other income on our statement of operations forthe three months ended March 31, 2006.

 

F-36

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**CYMER, INC.**

**SCHEDULE II**

**VALUATIONAND QUALIFYING ACCOUNTS**

**Years Ended December 31,2003, 2004 and 2005**

**(in thousands)**

 
| ** **                           | ** ** | **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, 2003   |       | $                   | 1,756      |          | $          | 250            |       | $                | (42        | ) | $ | 1,964 |   |
| Year ended  December 31, 2004   |       | $                   | 1,964      |          | $          | 199            |       | $                | (1,543     | )(2) | $ | 620 |   |
| Year ended  December 31, 2005   |       | $                   | 620        |          | $          | 136            |       | $                | —     |   | $ | 756 |   |
|                                 |       |                |       |          |       |           |       |             |       |
| **Inventory  Allowance**             |       |                |       |          |       |           |       |             |       |
|                                 |       |                |       |          |       |           |       |             |       |
| Year ended  December 31, 2003   |       | $                   | 14,700     |          | $          | 4,324          |       | $                | (6,996     | ) | $ | 12,028 |   |
| 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 |   |

 

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**(1)    **Includesreversals of allowance amounts as deemed necessary.

**(2)    **Representswrite-off of note receivable and accrued interest.

 

Seeaccompanying report of independent registered public accounting firm. 

 

S-1

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