**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C.  20549**

**FORM 10-K**

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

**For the Fiscal YearEnded: December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Commission File Number: 000-22780**

| **FEI COMPANY**                                         |
|---------------------------------------------------------|
| (Exact name of  registrant as specified in its charter) |

 

| **Oregon**                                     |   | **93-0621989**                        |
|------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation |   | (I.R.S. Employer  Identification No.) |
| or organization)                               |   |                                  |

 

| **5350 NE Dawson Creek Drive, Hillsboro, Oregon** |   | **97124-5793** |
|---------------------------------------------------|--------|----------------|
| (Address of  principal executive offices)         |   | (Zip Code)     |

 

Registrant’stelephone number, including area code:  **503-726-7500**

**Securitiesregistered pursuant to Section 12(b) of the Act:****Common Stock andassociated Preferred Stock Purchase Rights (currently attached to and tradingonly with the Common Stock)**

# **Securities registeredpursuant to Section 12(g) of the Act: None**

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Indicateby check mark if the Registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.Yes o No x

Indicateby check mark if the Registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. o

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K, or any amendment tothis Form 10-K.   x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

| Large accelerated  filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Act). Yes o No x

Theaggregate market value of the voting and non-voting common equity held bynon-affiliates, computed by reference to the last sales price ($22.68) asreported by The Nasdaq Global Stock Market, as of the last business day of theregistrant’s most recently completed second fiscal quarter (June 30, 2006), was$570,854,784.

The number of shares outstanding of the registrant’sCommon Stock as of February 19, 2007 was 34,690,227 shares.

**Documents Incorporated byReference**

The Registrant has incorporated by reference intoPart III of this Annual Report on Form 10-K portions of its ProxyStatement for its 2007 Annual Meeting of Shareholders to be filed pursuant toRegulation 14A.

 

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**FEI COMPANY2006 FORM 10-K ANNUAL REPORTTABLE OF CONTENTS**
|              | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **PART I**   | ** ** |
|         |       |                                                                                                                |       |       |       |
| Item 1.      |       | Business                                                                                                            |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 1A.     |       | Risk Factors                                                                                                        |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 1B.     |       | Unresolved Staff  Comments                                                                                          |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 2.      |       | Properties                                                                                                          |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 3.      |       | Legal Proceedings                                                                                                   |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 4.      |       | Submission of  Matters to a Vote of Security Holders                                                                |       |       |       |
|         |       |                                                                                                                |       |       |       |
| **PART II**  | ** ** |
|         |       |                                                                                                                |       |       |       |
| Item 5.      |       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 6.      |       | Selected Financial  Data                                                                                            |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 7.      |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 7A.     |       | Quantitative  and Qualitative Disclosures About Market Risk                                                         |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 8.      |       | Financial  Statements and Supplementary Data                                                                        |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 9.      |       | Changes in and  Disagreements With Accountants on Accounting and Financial Disclosure                               |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 9A.     |       | Controls and  Procedures                                                                                            |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 9B.     |       | Other Information                                                                                                   |       |       |       |
|         |       |                                                                                                                |       |       |       |
| **PART III** | ** ** |
|         |       |                                                                                                                |       |       |       |
| Item 10.     |       | Directors,  Executive Officers and Corporate Governance                                                             |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 11.     |       | Executive  Compensation                                                                                             |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 12.     |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 13.     |       | Certain  Relationships and Related Transactions, and Director Independence                                          |       |       |       |
|         |       |                                                                                                                |       |       |       |
| Item 14.     |       | Principal  Accountant Fees and Services                                                                             |       |       |       |
|         |       |                                                                                                                |       |       |       |
| **PART IV**  | ** ** |
|         |       |                                                                                                                |       |       |       |
| Item 15.     |       | Exhibits and  Financial Statement Schedules                                                                         |       |       |       |
|         |       |                                                                                                                |       |       |       |

Signatures

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**PART I**

**Item1.  Business**

**Overview**

Wewere founded in 1971 and our shares began trading on The Nasdaq Stock Market in1995. We are a leading supplier of instrumentsfor nanoscale imaging, analysis and prototyping to enable research, developmentand manufacturing in a range of industrial, academic and research institutionalapplications. In 2006, we completed our reorganization from productdivisions to market divisions. Accordingly, our semiconductor and data storageproduct markets are being reported together as the NanoElectronics market andour Industry and Institute product market has been divided into theNanoResearch and Industry market and the NanoBiology market.

Our products and systems include hardware and software for focused ion beamsystems, or FIBs, scanning electron microscopes, or SEMs, transmission electronmicroscopes, or TEMs, and *DualBeam*systems, which combine a FIB and SEM on a single platform.

Our *DualBeam* systems include models that have wafer handlingcapability that are purchased by semiconductor and data storage manufacturers (“wafer-level*DualBeam*systems”) and models that havesmall stages and are sold to customers in several markets (“small-stage *DualBeam*systems”).

Sales and serviceoperations are conducted in approximately 50 countries around the world, 29with a direct presence and the remainder through independent agents,distributors and representatives in additional countries.

To date, we have a total worldwide installed base ofapproximately 6,600 systems. The development of these solutions has been drivenby our strong technology base that includes patented and proprietarytechnologies and the technical expertise and knowledge base of approximately331 research and development personnel worldwide.

The NanoElectronicsmarket consists of customers in the semiconductor, data storage and relatedindustries such as printers and microelectromechanical systems (“MEMs”). Forthe semiconductor market, our growth is driven by shrinking line widths andprocess nodes of 65 nanometers and smaller, the use of multiple layers of newmaterials such as copper and low-k dielectrics, the increase in wafer size to300 millimeters in diameter and increasing device complexity. Our products areused primarily in laboratories to speed new product development and increaseyields by enabling three-dimensional (“3D”) wafer metrology, defectanalysis, root cause failure analysis and circuit edit for modifying devicestructures. In the data storage market, our growth is driven by the transitionfrom longitudinal to perpendicular recording heads as well as by rapidlyincreasing storage densities that require smaller recording heads, thinnergeometries and materials that increase the complexity of device structures. Ourproducts offer 3D metrology for thin film head processing and root causefailure analysis.

The NanoResearch andIndustry market includes universities, public and private research laboratoriesand a wide range of industrial customers, including automobiles, aerospace,metals, mining and petrochemicals. Growth in these markets is driven bycorporate and government funding for research and development in materialsscience and by development of new products based on innovations in materials atthe nanoscale. Our solutions provide researchers and manufacturers withatomic-level resolution images and permit development, analysis and productionof advanced products. Our products are also used in root cause failure analysisand quality control applications.

The NanoBiologymarket includes universities and research institutes engaged in biotech andlife sciences applications, as well as pharmaceutical, biotech, medical deviceand hospital companies. Our products’ ultra-high resolution imaging allows cellbiologists and drug researchers to create detailed 3D 

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reconstructions ofcomplex biological structures, enabling them to map proteins within cells. Ourproducts are also used in a range of pathology and quality controlapplications.

**Discontinued Operations**

The financial statements, footnotes, management’s discussionand analysis of financial condition and results of operations and otherfinancial information presented elsewhere in this document have beenreclassified to reflect the sale of our Knights Technology Inc. subsidiary inthe fourth quarter of 2006 and the accounting for it as a discontinuedoperation.

**Core Technologies**

We use several coretechnologies to deliver a range of value-added customer solutions. Ourcore technologies include:

·                  focused ion beams, which allow modification ofstructures in sub-micron geometries;

·                  focused electron beams, which allow imaging, analysisand measurement of structures at sub-micron and even atomic levels;

·                  beam gas chemistries, which increase the effectivenessof ion and electron beams and allow etching and deposition of materials onstructures at sub-micron levels; and

·                  system automation and sample management tools, whichprovide faster access to data and improved ease of use for operators of oursystems.

*Particle beamtechnologies—focused ion beams and electron beams.* Theemission and focusing of ions, which are positively or negatively chargedatoms, or electrons from a source material, is fundamental to many of ourproducts. Particle beams are accelerated and focused on a sample forpurposes of high resolution imaging and sample processing. The fundamentalproperties of ion and electron beams permit them to perform various functions.The relatively low mass subatomic electrons interact with the sample andrelease secondary electrons. When collected, these secondary electrons canprovide high quality images at nanometer scale resolution. Inpreviously thinned samples, collection of high energy electrons transmittedthrough the sample can yield image resolution at the atomicscale. The much greater mass ions dislodge surface particles, alsoresulting in displacement of secondary ions and electrons. Through the useof FIBs, the surface can be modified or milled with sub-micron precision bydirect action of the ion beam or in combination with gases. Secondary electronsand ions may also be collected for imaging and compositional analysis. Our ionand electron beam technologies provide advanced capabilities and applicationswhen coupled with our other core technologies.

*Beam gas chemistry.* Beamgas chemistry plays an important role in enabling our electron and ionbeam based products to perform many tasks successfully. Beam gas chemistryinvolves the interaction of the primary ion beam with an injected gas near thesurface of the sample. This interaction results in either the deposition ofmaterial or the enhanced removal of material from the sample. Both ofthese processes are critical to optimizing and expanding FIB andSEM applications. Our markets have growing needs for gas chemistrytechnologies, and we have aimed our development strategy at meeting theserequirements.

·                  Deposition: For example, deposition of materialsenables our FIBs to connect or isolate features electrically on an integratedcircuit. A deposited layer of metal also can be used before FIB milling toprotect surface features for more accurate cross-sectioning or samplepreparation.

·                  Etching: The fast, clean and selective removal ofmaterial is the most important function of our FIBs. Our FIBs have the abilityto mill specific types of material faster than other surroundingmaterial. This process is called selective etching and is used to enhanceimage contrast or aid in the modification of various structures.

*System automation andsample management.* Drawing on ourknowledge of application needs, and using robotics and imagerecognition and reconstruction software, we have developed automationcapabilities that allow us to increase system performance, speed and precision.These capabilities have been especially important to our development effortsfor in-line products and applications in the 

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NanoElectronics market and are expectedto be increasingly important in emerging production and process controlapplications in NanoResearch and Industry and NanoBiology markets. Twoimportant areas where we have developed significant automation technologies areTEM sample preparation and 3D process control. TEMs are widely used in thesemiconductor and data storage markets to obtain valuable high-resolutionimages of extremely small, even atomic-level, structures. TEM samplepreparation has traditionally been a slow and difficult manual process. Withour *DualBeam* systems andproprietary software, we have automated this process, significantly improvingthe sample consistency and overall throughput. Similarly, by automating 3Dprocess control applications, we allow customers to acquire previouslyunobtainable subsurface process metrics directly from within the productionline, improving process management.

**Researchand Development**

We have research,development and manufacturing operations in Hillsboro, Oregon; Eindhoven, theNetherlands; and Brno, Czech Republic.

Our research and development staff atDecember 31, 2006 consisted of 331 employees, including scientists,engineers, designer draftsmen, technicians and software developers. We alsocontract with Philips Research Laboratories for basic research applicable toour FIB, SEM and TEM technologies. In 2006, we paidPhilips Research Laboratories approximately $2.8 million under these researchcontracts.

For more information onour relationship with Koninklijke PhilipsElectronics N.V. (“Philips”), see Note 18 ofNotes to Consolidated Financial Statements included in Item 8 of this AnnualReport on Form 10-K.

During 2006, we introduced several newand improved products, including:

·                  theV600FIB focused ion beam system for circuit modification, cross-sectioning,sample preparation and failure analysis applications;

·                  the*Helios NanoLab**DualBeam*,a new generation system with higher resolution imaging and contrast, for 3D characterization,analysis and image reconstruction, nano-prototyping (fabrication and testing),and sample preparation applications;

·                  record-settinglow voltage resolution of <1.4 angstroms at 80 kilovolt (“kV”) wasdemonstrated, further extending the capabilities of the *Titan*80-300 product introduced in 2005; and

·                  theEBS3 *DualBeam* solution for rapid serialsectioning and 3D crystallographic reconstructions of materials. This fullyintegrated solution utilizes an FEI *DualBeam*(FIB/SEM) system with an electron back-scatter defraction (“EBSD”) detector andadvanced automation software.

We believe our knowledge of fieldemission technology and products incorporating focused ion beams remain critical to our performance in thefocused charged particle beam business. Drawing on this technology, we havedeveloped a number of product innovations, including:

·                  thescanning transmission electron microscope (“S/TEM”) system platform withunprecedented stability coupled with aberration correction and monochromator technology,enabling sub-angstrom resolution;

·                  enhancedrobotics, processes and tool connectivity enabling in-line sample liftout andS/TEM imaging from semiconductor wafers for defect analysis and process controlapplications;

·                  advancedenvironmental scanning electron microscope (“ESEM”) detector (the “HelixDetector”) and immersion lens technology, enabling ultra-high resolution SEMimaging at low pressure in the new *Nova* NanoSEM;

·                  advancedimage processing hardware and software enabling high performance 3Dtomographic, TEM based imaging; and

·                  advancedcryogenic fixation technology and subsequent imaging of aqueous samples atcryo temperatures in a TEM for aqueous biological, and colloidal polymer,pigment and nanoparticle samples.

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From time to time, weengage in joint research and development projects with some of our customersand other parties. In Europe, our electron microscope development is conductedin collaboration with universities and research institutions, often supportedby European Union research and development programs. We periodically havereceived public funds under Dutch government and European Union-fundedresearch and development programs, and expect to continue to leverage thesefunding opportunities in the future. However, these funds have decreased overthe past several years and we are not able to predict the amount of futurefunding. We also maintain other informal collaborative relationships withuniversities and other research institutions, and we work with several of ourcustomers to evaluate new products.

The markets into whichwe sell our principal products are subject to rapid technological development,product innovation and competitive pressures. Consequently, we have expendedsubstantial amounts of money on research and development. We generally intendto continue investing in research and development at approximately the currentpercentage of our net sales and believe that continued investment will beimportant to our ability to address the needs of our customers and to developadditional product offerings. Research and development efforts continue to bedirected toward development of next generation product platforms, new ion andelectron columns, beam chemistries, system automation and new applications. Webelieve these areas hold promise of yielding significant new products andexisting product enhancements. Research and development efforts are subject tochange due to product evolution and changing market needs. Often, these changescannot be predicted.

**Net research and developmentexpense was $57.5 million in 2006, $56.6 million in 2005 and $51.7 million in2004.**

**Manufacturing**

We have manufacturing operations located in Hillsboro,Oregon; Eindhoven, the Netherlands; and Brno, Czech Republic. Our systemmanufacturing operations consist largely of final assembly and the testing of finished products. Productperformance is documented and validated with factory acceptance and selectivecustomer witness acceptance tests before these products are shipped. We alsofabricate electron and ion source materials and manufacture component productsat our facilities in Oregon and the CzechRepublic.

We currently use numerous vendors tosupply parts, components and subassemblies for the manufacture and support ofour products. Some key parts, however, may only be obtained from a singlesupplier or a limited group of suppliers. In particular, we rely on: VDLEnabling Technologies Group, or ETG, and Frencken Mechatronics B.V. for oursupply of mechanical parts and subassemblies; Gatan, Inc. for criticalaccessory products; and Neways Electronics, N.V. and Benchmark Electronics forsome of our electronic subassemblies. Some of the subcomponents that make up the components and sub-assemblies supplied to us areproprietary in nature and are provided toour suppliers only from single sources.We monitor those parts subject to single or a limited source supply to minimizefactory down time due to unavailability of such parts, which could impact ourability to meet manufacturing schedules.

**Sales, Marketing and Service**

Sales and serviceoperations are conducted in the United States and approximately 50 othercountries around the world. We also sell our products through independentagents, distributors and representatives in various additional countries.

Our sales and marketing staff atDecember 31, 2006 consisted of 291 employees, including account managers,direct salespersons, sales support management, administration, demo labpersonnel, marketing support, product managers, product marketing engineers,applications specialists and technical writers. Applications specialistsidentify and develop new applications for our products, which we expect tofurther expand our markets. Our sales force and marketing efforts are organizedthrough three geographic sales and services divisions: North America, Europeand the Asia-Pacific region.

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We require sales representatives to havethe technical expertise and understanding of the businesses of our principaland potential customers to meet the requirements for selling our products.Normally, a sales representative will have the knowledge of, and experiencewith, our products or similar products, markets or customers at the time thesales representative is hired. We also provide additional training to our salesforce on an ongoing basis. Our marketing efforts include presentations at tradeshows, advertising in trade journals, development of printed collateralmaterials, customer forums, public relations efforts in trade media and ourwebsite. In addition, our employees publish articles in scientific journals andmake presentations at scientific conferences.

In a typical sale, a potential customeris provided with information about our products, including specifications andperformance data, by one of our sales representatives. The customer then oftenparticipates in a product demonstration at our facilities, using samplesprovided by the customer. The sales cycle for our systems typically ranges fromthree to twelve months, but can be longer when our customers are evaluatingnew applications of our technology.

Our products are sold generally with atwelve month warranty. Customers may purchase service contracts for ourproducts of one year or more in duration after expiration of any warranty. Weemploy service engineers in each of the three regions in which we have salesand service divisions. We also contract with independent servicerepresentatives for product service in some foreign countries.

**Competition**

The markets for our productsare highly competitive. A number of our competitors and potential competitorshave greater financial, marketing and production resources than we do. Inaddition, some of our competitors may cooperate with each other. Additionally,markets for our products are subject to constant change, due in part toevolving customer needs. As we respond to this change, the elements ofcompetition as well as the specific competitors may change. Moreover, one ormore of our competitors might achieve a technological advance that would put usat a competitive disadvantage.

Our principalcompetitors include JEOL Ltd., Hitachi, Ltd., Seiko Instruments Inc.,Carl Zeiss SMT A.G., Applied Materials, Inc., Credence Systems Corporation andOrsay Physics S.A. We believe the key competitive factors are performance, rangeof features, reliability and price. We believe that we are competitive withrespect to each of these factors. Our ability to remain competitive depends inpart upon our success in developing new and enhanced systems and introducingthese systems at competitive prices on a timely basis.

**Our servicebusiness faces little significant third-party competition. Because of thehighly specialized nature of our products and technology, and because of thecritical mass necessary to support a worldwide field service capability, fewcompetitors have emerged to provide service to our installed base of systems.Some of our older, less sophisticated equipment, particularly in theNanoResearch and Industry market, is serviced by independent field serviceengineers who compete directly with us. We believe we will continue to providemost of the field service for our products.**

**Patents and Intellectual Property**

We rely on a combination of trade secretprotection (including use of nondisclosure agreements), trademarks, copyrightsand patents to establish and protect our proprietary rights. These intellectualproperty rights may not have commercial value or may not be sufficiently broadto protect the aspect of our technology to which they relate or competitors maydesign around the patents. We own, solely or jointly, 136 patents in theUnited States and 164 patents outside of the United States, many of whichcorrespond to the United States patents. Further, we have licenses foradditional patents. Our patents expire over a period of time from 2007 to 2025.

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Several of our competitors hold patentscovering a variety of focused ion beam products and applications and methods ofuse of focused ion and electron beam products. Some of our customers may useour products for applications that are similar to those covered by thesepatents. As the number and sophistication of focused ion and electron beamproducts in the industry increase through the continued introduction of newproducts by us and others, and the functionality of these products furtheroverlaps, manufacturers and users of ion and electron beam products may becomeincreasingly subject to infringement claims.

We also depend on trade secrets used inthe development and manufacture of our products. We endeavor to protect thesetrade secrets but the measures we have taken to protect these trade secrets maybe inadequate or ineffective.

We claim trademarks on a number of ourproducts and have registered some of these marks. Use of the registered andunregistered marks, however, may be subject to challenge with the potentialconsequence that we would have to cease using marks or pay fees for their use.

Our automation software incorporatessoftware from third-party suppliers, which is licensed to end users alongwith our proprietary software. We depend on these outside software suppliers tocontinue to develop automation capacities. The failure of these suppliers tocontinue to offer and develop software consistent with our automation effortscould undermine our ability to deliver product applications.

**Employees**

At December 31, 2006, we had 1,624full-time, permanent employees and 59 temporary employees worldwide. Theemployees, including temporary employees, included 408 in manufacturing, 331 inresearch and development, 490 in customer service; 291 in sales and marketing;and 163 in general and administration. Some of the 1,063 employees who areemployed outside of the United States are covered by national, industry-wideagreements or national work regulations that govern various aspects ofemployment conditions and compensation. None of our United States employees aresubject to collective bargaining agreements, and we have never experienced awork stoppage, slowdown or strike in any of our worldwide operations. Webelieve we maintain good employee relations.

***Backlog***

At December 31, 2006, our total backlog was $305.9 million, which consistedof product and service and components backlog of unfilled orders of $259.1million and $46.8 million, respectively, compared to $145.5 million and $38.5million, respectively, at December 31, 2005. We only recognize backlog for firmpurchase orders for which the terms of the sale have been agreed upon,including price, configuration, options and payment terms. Product backlogconsists of all open orders meeting these criteria. Service backlog consists ofopen orders for service, unearned revenue on service contracts and open ordersfor spare parts. United States government backlog is limited to contractedamounts.

The increase in backlog from December 31, 2005 to December 31, 2006reflects increases in all of our segments and each of our major product lines.

Of our total backlog at December 31, 2006, approximately 90% is shippableby the end of 2007 and approximately 10% to 15% requires some incrementaldevelopment. Customers may cancel or delay delivery on previously placedorders, although our standard terms and conditions include penalties forcancellations made close to the scheduled delivery date. As a result, thetiming of the receipt of orders or the shipment of products could have asignificant impact on our backlog at any date. Historically, cancellations havebeen insignificant. Recently, our ability to ship product from backlog has beennegatively affected by single-sourcing issues and problems insecuring electronic components from a certain vendor. In addition, productshipments have been delayed due to delays in completing certain applicationdevelopment. For these and other reasons, the amount of backlog at any date isnot necessarily indicative of revenue to be recognized in future periods.

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**Geographic Revenue and Assets**

The following tablesummarizes sales by geographic region in 2006 (in thousands):

|                              | ** ** | **North   America** | ** ** | **Europe** | ** ** | **Asia-   Pacific** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|-----------|------------|
| Product sales                |       | $                        | 104,879    |       | $          | 150,933                  |       | $         | 104,831    |   | $ | 360,643 |   |
| Service and  Component sales |       | 62,510                   |       | 36,296     |       | 20,042                   |       | 118,848   |       |
| Total sales                  |       | $                        | 167,389    |       | $          | 187,229                  |       | $         | 124,873    |   | $ | 479,491 |   |

 

Salesto countries which totaled 10% or more of our total net sales in 2006 were as follows(dollars in thousands):

|               | ** ** | **Dollar   Amount** | ** ** | **% of Total   Net Sales** | ** ** |
|---------------|------------|--------------------------|------------|------------------------------------------------|------------|
| United States |       | $                        | 165,130    |                                           | 34.4       | % |
| Germany       |       | 49,743                   |       | 10.4                                           | %          |
|               |            |                          |            |                                                |            |  |

 

Our long-lived assets were geographicallylocated as follows at December 31, 2006 (in thousands):

| United States   |   | $      | 40,730 |   |
|-----------------|--------|--------|--------|--------|
| The Netherlands |   | 17,926 |   |
| Other           |   | 8,772  |   |
| Total           |   | $      | 67,428 |   |

 

**Seasonality**

In general, oursales have tended to grow more rapidly from the third to the fourth quarter ofthe year than in other sequential quarterly periods, primarily because ourNanoResearch and Industry customers budget their spending on an annual basis.Correspondingly, the NanoResearch and Industry market has tended to recorddeclines in revenue from the fourth quarter of one year to the first quarter ofthe next year. These seasonal trends can be offset by numerous other factors,including our introduction of new products, the overall economic cycle and thebusiness cycles in the semiconductor and data storage industries.

**Where You Can Find MoreInformation**

Our principal executiveoffices are located at 5350 NE Dawson Creek Drive, Hillsboro, Oregon97124.  Our website is athttp://www.fei.com. We file annual, quarterly and special reports, proxystatements and other information with the Securities and Exchange Commission (“SEC”)under the Securities Exchange Act of 1934 as amended (“Exchange Act”). We makeavailable free of charge on our website our Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments tothese reports as soon as reasonably practicable after we file such materialwith, or furnish it to, the SEC. You can inspect and copy our reports, proxystatements and other information filed with the SEC at the offices of the SEC’sPublic Reference Room located at 100 F Street, NE, Washington D.C. 20549.Please call the SEC at 1-800-SEC-0330 for further information on the operationof Public Reference Rooms. The SEC also maintains an Internet website athttp://www.sec.gov/ where you can obtain most of our SEC filings. You can alsoobtain copies of these materials free of charge by contacting our investorrelations department at 503-726-7500.

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**Item 1A.  Risk Factors**

A description ofthe risks and uncertainties associated with our business is set forth below.You should carefully consider such risks and uncertainties, together with theother information contained in this report and in our other public filings. Ifany of such risks and uncertainties actually occurs, our business, financialcondition or operating results could differ materially from the plans,projections and other forward-looking statements included in the section titled“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and elsewhere in this report and in our other public filings. Inaddition, if any of the following risks and uncertainties, or if any otherrisks and uncertainties, actually occurs, our business, financial condition oroperating results could be harmed substantially, which could cause the marketprice of our stock to decline, perhaps significantly.

**Ourbusiness is complex, and changes to the business may not achieve their desiredbenefits.**

Our business isbased on a myriad of technologies, encompassed in multiple different productlines, addressing various markets in different regions of the world. A businessof our breadth and complexity requires significant management time, attentionand resources. In addition, significant changes to our business, such aschanges in manufacturing, operations, product lines, market focus ororganizational structure or focus, can be distracting, time-consuming andexpensive. These changes can have short-term adverse effects on our financialresults and may not provide their intended long-term benefits. Failure toachieve these benefits would have a material adverse impact on our financialposition, results of operations or cash flow.

**Weoperate in highly competitive industries, and we cannot be certain that we willbe able to compete successfully in such industries.**

The industries inwhich we operate are intensely competitive. Established companies, bothdomestic and foreign, compete with us in each of our product lines. Many of ourcompetitors have greater financial, engineering, manufacturing and marketingresources than we do and may price their products very aggressively. Oursignificant competitors include: JEOL Ltd., Hitachi Ltd., Seiko InstrumentsInc., Carl Zeiss SMT A.G., Applied Materials, Inc., Credence SystemsCorporation and Orsay Physics S.A. In addition, some of our competitors haveformed collaborative relationships and otherwise may cooperate with each other.

A substantialinvestment by customers is required for them to install and integrate capitalequipment into their laboratories and process applications. As a result, once amanufacturer has selected a particular vendor’s capital equipment, themanufacturer generally relies on that equipment for a specific production lineor process control application and frequently will attempt to consolidate itsother capital equipment requirements with the same vendor. Accordingly, if aparticular customer selects a competitor’s capital equipment, we expect toexperience difficulty selling to that customer for a significant period oftime.

Our ability tocompete successfully depends on a number of factors both within and outside ofour control, including:

·                  price;

·                  product quality;

·                  breadth ofproduct line;

·                  systemperformance;

·                  ease of use;

·                  cost ofownership;

·                  global technicalservice and support;

·                  success indeveloping or otherwise introducing new products; and

·                  foreign currencymovements.

We cannot becertain that we will be able to compete successfully on these or other factors,which could negatively impact our revenues, gross margins and net income in thefuture.

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**Theindustries in which we sell our products are cyclical, which may cause ourresults of operations to fluctuate.**

Our businessdepends in large part on the capital expenditures of customers within ourNanoElectronics, NanoResearch and Industry and NanoBiology market segments,which, along with Service and Components sales, accounted for the followingamounts (in thousands) and percentages of our net sales for the periodsindicated:

 

|                            | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| NanoElectronics            |       | $                                          | 154,648    |   | 32.3 | % | $ | 145,951 |   | 34.7 | % |
| NanoResearch and  Industry |       | 165,067                                    |       | 34.4 | % | 130,045 |   | 31.0 | % |
| NanoBiology                |       | 40,928                                     |       | 8.5 | % | 35,355 |   | 8.4 | % |
| Service and  Components    |       | 118,848                                    |       | 24.8 | % | 108,746 |   | 25.9 | % |
|                       |       | $                                          | 479,491    |   | 100.0 | % | $ | 420,097 |   | 100.0 | % |

 

The largestsub-parts of the NanoElectronics market are the data storage and semiconductorindustries. These industries are cyclical and have experienced significanteconomic downturns at various times in the last decade. Such downturns havebeen characterized by diminished product demand, accelerated erosion of averageselling prices and production overcapacity. A downturn in one or both of theseindustries, or the businesses of one or more of our customers, could have amaterial adverse effect on our business, prospects, financial condition andresults of operations. For example, in 2005, the semiconductor equipment marketexperienced weakness. Global economic conditions continue to be volatile andslower growth or reduced demand for our customers’ products in the future wouldcause our business to decline. During downturns, our sales or margins maydecline.

The NanoResearchand Industry market is also affected by overall economic conditions, but is notas cyclical as the NanoElectronics market. However, NanoResearch and Industrycustomer spending is highly dependent on governmental and private fundinglevels and timing, which can vary depending on budgetary and/or economicconstraints.

The NanoBiologymarket is a smaller and emerging market, and the tools we sell into that marketoften have average selling prices of over $1.0 million. As a result, movementof a small number of sales from one quarter to the next could cause significantvariability in quarter-to-quarter growth rates, even as we believe that thismarket has the potential for long-term growth.

As a capitalequipment provider, our revenues depend in large part on the spending patternsof our customers, who often delay expenditures or cancel orders in reaction tovariations in their businesses or general economic conditions. Because a highproportion of our costs are fixed, we have a limited ability to reduce expensesquickly in response to revenue shortfalls. In a prolonged economic downturn, wemay not be able to reduce our significant fixed costs, such as manufacturingoverhead, capital equipment or research and development costs, which may causeour gross margins to erode and our net loss to increase or earnings to decline.

**Theloss of one or more of our key customers would result in the loss ofsignificant net revenues.**

A relatively smallnumber of customers account for a large percentage of our net revenues. Ourbusiness will be seriously harmed if we do not generate as much revenue as weexpect from these key customers, if we experience a loss of any of our keycustomers or if we suffer a substantial reduction in orders from thesecustomers. Our ability to continue to generate revenues from our key customerswill depend on our ability to introduce new products that are desirable tothese customers.

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**Becausewe do not have long-term contracts with our customers, our customers may stoppurchasing our products at any time, which makes it difficult to forecast ourresults of operations and to plan expenditures accordingly.**

We do not havelong-term contracts with our customers. Accordingly:

·                  customers canstop purchasing our products at any time without penalty;

·                  customers maycancel orders that they previously placed;

·                  customers maypurchase products from our competitors;

·                  we are exposedto competitive pricing pressure on each order; and

·                  customers arenot required to make minimum purchases.

If we do notsucceed in obtaining new sales orders from existing customers, our results ofoperations will be negatively impacted.

**Ifour customers cancel or reschedule orders or if an anticipated order for evenone of our systems is not received in time to permit shipping during a certainfiscal period, our operating results for that fiscal period may fluctuate andour business and financial results for such period could be materially andadversely affected.**

Our customers areable to cancel or reschedule orders, generally with limited or no penalties,depending on the product’s stage of completion. The amount of purchase ordersat any particular date, therefore, is not necessarily indicative of sales to bemade in any given period. Our build cycle, or the time it takes us to build aproduct to customer specifications, typically ranges from one to six months.During this period, the customer may cancel the order, although generally wewill be entitled to receive a cancellation fee based on the agreed-uponshipment schedule. In addition, we derive a substantial portion of our netsales in any fiscal period from the sale of a relatively small number ofhigh-priced systems, with a large portion in the last month of the quarter.Further, in some cases, our customers have to make changes to their facilitiesto accommodate the site requirements for our systems and may reschedule theirorders because of the time required to complete these facility changes. This isparticularly true of the high-performance TEMs. As a result, the timing ofrevenue recognition for a single transaction could have a material effect onour revenue and results of operations for a particular fiscal period.

Due to these andother factors, our net revenues and results of operations have fluctuated inthe past and are likely to fluctuate significantly in the future on a quarterlyand annual basis. It is possible that in some future quarter or quarters ourresults of operations will be below the expectations of public market analystsor investors. In such event, the market price of our common stock may declinesignificantly.

**Werely on a limited number of parts, components and equipment manufacturers.Failure of any of these suppliers to provide us with quality products in atimely manner could negatively affect our revenues and results of operations.**

Failure ofcritical suppliers of parts, components and manufacturing equipment to deliversufficient quantities to us in a timely and cost-effective manner couldnegatively affect our business, including our ability to convert backlog intorevenue. We currently use numerous vendors to supply parts, components andsubassemblies for the manufacture and support of our products. Some key parts,however, may only be obtained from a single supplier or a limited group ofsuppliers. In particular, we rely on: VDL Enabling Technologies Group, or ETG,and Frencken Mechatronics B.V. for our supply of mechanical parts andsubassemblies; Gatan, Inc. for critical accessory products; and NewaysElectronics, N.V. and Benchmark Electronics for some of our electronicsubassemblies. In addition, some of our suppliers rely on sole suppliers. As aresult of this concentration of key suppliers, our results of operations may bematerially and adversely affected if we do not timely and cost-effectivelyreceive a sufficient quantity of quality parts to meet our productionrequirements or if we are required to find alternative suppliers for thesesupplies. We may not be able to expand our supplier group or to reduce ourdependence on single suppliers. From time to time, we have experienced supplyconstraints with respect to the mechanical parts and subassemblies produced byETG and electronic components manufactured by Neways Electronics, N.V. 

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and BenchmarkElectronics, which in turn have delayed our product shipments. In the future,if ETG or our electronics suppliers are not able to meet our supply requirements,these constraints may affect our ability to deliver products to customers in atimely manner, which could have an adverse effect on our results of operations.Further, ETG was recently acquired by a new owner and Benchmark Electronicsmade a significant acquisition. Integration issues, strategic redirection orother business changes from the acquisitions could add to our supplierconstraints and adversely affect our operating results. In addition, newEuropean Union restrictions governing the use of certain hazardous substancesin electrical and electronic equipment (Restrictions on Hazardous Substances,or “RoHS,” regulations) may impact parts and component availability or ourelectronics suppliers’ ability to source parts and components in a timely and cost-effectivemanner. Overall, because we only have a few equipment suppliers, we may be moreexposed to future cost increases for this equipment.

**Becausemany of our shipments occur in the last month of a quarter, we are at risk ofone or more transactions not being delivered according to forecast.**

We havehistorically shipped approximately 75% of our products in the last month ofeach quarter. As any one shipment may be significant to meeting our quarterlysales projection, any slippage of shipments into a subsequent quarter mayresult in our not meeting our quarterly sales projection, which may adverselyimpact our results of operations for the quarter.

**Manyof our projects are funded under federal, state and local government contractsand if we are found to have violated the terms of the government contracts orapplicable statutes and regulations, we are subject to the risk of suspensionor debarment from government contracting activities, which could have amaterial adverse effect on our business and results of operations.**

Many of ourprojects are funded under federal, state and local government contractsworldwide.****Government contractsare subject to specific procurement regulations, contract provisions andrequirements relating to the formation, administration, performance andaccounting of these contracts. Many of these contracts include express orimplied certifications of compliance with applicable laws and contractprovisions. As a result of our government contracting, claims for civil orcriminal fraud may be brought by the government for violations of theseregulations, requirements or statutes. Further, if we fail to comply with anyof these regulations, requirements or statutes, our existing governmentcontracts could be terminated, we could be suspended or debarred fromgovernment contracting or subcontracting, including federally funded projectsat the state level. If one or more of our government contracts are terminatedfor any reason, or if we are suspended from government work, we could sufferthe loss of the contracts, which could have a material adverse effect on ourbusiness and results of operations.

**Changesand fluctuations in government spending priorities could adversely affect ourrevenue.**

Because asubstantial part of our overall business is generated either directly orindirectly as a result of worldwide federal and local government regulatory andinfrastructure priorities, shifts in these priorities due to changes in policyimperatives or economic conditions, which are often unpredictable, may affectour revenues.

Politicalinstability in key regions around the world coupled with the U.S. government’scommitment to the “war on terror” put at risk federal discretionary spending,including spending on nanotechnology research programs and projects that are ofparticular importance to our business. Also, recent changes in U.S.Congressional appropriations practices could result in decreased funding forsome of our customers. At the state and local levels, the need to compensatefor reductions in federal matching funds, as well as financing of federalunfunded mandates, creates strong pressures to cut back on researchexpenditures as well. A potential reduction of federal funding may adverselyaffect our business.

 

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** **

**Wehave long sales cycles for our systems, which may cause our results ofoperations to fluctuate and could negatively impact our stock price.**

Our sales cyclecan be twelve months or longer and is unpredictable. Variations in thelength of our sales cycle could cause our net sales and, therefore, ourbusiness, financial condition, results of operations, operating margins andcash flows, to fluctuate widely from period to period. These variations couldbe based on factors partially or completely outside of our control.

The factors thatcould affect the length of time it takes us to complete a sale depend on manyelements, including:

·                  the efforts ofour sales force and our independent sales representatives;

·                  changes in thecomposition of our sales force, including the departure of senior salespersonnel;

·                  the history ofprevious sales to a customer;

·                  the complexityof the customer’s manufacturing processes;

·                  the economicenvironment;

·                  the internaltechnical capabilities and sophistication of the customer; and

·                  the capitalexpenditure budget cycle of the customer.

 

Our sales cyclealso extends in situations where the sale involves developing new applicationsfor a system or technology. As a result of these and a number of other factorsthat could influence sales cycles with particular customers, the period betweeninitial contact with a potential customer and the time when we recognizerevenue from that customer, if ever, may vary widely.

**Theloss of key management or our inability to attract and retain managerial,engineering and other technical personnel could have a material adverse effecton our business, financial condition and results of operations.**

Attractingqualified personnel is difficult, and our recruiting efforts may not besuccessful. Specifically, our product generation efforts depend on hiring andretaining qualified engineers. The market for qualified engineers is verycompetitive. In addition, experienced management and technical, marketing andsupport personnel in the technology industry are in high demand, andcompetition for such talent is intense. The loss of key personnel, or ourinability to attract key personnel, could have an adverse effect on ourbusiness, financial condition or results of operations.

**Ourcustomers experience rapid technological changes, with which we must keep pace,but we may be unable to introduce new products on a timely and cost-effectivebasis to meet such changes.**

Each of our marketsegments experience rapid technological change and new product introductions andenhancements. Our ability to remain competitive depends in large part on ourability to develop, in a timely and cost-effective manner, new and enhancedsystems at competitive prices and to accurately predict technology transitions.In addition, new product introductions or enhancements by competitors couldcause a decline in our sales or a loss of market acceptance of our existingproducts. Increased competitive pressure also could lead to intensified pricecompetition, resulting in lower margins, which could materially adverselyaffect our business, prospects, financial condition and results of operations.

Our success indeveloping, introducing and selling new and enhanced systems depends on avariety of factors, including:

·                  selectionand development of product offerings;

·                  timelyand efficient completion of product design and development;

·                  timelyand efficient implementation of manufacturing processes;

·                  effectivesales, service and marketing functions; and

·                  productperformance.

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Because newproduct development commitments must be made well in advance of sales, newproduct decisions must anticipate both the future demand for products underdevelopment and the equipment required to produce such products. We cannot becertain that we will be successful in selecting, developing, manufacturing andmarketing new products or in enhancing existing products. On occasion, certainproduct and application development has taken longer than expected. Thesedelays can have an adverse affect on product shipments and results ofoperations.

The process ofdeveloping new high technology capital equipment products and services iscomplex and uncertain, and failure to accurately anticipate customers’ changingneeds and emerging technological trends, to complete engineering anddevelopment projects in a timely manner and to develop or obtain appropriateintellectual property could significantly harm our results of operations. Wemust make long-term investments and commit significant resources before knowingwhether our predictions will result in products that the market will accept.For example, we have invested substantial resources in our new *Titan* S/TEM, and further engineering anddevelopment will be required to take full advantage of this new S/TEM platform.If the completion of further development is delayed, potential revenue growthcould be deferred or may not happen at all.

To the extent thata market does not develop for a new product, we may decide to discontinue ormodify the product. These actions could involve significant costs and/orrequire us to take charges in future periods. If these products are accepted bythe marketplace, sales of our new products may cannibalize sales of ourexisting products. Further, after a product is developed, we must be able to manufacturesufficient volume quickly and at low cost. To accomplish this objective, wemust accurately forecast production volumes, mix of products and configurationsthat meet customer requirements. If we are not successful in making accurateforecasts, our business and results of operations could be significantlyharmed.

**Becausewe have significant operations outside of the United States, we are subject topolitical, economic and other international conditions that could result inincreased operating expenses and regulation of our products and increaseddifficulty in maintaining operating and financial controls.**

Since asignificant portion of our operations occur outside of the United States, ourrevenues and expenses are impacted by foreign economic and regulatoryconditions. Approximately 65% and 70%, respectively, of our revenues in theyears ended December 31, 2006 and 2005 came from outside of the UnitedStates. We have manufacturing facilities in Brno, Czech Republic and Eindhoven,the Netherlands and sales offices in many other countries.

Moreover, weoperate in approximately 50 countries, 29 with a direct presence and anadditional 21 via sales agents. Some of our global operations aregeographically isolated, are distant from corporate headquarters and/or havelittle infrastructure support. Therefore, maintaining and enforcing operatingand financial controls can be difficult. Failure to maintain or enforcecontrols could have a material adverse effect on our control over serviceinventories, quality of service, customer relationships and financialreporting.

Our exposure tothe business risks presented by foreign economies will increase to the extentwe continue to expand our global operations. International operations willcontinue to subject us to a number of risks, including:

·                  longersales cycles;

·                  multiple,conflicting and changing governmental laws and regulations;

·                  protectionistlaws and business practices that favor local companies;

·                  priceand currency exchange rates and controls;

·                  taxesand tariffs;

·                  exportrestrictions;

·                  difficultiesin collecting accounts receivable;

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·                  traveland transportation difficulties resulting from actual or perceived health risks(e.g., SARS and avian influenza);

·                  changes in the regulatory environment incountries where we do business could lead to delays in the importation ofproducts into those countries;

·                  the implementation of China RoHS regulationscould lead to delays in the importation of products into China; and

·                  politicaland economic instability.

**Ifthird parties assert that we violate their intellectual property rights, ourbusiness and results of operations may be materially adversely affected.**

Several of ourcompetitors hold patents covering a variety of technologies that may beincluded in some of our products. In addition, some of our customers may useour products for applications that are similar to those covered by thesepatents. From time to time, we and our respective customers have receivedcorrespondence from our competitors claiming that some of our products, as usedby our customers, may be infringing one or more of these patents. To date, noneof these allegations has resulted in litigation. Our competitors or otherentities may, however, assert infringement claims against us or our customersin the future with respect to current or future products or uses, and theseassertions may result in costly litigation or require us to obtain a license touse intellectual property rights of others. Additionally, if claims ofinfringement are asserted against our customers, those customers may seekindemnification from us for damages or expenses they incur.

If we becomesubject to infringement claims, we will evaluate our position and consider theavailable alternatives, which may include seeking licenses to use thetechnology in question or defending our position. These licenses, however, maynot be available on satisfactory terms or at all. If we are not able tonegotiate the necessary licenses on commercially reasonable terms orsuccessfully defend our position, these potential infringement claims couldhave a material adverse effect on our business, prospects, financial conditionand results of operations.

**Wemay not be able to enforce our intellectual property rights, especially inforeign countries, which could materially adversely affect our business.**

Our successdepends in large part on the protection of our proprietary rights. We incursignificant costs to obtain and maintain patents and defend our intellectualproperty. We also rely on the laws of the United States and other countrieswhere we develop, manufacture or sell products to protect our proprietaryrights. We may not be successful in protecting these proprietary rights, theserights may not provide the competitive advantages that we expect or otherparties may challenge, invalidate or circumvent these rights.

Further, ourefforts to protect our intellectual property may be less effective in somecountries where intellectual property rights are not as well protected as theyare in the United States. Many U.S. companies have encountered substantialproblems in protecting their proprietary rights against infringement in foreigncountries. We derived approximately 65% and 70%, respectively, of our salesfrom foreign countries in the years ended December 31, 2006 and 2005. Ifwe fail to adequately protect our intellectual property rights in thesecountries, our business may be materially adversely affected.

Infringement ofour proprietary rights could result in weakened capacity to compete for salesand increased litigation costs, both of which could have a material adverseeffect on our business, prospects, financial condition and results ofoperations.

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**Weare substantially leveraged, which could adversely affect our ability to adjustour business to respond to competitive pressures and to obtain sufficient fundsto satisfy our future manufacturing capacity and research and developmentneeds.**

We havesignificant indebtedness. As of December 31, 2006, we had total convertiblelong-term debt of approximately $195.9 million due in 2008 and $115.0million due in 2013. The degree to which we are leveraged could have importantconsequences, including but not limited to the following:

·                  ourability to obtain additional financing in the future for working capital,capital expenditures, acquisitions, general corporate or other purposes may belimited;

·                  ourshareholders would be diluted if we elect to settle all or a portion of ourzero coupon convertible notes in shares, up to a maximum aggregate of 5,528,527shares of our common stock, upon the bondholders’ election to convert the notesonce certain stock price metrics are met. These shares were included inour diluted share count for 2006;

·                  ourshareholders would be diluted if holders of all or a portion of our 5.5%subordinated convertible notes elect to convert their notes, up to a maximumaggregate of 926,534 shares of our common stock;

·                  ourshareholders would be diluted if holders of all or a portion of our 2.875%subordinated convertible notes elect to convert their notes, up to a maximumaggregate of 3,918,395 shares of our common stock. These shares were includedin our diluted share count for the fourth quarter of 2006;

·                  asubstantial portion of our cash flow from operations will be dedicated to thepayment of the principal of, and interest on, our indebtedness; and

·                  wemay be more vulnerable to economic downturns, less able to withstandcompetitive pressures and less flexible in responding to changing business andeconomic conditions.

 

Our ability to payinterest and principal on our debt securities, to satisfy our other debtobligations and to make planned expenditures will be dependent on our futureoperating performance, which could be affected by changes in economicconditions and other factors, some of which are beyond our control. A failureto comply with the covenants and other provisions of our debt instruments couldresult in events of default under such instruments, which could permitacceleration of the debt under such instruments and in some cases accelerationof debt under other instruments that contain cross-default orcross-acceleration provisions. If we are at any time unable to generatesufficient cash flow from operations to service our indebtedness, we may berequired to attempt to renegotiate the terms of the instruments relating to theindebtedness, seek to refinance all or a portion of the indebtedness or obtainadditional financing. We cannot assure you that we will be able to successfullyrenegotiate such terms, that any such refinancing would be possible or that anyadditional financing could be obtained on terms that are favorable oracceptable to us.

As of December 31,2006, we had cash, cash equivalents and short-term investments of $344.9million. While some of those amounts are required for ongoing operations, wecurrently expect to use a portion of those funds to repay debt maturities in2008, as necessary.

**Anyfailure by us to execute planned cost reductions successfully could result intotal costs and expenses that are greater than expected.**

We have undertakenrestructuring plans to bring operational expenses to appropriate levels for ourbusiness. In 2005, we took significant restructuring charges in connection withthe closing of our Peabody, Massachusetts plant and otherwise. We may havefurther workforce reductions or rebalancing actions in the future. Significantrisks associated with these actions and other workforce management issues thatmay impair our ability to achieve anticipated cost reductions or that may otherwiseharm our business include delays in implementation of anticipated workforcereductions in highly regulated locations outside of the United States,particularly in Europe and Asia, redundancies among restructuring programs,decreases in employee morale and the failure to meet operational targets due tothe loss of employees, particularly sales and service employees and engineers.

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**Dueto our extensive international operations and sales, we are exposed to foreigncurrency exchange rate risks that could adversely affect our revenues, grossmargins and results of operations.**

A significantportion of our sales and expenses are denominated in currencies other than theUnited States dollar, principally the euro. For the year endedDecember 31, 2006, approximately 30 to 40% of our revenue wasdenominated in euros, while more than half of our expenses were denominated ineuros or other foreign currencies. Particularly as a result of this imbalance,changes in the exchange rate between the U.S. dollar and foreign currencies,especially the euro, can impact our revenues, gross margins, results ofoperations and cash flows. We undertake hedging transactions to limit ourexposure to changes in the dollar/euro exchange rate. The hedges are designedto protect us as the dollar weakens but also provide us with some flexibilityif the dollar strengthens.

We enter intovarious forward extra contracts, which are a combination of a foreign forwardexchange contract and an option, as well as standard option contracts, to partiallymitigate the impact of changes in the euro against the dollar on our Europeanoperating results. These contracts are considered derivatives. We are requiredto carry all open derivative contracts on our balance sheet at fair value. Whenspecific accounting criteria have been met, derivative contracts can bedesignated as hedging instruments and changes in fair value related to thesederivative contracts are recorded in other comprehensive income, rather thannet income, until the underlying hedged transaction affects net income. Whenthe designated hedges mature, they are recorded in cost of goods sold. We arerequired to record changes in fair value for derivatives not designated ashedges in net income in the current period. Prior to the second quarter offiscal 2004, none of our derivative contracts were designated as hedges and allrealized and unrealized gains and losses were recognized in net income in thecurrent period. Our ability to designate derivative contracts as hedgessignificantly reduces the volatility in our operating results due to changes inthe fair value of the derivative contracts.

Achieving hedgedesignation is based on evaluating the effectiveness of the derivativecontracts’ ability to mitigate the foreign currency exposure of the linkedtransaction. We are required to monitor the effectiveness of all new and openderivative contracts designated as hedges on a quarterly basis. Based on ourevaluation in 2005, we recorded charges totaling $0.5 million in otherincome (expense) related to hedge dedesignations and ineffectiveness. We didnot record any charges for hedge dedesignations or ineffectiveness in 2006.Failure to meet the hedge accounting requirements could result in therequirement to record deferred and current realized and unrealized gains andlosses into net income in the current period. This failure could result insignificant fluctuations in operating results. In addition, we will continue torecognize unrealized gains and losses related to the changes in fair value ofderivative contracts not designated as hedges in the current period net income.Accordingly, the related impact to operating results may be recognized in adifferent period than the foreign currency impact of the linked asset,liability or transaction.

We also enter intoforeign forward exchange contracts to partially mitigate the impact of specificcash, receivables or payables positions denominated in foreign currencies.Foreign currency losses recorded in other income (expense), inclusive of theimpact of derivatives which are not designated as hedges, totaled $1.9 millionin 2006, $1.5 million during 2005 and $3.1 million during 2004.

**Wemay have exposure to income tax rate fluctuations as well as to additional taxliabilities, which would impact our financial position.**

As a corporationwith operations both in the United States and abroad, we are subject to incometaxes in both the United States and various foreign jurisdictions. Our effective tax rate is subject to fluctuationas the income tax rates for each year are a function of the following factors,among others:

·                  the effects of amix of profits or losses earned by us and our subsidiaries in numerous foreigntax jurisdictions with a broad range of income tax rates;

·                  our ability toutilize recorded deferred tax assets;

·                  changes incontingencies related to taxes, interest or penalties resulting from taxaudits; and

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·                  changes in taxlaws or the interpretation of such laws.

Changes in the mixof these items and other items may cause our effective tax rate to fluctuatebetween periods, which could have a material adverse effect on our financialposition.

We are alsosubject to non-income taxes, such as payroll, sales, use, value-added, networth, property and goods and services taxes, in both the United States andvarious foreign jurisdictions.

We are regularlyunder audit by tax authorities with respect to both income and non-income taxesand may have exposure to additional tax liabilities as a result of theseaudits.

Significantjudgment is required in determining our provision for income taxes and othertax liabilities. Although we believe that our tax estimates are reasonable, wecannot assure you that the final determination of tax audits or tax disputeswill not be different from what is reflected in our historical income taxprovisions and accruals.

**Ouracquisition and investment strategy subjects us to risks associated withevaluating and pursuing these opportunities and integrating these businesses.**

In addition to ourefforts to develop new technologies from internal sources, we also may seek toacquire new technologies or operations from external sources. As part of thiseffort, we may make acquisitions of, or make significant debt and equityinvestments in, businesses with complementary products, services and/ortechnologies. Acquisitions can involve numerous risks, including managementissues and costs in connection with the integration of the operations andpersonnel, technologies and products of the acquired companies, the possiblewrite-downs of impaired assets and the potential loss of key employees of theacquired companies. The inability to effectively manage any of these riskscould seriously harm our business. Additionally, difficulties in integratingany potential acquisitions into our internal control structure could result ina failure of our internal control over financial reporting, which, in turn,could create a material weakness.

During the fourthquarter of 2006, we sold one such investment, Knights Technology, which was aconsolidated subsidiary. During the third quarter of 2006, we sold anothercost-method investment for a gain of $5.2 million and wrote-off the remainingsuch investments, incurring an aggregate charge of $3.9 million. In 2005, werecorded impairment charges and realized losses totaling $6.4 millionrelated to these investments.

To the extent wemake investments in entities that we control, or have significant influence in,our financial results will reflect our proportionate share of the financialresults of the entity.

**Manyof our current and planned products are highly complex and may contain defectsor errors that can only be detected after installation, which may harm ourreputation.**

Our products arehighly complex, and our extensive product development, manufacturing andtesting processes may not be adequate to detect all defects, errors, failuresand quality issues that could impact customer satisfaction or result in claimsagainst us. As a result, we could have to replace certain components and/orprovide remediation in response to the discovery of defects in products thatare shipped. The occurrence of any defects, errors, failures or quality issuescould result in cancellation of orders, product returns, diversion of ourresources, legal actions by our customers and other losses to us or to ourcustomers. These occurrences could also result in the loss of, or delay in,market acceptance of our products and loss of sales, which would harm ourbusiness and adversely affect our revenues and profitability.

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**Issuesarising from our enterprise resource planning system could affect our operatingresults and ability to manage our business effectively.**

Our ability todesign, manufacture, market and service products and systems is dependent oninformation technology systems that encompass all of our major businessfunctions.****During 2005, we embarked upon implementation of anew enterprise resource planning (“ERP”) software system to enable us to fullyintegrate our diverse locations and processes. In total, we expensed $7.6million in 2005 and another $0.5 million in the first quarter of 2006. After areview of the projected costs and time to complete the project, we abandonedthis project and expensed these costs in the respective periods discussedabove.

Updating our existingsystem presents the potential for additional difficulties. Moreover, if theexisting system, as updated, is not sufficient to meet our needs, it couldadversely affect our ability to do the following in a timely manner: manage andreplenish inventory; fulfill and process orders; manufacture and ship productsin a timely manner; invoice and collect receivables; place purchase orders andpay invoices; coordinate sales and marketing activities; prepare our financialstatements and manage our accounting systems and controls; and otherwise carryon our business in the ordinary course. Any such disruption could adverselyaffect our business, prospects, financial condition and results of operations.Moreover, difficulties arising from the ERP system could result in a failure ofour internal control over financial reporting, which, in turn, could result ina material weakness and a qualified report from our independent registeredpublic accounting firm.

**Wemay have underestimated past restructuring charges or we may incur futurerestructuring and asset impairment charges, either of which may adverselyimpact our results of operations.**

In 2006, werecorded restructuring, reorganization, relocation and severance charges of$12.6 million, of which $3.3 million was for facilities and severance chargesrelated to the closure of certain of our European field offices, the closure ofour Tempe, Arizona research and development facility, as well as residual costsrelated to the Peabody, Massachusetts plant closure and the downsizing of therelated semiconductor businesses, and $9.3 million was related to thetermination of our former Chief Executive Officer. Of the $9.3 million charge,$2.2 million was cash compensation and $7.1 million was non-cash stock-basedcompensation. In addition, in 2005 and over the last few years, we initiated aseries of restructurings of our operations involving, among other things, thereduction of our workforce and the consolidation of excess facilities.Restructuring charges for 2005 totaled $8.5 million. We may incuradditional restructuring and related expenses, which may have a materialadverse effect on our business, financial condition or results of operations.The charges in connection with these restructurings are only estimates and maynot be accurate. As part of these restructurings, we ceased to use certain ofour leased facilities and, accordingly, we have negotiated, and are continuingto negotiate, certain lease terminations and/or subleases of our facilities. Wecannot predict when or if we will be successful in negotiating leasetermination agreements or subleases of our facilities on terms acceptable tous. If we are not successful in negotiating terms acceptable to us, or at all,we may be required to materially increase our restructuring and relatedexpenses in future periods. Further, if we have additional reductions to ourworkforce or consolidate additional facilities in the future we may incuradditional restructuring and related expenses, which could have a material adverseeffect on our business, financial condition or results of operations.

In addition, wetest our goodwill and other intangible assets for impairment annually or whenan event occurs indicating the potential for impairment. If we record animpairment charge as a result of this analysis, it could have a material impacton our results of operations. We could also incur material charges as a resultof write-downs of inventories or other tangible assets.

**FASB’sadoption of Statement 123(R) affects our reported results of operationsand may affect how we compensate our employees and conduct our business.**

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123(R), “*Share-Based Payment*,”which required us, effective

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January 1,2006, to measure compensation costs for all stock-based compensation, includingstock options and our employee share purchase plan, as currently constructed,at fair value and take a compensation charge equal to that value. If SFAS No.123(R) was in effect for 2005 and 2004, our net income would have beenreduced by approximately $34.4 million in 2005 and $12.4 million in 2004.

Changes inaccounting pronouncements or taxation rules or practices can have asignificant effect on our reported results. Other new accounting pronouncementsor taxation rules and varying interpretations of accounting pronouncementsor taxation practices have occurred and may occur in the future. This change toexisting rules, future changes, if any, or the questioning of current practicesmay adversely affect our reported financial results, change the mix ofcompensation we pay to our employees or change the way we conduct our business.

**Terroristacts, acts of war and natural disasters may seriously harm our business andrevenues, costs and expenses and financial condition.**

Terrorist acts,acts of war and natural disasters, wherever located around the world, may causedamage or disruption to us or our employees, facilities, partners, suppliers,distributors and customers, any and all of which could significantly impact ourrevenues, expenses and financial condition. This impact could bedisproportionately greater on us than on other companies as a result of oursignificant international presence. The potential for future terrorist attacks,the national and international responses to terrorist attacks and other acts ofwar or hostility have created many economic and political uncertainties thatcould adversely affect our business and results of operations in ways thatcannot presently be predicted. We are largely uninsured for losses andinterruptions caused by terrorist acts, acts of war and natural disasters,including at our headquarters located in Oregon, which is in a region subjectto earthquakes.

**Someof our systems use hazardous gases and emit x-rays, which, if not properlycontained, could result in property damage, bodily injury and death.**

A hazardous gas orx-ray leak could result in substantial liability and could also significantlydamage customer relationships and disrupt future sales. Moreover, remediationcould require redesign of the tools involved, creating additional expense,increasing tool costs and damaging sales. In addition, the matter could involvesignificant litigation that would divert management time and resources andcause unanticipated legal expense. Further, if such a leak involved violationof health and safety laws, we may suffer substantial fines and penalties inaddition to the other damage suffered.

**Unforeseenhealth, safety and environmental costs could impact our future net earnings.**

Some of ouroperations use substances that are regulated by various federal, state andinternational laws governing health, safety and the environment. We could besubject to liability if we do not handle these substances in compliance withsafety standards for storage and transportation and applicable laws. It is ourpolicy to apply strict standards for environmental protection to sites insideand outside the United States, even when not subject to local governmentregulations. We will record a liability for any costs related to health, safetyor environmental remediation when we consider the costs to be probable and theamount of the costs can be reasonably estimated.

**Wemay not be successful in obtaining the necessary export licenses to conductoperations abroad, and the U.S. Congress may prevent proposed sales to foreigncustomers.**

We are subject toexport control laws that limit which products we sell and where and to whom wesell our products. Moreover, export licenses are required from governmentagencies for some of our products in accordance with various statutoryauthorities, including the Export Administration Act of 1979, the InternationalEmergency Economic Powers Act of 1977, the Trading with the Enemy Act of 1917and the Arms Export Control Act of 1976. We may not be successful in obtainingthese necessary licenses in order to conduct business abroad. Failure to complywith applicable export controls or the termination or

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significantlimitation on our ability to export certain of our products would have anadverse effect on our business, results of operations and financial condition.

**Provisionsof our charter documents, our shareholder rights plan and Oregon law could makeit more difficult for a third party to acquire us, even if the offer may beconsidered beneficial by our shareholders.**

Our articles ofincorporation and bylaws contain provisions that could make it harder for athird party to acquire us without the consent of our board of directors. Ourboard of directors has also adopted a shareholder rights plan, or “poison pill,”which would significantly dilute the ownership of a hostile acquirer. Inaddition, the Oregon Control Share Act and the Oregon Business Combination Actlimit the ability of parties who acquire a significant amount of voting stockto exercise control over us. These provisions may have the effect oflengthening the time required for a person to acquire control of us through aproxy contest or the election of a majority of our board of directors, maydeter efforts to obtain control of us and may make it more difficult for athird party to acquire us without negotiation. These provisions may apply evenif the offer may be considered beneficial by our shareholders.

**Item 1B.Unresolved Staff Comments**

None.

**Item 2.Properties**

Our corporate headquarters is located ina facility we own in Hillsboro, Oregon. This facility totals approximately180,000 square feet and houses a range of activities, including manufacturing,research and development, corporate finance and administration and sales andmarketing.

We also maintain a major facility inEindhoven, the Netherlands, consisting of 244,169 square feet of space. Thelease for this space expires in 2018. Present lease payments are approximately$260,000 per month. This facility is used for research and development,manufacturing, sales, marketing and administrative functions.

We maintain a manufacturing anddevelopment facility in Brno, Czech Republic, which consists of 92,570 squarefeet of space, and is leased for approximately $140,000 per month. The leaseexpires in 2012.

We operate sales and service offices inleased facilities in the People’s Republic of China (“PRC”), Japan, Hong Kong,Singapore, the Netherlands, the United Kingdom and the United States, as wellas other smaller offices in the other countries where we have direct sales andservice operations. In some of these locations, we lease space directly. Inother locations, we obtain space through service agreements with affiliates ofPhilips. We closed several European sales offices and consolidated theseoperations into our offices in the Netherlands in the first half of 2006. Weexpect that our facilities arrangements will be adequate to meet our needs forthe foreseeable future and, overall, believe we can meet increased demand forfacilities that may be required to meet increased demand for our products. Inaddition, we believe that if product demand increases, we can use outsourcedmanufacturing of spare parts, additional manufacturing shifts and currentlyunderutilized space as a means of adding capacity without increasing our directinvestment in additional facilities.

**Item 3.Legal Proceedings**

As of the date hereof, there is nomaterial litigation pending against us. From time to time, we become party tolitigation and subject to claims arising in the ordinary course of ourbusiness. To date, these actions have not had a material adverse effect on ourbusiness, financial position, results of operations or cash flows, and althoughthe results of litigation and claims cannot be predicted with certainty, webelieve that the final outcome of such matters will not have a material adverseeffect on our business, financial position, results of operations or cashflows.

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**Item 4.Submission of Matters to a Vote of Security Holders**

No matters weresubmitted to a vote of our shareholders during the fourth quarter endedDecember 31, 2006.

**PART II**

**Item 5. Market for Registrant’s Common Equity, RelatedStockholder Matters and Issuer Purchases of Equity Securities**

***StockPrices, Issuances of Common Stock and Dividends***

Our common stock is quoted on The NasdaqStock Market under the symbol FEIC. The high and low sales prices on The NasdaqStock Market for the past two years were as follows:

| 2005      | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------|------------|----------|------------|---------|------------|
| Quarter 1 |       | $25.78   |       | $19.39  |       |
| Quarter 2 |       | 23.70    |       | 17.66   |       |
| Quarter 3 |       | 24.65    |       | 18.96   |       |
| Quarter 4 |       | 21.08    |       | 17.75   |       |

 

| 2006      | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------|------------|----------|------------|---------|------------|
| Quarter 1 |       | $        | 26.00      |    | $          | 19.28 |   |
| Quarter 2 |       | 25.90    |       | 19.78   |       |
| Quarter 3 |       | 23.20    |       | 18.78   |       |
| Quarter 4 |       | 27.37    |       | 20.49   |       |
|           |            |          |            |         |            |  |  |

 

The approximate number of beneficialshareholders and shareholders of record at February 16, 2007 was 6,700 and 99,respectively.

In February 1997,we acquired the electron optics business of Koninklijke Philips ElectronicsN.V., or Philips, pursuant to a combination agreement between us and asubsidiary of Philips. We issued shares of our common stock to Philips at thetime of the combination and agreed to issue additional shares of our commonstock when stock options that were outstanding on the date of the closing ofthe combination (February 21, 1997) are exercised. The additional sharesare issued at a rate of approximately 1.22 shares to Philips for eachshare issued on exercise of these options. During 2006, we did not issue anyshares of our common stock to Philips in connection with this agreement. As ofDecember 31, 2006, 185,000 shares of our common stock remain issuableunder this agreement.

We did not pay ordeclare any cash dividends in 2006 or 2005. We intend to retain any earningsfor use in our business and, therefore, do not anticipate paying any cashdividends in the foreseeable future.

***Equity Compensation Plans***

Information regarding securities authorized for issuanceunder equity compensation plans will be included in the section titled “SecuritiesAuthorized for Issuance Under Equity Compensation Plans” in the proxy statementfor our 2007 Annual Meeting of Shareholders and is incorporated by referenceherein.

 

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***Stock Performance Graph***

The following line-graph presentation comparescumulative five-year shareholder returns on an indexed basis, assuming a $100initial investment and reinvestment of dividends, of (a) FEI Company,(b) a broad-based equity market index and (c) an industry-specificindex. The broad-based market index used is the Nasdaq Stock Market TotalReturn Index - U.S. and the industry-specific index used is the NasdaqNon-Financial Index.

 
| ** **           | ** ** | **Base**     | ** ** | **Indexed Returns** | ** ** |
|----------------------|------------|--------------|------------|--------------------------|------------|
| ** **           | ** ** | **Period**   | ** ** | **Year Ended**      | ** ** |
| **Company/Index**    | ** ** | **12/31/01** | ** ** | **12/31/02**             | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
| FEI Company          |       | $            | 100.00     |                     | $          | 48.52 |   | $ | 71.41 |   | $ | 66.65 |   | $ | 60.84 |   | $ | 83.69 |   |
| Nasdaq Non Financial |       | 100.00       |       | 65.33                    |       | 100.01 |   | 107.86 |   | 110.31 |   | 120.97 |   |
| Nasdaq U.S. Index    |       | 100.00       |       | 69.13                    |       | 103.36 |   | 112.49 |   | 114.88 |   | 126.22 |   |
|                      |            |              |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 6.**  **Selected Financial Data**

The selectedconsolidated financial data below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe consolidated financial statements and notes thereto included elsewhere inthis Annual Report on Form 10-K.
| **In thousands,  except per share amounts** | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ***Statement  of Operations Data***                             |       |                                       |       |   |   |   |   |   |   |   |   |
| Net sales                                                       |       | $                                          | 479,491    |   | $ | 420,097 |   | $ | 457,525 |   | $ | 356,892 |   | $ | 341,381 |   |
| Cost of sales(1)                                                |       | 283,045                                    |       | 274,903 |   | 276,131 |   | 215,534 |   | 191,568 |   |
| Gross profit                                                    |       | 196,446                                    |       | 145,194 |   | 181,394 |   | 141,358 |   | 149,813 |   |
| Total operating  expenses(2)                                    |       | 173,399                                    |       | 191,752 |   | 150,209 |   | 128,312 |   | 131,199 |   |
| Operating income  (loss)                                        |       | 23,047                                     |       | (46,558 | ) | 31,185 |   | 13,046 |   | 18,614 |   |
| Other income  (expense), net(3)                                 |       | 5,072                                      |       | (9,831 | ) | (8,264 | ) | (2,831 | ) | (4,946 | ) |
| Income (loss)  from continuing operations before income taxes   |       | 28,119                                     |       | (56,389 | ) | 22,921 |   | 10,215 |   | 13,668 |   |
| Income tax  expense(4)                                          |       | 10,467                                     |       | 22,071 |   | 7,205 |   | 3,543 |   | 4,990 |   |
| Income (loss)  from continuing operations                       |       | 17,652                                     |       | (78,460 | ) | 15,716 |   | 6,672 |   | 8,678 |   |
| (Loss) income  from discontinued operations, net of tax         |       | (947                                       | )          | 302 |   | 857 |   | 522 |   | — |   |
| Gain on disposal  of discontinued operations, net of tax(5)     |       | 3,335                                      |       | — |   | — |   | — |   | — |   |
| Net income  (loss)                                              |       | $                                          | 20,040     |   | $ | (78,158 | ) | $ | 16,573 |   | $ | 7,194 |   | $ | 8,678 |   |
|                                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic income  (loss) per share from continuing operations       |       | $                                          | 0.52       |   | $ | (2.34 | ) | $ | 0.47 |   | $ | 0.20 |   | $ | 0.27 |   |
| Basic income per  share from discontinued operations            |       | 0.07                                       |       | 0.01 |   | 0.03 |   | 0.02 |   | — |   |
| Basic net income  (loss) per share                              |       | $                                          | 0.59       |   | $ | (2.33 | ) | $ | 0.50 |   | $ | 0.22 |   | $ | 0.27 |   |
|                                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| Diluted income  (loss) per share from continuing operations     |       | $                                          | 0.47       |   | $ | (2.34 | ) | $ | 0.41 |   | $ | 0.18 |   | $ | 0.26 |   |
| Diluted income  per share from discontinued operations          |       | 0.06                                       |       | 0.01 |   | 0.02 |   | 0.02 |   | — |   |
| Diluted net  income (loss) per share                            |       | $                                          | 0.53       |   | $ | (2.33 | ) | $ | 0.43 |   | $ | 0.20 |   | $ | 0.26 |   |
|                                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| Shares used in  basic per share calculations                    |       | 33,818                                     |       | 33,595 |   | 33,253 |   | 32,930 |   | 32,493 |   |
| Shares used in diluted  per share calculations                  |       | 39,752                                     |       | 33,595 |   | 39,668 |   | 36,844 |   | 33,460 |   |

 

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ***Balance  Sheet Data***  |       |                  |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents |       | $                     | 110,656    |   | $ | 58,766 |   | $ | 112,162 |   | $ | 97,108 |   | $ | 162,879 |   |
| Working capital            |       | 477,660               |       | 327,789 |   | 433,895 |   | 420,400 |   | 297,539 |   |
| Total assets               |       | 838,079               |       | 656,031 |   | 841,044 |   | 755,145 |   | 636,479 |   |
| Convertible debt           |       | 310,882               |       | 225,000 |   | 295,000 |   | 295,000 |   | 175,000 |   |
| Shareholders’ equity  |       | 349,908               |       | 292,443 |   | 379,570 |   | 336,293 |   | 326,925 |   |
|                            |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Included in 2005 cost of sales was $14.2 million of inventorywrite-downs related to the closure of our Peabody, Massachusetts facility, therelocation and refocus of the product lines that were at that facility, a priceadjustment on a product sale from that operation and capitalized softwareimpairment charges related to certain semiconductor products.

(2)          Included in 2006 operating expenses were the following:

·                  restructuring,reorganization, relocation and severance charges of $12.6 million;

·                  mergercosts of $0.5 million;

·                  assetimpairment charges of $0.5 million; and

·                  a$1.5 million gain related to the  sale ofcertain intellectual property rights to a privately-held company.

Included in 2005 operating expenses were thefollowing:

·                  $25.4million of asset impairment charges primarily related to semiconductor productsand the write-off of all costs related to our enterprise resource planning (“ERP”)system as we determined that the future cost required to complete the ERPsystem did not justify the potential return; and

·                  $8.5million of restructuring charges, primarily for severance, lease terminationsand relocation expenses for the closure of our Peabody facility andconsolidation of certain of our European facilities.

Included in 2004 operatingexpenses was a $0.6 million charge for restructuring, reorganization andrelocation.

Included in 2003 operatingexpenses was a $1.7 million charge for restructuring, reorganization andrelocation related to our fourth quarter 2002 and second quarter 2003restructuring and reorganization plans, plus $1.2 million for the write-off ofin-process purchased technology.

Included in 2002 operatingexpenses was a restructuring charge of $5.5 million undertaken to consolidateoperations, eliminate redundant facilities and reduce operating expenses, plusa charge of $6.8 million for the proposed merger with Veeco Instruments Inc.,which was subsequently cancelled.

(3)          Included in other income (expense) in 2006 were the following thataffect comparability:

·                  interest expense of $0.5 million in the firsthalf of 2006 related to the repurchase of $29.0 million face value of our 5.5%convertible notes;

·                  a $5.2 million gain related to the sale of ourentire ownership interest in a privately-held company in the third quarter of2006; and

·                  a $3.9 million charge related to the write-offof our equity and debt investment in a privately-held company in the thirdquarter of 2006.

Included in 2005 otherexpense, net was $6.4 million for realized losses on investments inprivately-held companies and the write-down of certain of these investments forwhich we concluded an “other-than-temporary” impairment existed.

Included in 2003 otherexpense, net was $3.5 million related to currency and hedging gains.

(4)          Our 2006 tax provision consisted primarily of taxes accrued in foreignjurisdictions and reflects a benefit of $1.5 million related to the release ofvaluation allowances against a portion of United States deferred tax assetsutilized during the period. Our 2005 tax expense primarily consisted of$15.1 million in expense related to the establishment of valuation allowancesagainst the United States deferred tax assets, which offset the benefit fromUnited States net operating losses generated in 2005. Additionally, we hadapproximately $10.9 million of foreign tax expense, which was offset by a netcurrent tax benefit of $4.1 million primarily related to tax audit settlementsin the United States.

(5)          Represents the gain on the sale of our KnightsTechnology assets in the fourth quarter of 2006.

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**Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

**CautionaryFactors That May Affect Future Results**

ThisAnnual Report on Form 10-K contains forward-looking statements that involverisks and uncertainties, as well as assumptions that, if they never materializeor prove incorrect, could cause our results to differ materially from thoseexpressed or implied by such forward-looking statements. Such forward-lookingstatements include any expectations of earnings, revenues or other financialitems; any statements of the plans, strategies and objectives of management forfuture operations; factors that may affect our 2007 operating results; anystatements concerning proposed new products, services, developments, changes toour restructuring reserves or anticipated performance of products or services;any statements related to the needs or expected growth of our target markets;any statements regarding future economic conditions or performance; statementsof belief; and any statement of assumptions underlying any of the foregoing.You can identify these statements by the fact that they do not relate strictlyto historical or current facts and use words such as “anticipate,” “estimate,” “expect,”“project,” “intend,” “plan,” “believe” and other words and terms of similarmeaning. From time to time, we also may provide oral or written forward-lookingstatements in other materials we release to the public. The risks,uncertainties and assumptions referred to above include, but are not limitedto, those discussed here and the risks discussed from time to time in our otherpublic filings. All forward-looking statements included in this Annual Reporton Form 10-K are based on information available to us as of the date of thisreport, and we assume no obligation to update these forward-looking statements.You are advised, however, to consult any further disclosures we make on relatedsubjects in our Forms 10-Q and 8-K filed with, or furnished to, the SEC. Youalso should read Item 1A. “Risk Factors” for factors that we believe couldcause our actual results to differ materially from expected and historicalresults. Other factors also could adversely affect us.

**Summary ofProducts and Segments**

We are a leading supplier of instruments for nanoscaleimaging, analysis and prototyping to enable research, development andmanufacturing in a range of industrial, academic and research institutionalapplications. In 2006, we completed our reorganization from productdivisions to market divisions. Accordingly, our semiconductor and data storageproduct markets are being reported together as the NanoElectronics market andour Industry and Institute product market has been divided into theNanoResearch and Industry market and the NanoBiology market.

Our products and systems include hardware and software for focused ionbeams, or FIBs, scanning electron microscopes, or SEMs, transmission electronmicroscopes, or TEMs, and *DualBeam*systems, which combine a FIB and SEM on a single platform.

Our *DualBeam* systems include models that have wafer handlingcapability that are purchased by semiconductor and data storage manufacturers (“wafer-level*DualBeam*systems”) and models that havesmall stages and are sold to customers in several markets (“small-stage *DualBeam*systems”).

Sales and serviceoperations are conducted in approximately 50 countries around the world; 29with a direct presence and the remainder through independent agents,distributors and representatives in additional countries.

To date, we have a total worldwide installed base of over6,600 systems. The development of these solutions has been driven by our strongtechnology base that includes patented and proprietary technologies and thetechnical expertise and knowledge base of approximately 331 research anddevelopment personnel worldwide.

The NanoElectronicsmarket consists of customers in the semiconductor, data storage and relatedindustries such as printers and microelectromechanical systems (“MEMs”). Forthe semiconductor market, our growth is driven by shrinking line widths andprocess nodes of 65 nanometers and smaller, the use of 

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multiple layers ofnew materials such as copper and low-k dielectrics, the increase in wafer sizeto 300 millimeters in diameter and increasing device complexity. Our productsare used primarily in laboratories to speed new product development andincrease yields by enabling 3D wafer metrology, defect analysis, root causefailure analysis and circuit edit for modifying device structures.  In the data storage market, our growth isdriven by the transition from longitudinal to perpendicular recording heads aswell as by rapidly increasing storage densities that require smaller recordingheads, thinner geometries and materials that increase the complexity of devicestructures. Our products offer 3D metrology for thin film head processing androot cause failure analysis.

The NanoResearch andIndustry market includes universities, public and private research laboratoriesand a wide range of industrial customers, including automobiles, aerospace,metals, mining and petrochemicals. Growth in these markets is driven by corporate and government fundingfor research and development in materials science and by development of newproducts based on innovations in materials at the nanoscale. Our solutionsprovide researchers and manufacturers with atomic-level resolution images andpermit development, analysis and production of advanced products. Our productsare also used in root cause failure analysis and quality control applications.

The NanoBiologymarket includes universities and research institutes engaged in biotech andlife sciences applications, as well as pharmaceutical, biotech, medical deviceand hospital companies. Our products’ ultra-high resolution imaging allows cellbiologists and drug researchers to create detailed 3D reconstructions ofcomplex biological structures, enabling them to map proteins within cells. Ourproducts are also used in a range of pathology and quality controlapplications.

We have reclassified our 2005 and 2004 revenues and gross margin into thenew market segments to provide comparability to the 2006 presentation in thisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.

**Overview**

Net sales increased to $479.5 million in 2006 compared to $420.1 million in2005.  Net sales increased in each of ourproduct lines and market segments. Demand was particularly strong for our TEM line, led by the *Titan* high-end system, and for our small-stage *DualBeam* systems. Our growth was driven by a variety offactors, including positive customer response to our new product offerings,ongoing growth in spending on nanotechnology research by governments,institutes and corporations worldwide, and a cyclical upturn in thesemiconductor capital equipment industry.

At December 31, 2006, our total backlog was $305.9 million, which consistedof product and service and components backlog of unfilled orders of $259.1million and $46.8 million, respectively, compared to $145.5 million and $38.5million, respectively, at December 31, 2005. We only recognize backlog for firmpurchase orders for which the terms of the sale have been agreed upon,including price, configuration, options and payment terms. Product backlogconsists of all open orders meeting these criteria. Service backlog consists ofopen orders for service, unearned revenue on service contracts and open ordersfor spare parts. United States government backlog is limited to contractedamounts.

The increase in backlog from December 31, 2005 to December 31, 2006reflects increases in all of our segments and was driven by increases in ordersfor TEMs, including the *Titan*, andsmall-stage *DualBeam* systems.

Of our total backlog at December 31, 2006, approximately 90% is shippableby the end of 2007 and approximately 10% to 15% requires some incrementaldevelopment. Customers may cancel or delay delivery on previously placedorders, although our standard terms and conditions include penalties forcancellations made close to the scheduled delivery date. As a result, thetiming of the receipt of orders or the shipment of products could have asignificant impact on our backlog at any date. Historically, cancellations havebeen insignificant. Recently, our ability to ship product from backlog has beennegatively affected by single-sourcing issues and problems insecuring electronic components from a 

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certain vendor. In addition, product shipments have been delayed due todelays in completing certain application development. For these and otherreasons, the amount of backlog at any date is not necessarily indicative ofrevenue to be recognized in future periods.

Financial results for 2006 were affected by the following charges andgains, which netted to an aggregate of $8.0 million loss as follows:

·                  $9.3 million included in restructuring,reorganization, relocation and severance charges in connection with thetermination of our former CEO, including $2.2 million of cash payments and anon-cash charge of $7.1 million for stock-based compensation, as a result ofthe acceleration and extended exercisability of his existing stock options inaccordance with his 2002 severance agreement;

·                  $3.3 million of additional restructuring,reorganization, relocation and severance charges for facilities and severancecharges related to the closure of certain of our European field offices, aresearch and development center in Tempe, Arizona, as well as residual costsrelated to the Peabody, Massachusetts plant closure and the downsizing of therelated semiconductor businesses;

·                  $0.5 million for legal and other costs in connectionwith potential merger negotiations which were terminated by us in February2006;

·                  a $0.5 million charge for asset impairments relatedto the previously-announced decision to discontinue implementation of a newenterprise resource planning system and pursue less costly alternatives;

·                  a $0.5 million charge related to the repurchase andretirement of $29.0 million face value of our 5.5% convertible notes (includedas a component of interest expense);

·                  a $3.9 million charge related to the write-off of ourequity and debt investment in a privately-held company (included as a componentof other income, net);

·                  a $5.2 million gain related to the sale of our entireownership interest in a privately-held company (included as a component ofother income);

·                  a $1.5 million gain related to the sale of certainintellectual property rights to a privately-held company (included as areduction to selling, general and administrative expense); and

·                  a $3.3 million gain, net of tax, on the disposal ofdiscontinued operations.

In 2006, we implemented SFAS No. 123(R) using the modified prospectivetransition method. Stock-based compensation expense, excluding stockcompensation charges related to the severance of our former CEO, totaled $5.7million in 2006 and was recorded in cost of sales and operating expenses.

Prior to 2006, we accounted for stock-basedcompensation using Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issued to Employees*.” In 2006, we havecontinued to calculate compensation expense for restricted shares andrestricted stock units using the fair value of the underlying shares on thedate of grant as if the shares were vested and are recording compensationexpense based on fair value estimates using the Black-Scholes option pricingmodel for options granted under our stock incentive plans and employee sharepurchase plan. Based on existing grants as of December 31, 2006, stock-basedcompensation expense is expected to be approximately $5.2 million in 2007.

**Outlookfor 2007**

In 2006, ourbacklog of unfilled orders increased by $121.9 million to $305.9 million asorders totaled $601.4 million. The underlying trends in each of our marketsremain fundamentally positive and our product positions in those markets aregenerally strong. In NanoResearch and Industry, governments worldwide continueto invest in nanotechnology research, and industrial customers are seeking touse nanoscale features and material properties in new products. In NanoElectronics,the reduction in feature sizes in semiconductor and data storage devices, alongwith the use of new materials to improve performance, reduce power consumptionand facilitate finer line widths, continues to require new tools for product developmentand yield improvement. The NanoBiology market for our tools is relatively newand emerging, but we believe there will be increased demand from researchers infields such as structural 

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biology andproteomics, as well as increased use of our types of instruments in pathologyand quality control applications. Demand for service for our products is alsoexpected to grow with the expansion of our installed base of instruments.

While our marketenvironments are generally positive, the market positions of our broad productlines are also stable or improving. We believe we are the leader in *DualBeam* and TEM sales, led by new products that have beenwell received by customers. Our SEM products also remain competitive in themarketplace.

As a result of allof these factors, we expect net sales to increase in 2007 compared with 2006.

Our goal is tofurther increase our gross margins in 2007, primarily through the shipment of agreater percentage of higher-margin products, more efficient use ofmanufacturing overhead due to higher volumes of shipments, improved supplychain management and more linear shipments within each quarter. Research anddevelopment spending is expected to increase at approximately the same rate asthe increase in net sales, as we continue to invest in the development of newproducts. Selling, general and administrative expense is expected to grow moreslowly than net sales, even as we build our sales and distributionorganization, particularly in Asia.

Because of theexpected increase in revenue, the expense reduction efforts noted above andassuming a lack of restructuring and other one-time charges in 2007, net incomewill increase during 2007 if we are able to realize our plans and expectations.

OurNanoElectronics markets are cyclical, and some observers expect an industrydownturn in 2007.  While we enter theyear with a solid backlog on unfilled orders and our bookings have historicallybeen less cyclical than the overall semiconductor capital equipment industry,the depth of any decline in overall industry capital spending could affect therate of growth in our revenue for the year. Potential weakness in the value ofthe U.S. dollar compared with the euro would also increase our costs morerapidly than our revenue and would thus affect our ability to improve margins.Our foreign exchange hedging program will mitigate or delay those costincreases, but will not be able to completely offset a long-term significantweakening of the dollar. Revenue growth in 2007 will also be affected by ourlevel of success in meeting key operating objectives during the year, includingincreased production rates for high-performance new products and expansion ofour market position in major Asian markets. For other factors that could affectour revenue and income growth, please see the Risk Factors included in Item 1Aof this report.

**Results of Operations**

The following table setsforth our statement of operations data in thousands of dollars.
| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                                     |       | $                                          | 479,491    |   | $ | 420,097 |   | $ | 457,525 |   |
| Cost of sales                                                 |       | 283,045                                    |       | 274,903 |   | 276,131 |   |
| Gross profit                                                  |       | 196,446                                    |       | 145,194 |   | 181,394 |   |
| Research and  development                                     |       | 57,528                                     |       | 56,577 |   | 51,737 |   |
| Selling, general  and administrative                          |       | 100,279                                    |       | 97,460 |   | 92,497 |   |
| Merger costs                                                  |       | 484                                        |       | — |   | — |   |
| Amortization of  purchased technology                         |       | 2,034                                      |       | 3,819 |   | 5,368 |   |
| Asset impairment                                              |       | 465                                        |       | 25,352 |   | — |   |
| Restructuring,  reorganization and relocation costs           |       | 12,609                                     |       | 8,544 |   | 607 |   |
| Operating income  (loss)                                      |       | 23,047                                     |       | (46,558 | ) | 31,185 |   |
| Other income  (expense), net                                  |       | 5,072                                      |       | (9,831 | ) | (8,264 | ) |
| Income (loss)  from continuing operations before income taxes |       | 28,119                                     |       | (56,389 | ) | 22,921 |   |
| Income tax  expense                                           |       | 10,467                                     |       | 22,071 |   | 7,205 |   |
| Income (loss)  from continuing operations                     |       | 17,652                                     |       | (78,460 | ) | 15,716 |   |
| (Loss) income  from discontinued operations, net of tax       |       | (947                                       | )          | 302 |   | 857 |   |
| Gain on disposal  of discontinued operations, net of tax      |       | 3,335                                      |       | — |   | — |   |
| Net income (loss)                                             |       | $                                          | 20,040     |   | $ | (78,158 | ) | $ | 16,573 |   |

 

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Thefollowing table sets forth our statement of operations data as a percentage ofnet sales.
| ** **                                                    | ** ** | **Year Ended December 31,(1)** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                                     |       | 100.0                                         | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                                 |       | 59.0                                          |       | 65.4 |   | 60.4 |   |
| Gross profit                                                  |       | 41.0                                          |       | 34.6 |   | 39.6 |   |
| Research and  development                                     |       | 12.0                                          |       | 13.5 |   | 11.3 |   |
| Selling, general  and administrative                          |       | 20.9                                          |       | 23.2 |   | 20.2 |   |
| Merger costs                                                  |       | 0.1                                           |       | — |   | — |   |
| Amortization of  purchased technology                         |       | 0.4                                           |       | 0.9 |   | 1.2 |   |
| Asset impairment                                              |       | 0.1                                           |       | 6.0 |   | — |   |
| Restructuring,  reorganization and relocation costs           |       | 2.6                                           |       | 2.0 |   | 0.1 |   |
| Operating income  (loss)                                      |       | 4.8                                           |       | (11.1 | ) | 6.8 |   |
| Other income  (expense), net                                  |       | 1.1                                           |       | (2.3 | ) | (1.8 | ) |
| Income (loss)  from continuing operations before income taxes |       | 5.9                                           |       | (13.4 | ) | 5.0 |   |
| Income tax  expense                                           |       | 2.2                                           |       | 5.3 |   | 1.6 |   |
| Income (loss)  from continuing operations                     |       | 3.7                                           |       | (18.6 | ) | 3.4 |   |
| (Loss) income  from discontinued operations, net of tax       |       | (0.2                                          | )          | 0.1 |   | 0.2 |   |
| Gain on disposal  of discontinued operations, net of tax      |       | 0.7                                           |       | — |   | — |   |
| Net income (loss)                                             |       | 4.2                                           | %          | (18.6 | )% | 3.6 | % |

 

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(1) Percentagesmay not add due to rounding.

Net sales increased $59.4 million, or14.1%, to $479.5 million, in 2006 compared to $420.1 million in 2005. Theincrease in net sales was driven by improvements in all of our segments,primarily related to increases in our TEM and small-stage *DualBeam*sales as discussed in more detail below.

Net sales decreased $37.4 million, or8.2%, to $420.1 million, in 2005 compared to $457.5 million in 2004. Thedecrease in net sales was driven primarily by the slow-down in thesemiconductor industry, which resulted in lower sales volumes in oursemiconductor products within the NanoElectronics segment. These sales declineswere offset by higher service revenue in 2005 as described more fully below.

***Net Sales by Segment***

Net sales include sales in theNanoElectronics market, the NanoResearch and Industry market, the NanoBiologymarket and Service and Components. Net sales by market segment (in thousands)and as a percentage of net sales were as follows:

 
| ** **                 | ** ** | **Year Ended December 31,** |
|----------------------------|------------|--------------------------------------------|
| ** **                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** |
| NanoElectronics            |       | $                                          | 154,648 |   | 32.3 | % | $ | 145,951 |   | 34.7 | % | $ | 207,760 |   | 45.4 | % |
| NanoResearch and  Industry |       | 165,067                                    |   | 34.4 | % | 130,045 |   | 31.0 | % | 104,236 |   | 22.8 | % |
| NanoBiology                |       | 40,928                                     |   | 8.5 | % | 35,355 |   | 8.4 | % | 45,046 |   | 9.8 | % |
| Service and  Components    |       | 118,848                                    |   | 24.8 | % | 108,746 |   | 25.9 | % | 100,483 |   | 22.0 | % |
|                       |       | $                                          | 479,491 |   | 100.0 | % | $ | 420,097 |   | 100.0 | % | $ | 457,525 |   | 100.0 | % |

 

*NanoElectronics*

The $8.8 million, or 6.0%, increase inNanoElectronics sales in 2006 compared to 2005 was primarily due toimprovements in our wafer-level *DualBeam*, SEMand small-stage *DualBeam* system unit sales, whichresulted primarily from general demand in the semiconductor capital equipmentand data storage markets. These improvements were partially offset by volumedeclines related to products in our semiconductor businesses that weredeemphasized during our restructuring activities in the second half of 2005.

 

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*Ourbacklog in NanoElectronics increased in 2006 for each of our major productlines.*

The $61.8 million, or 29.7%, decrease inNanoElectronics sales in 2005 compared to 2004 was primarily due to weakness in the global semiconductor and datastorage markets, which resulted in fewer units sold in 2005 compared to 2004,particularly in our circuit edit, mask repair and data storage tools. Thedecrease in data storage tools was primarily due to the industry’stiming of purchases and a shift to higher recording density technology. Also, as discussed above, we deemphasized certainproduct lines in the second half of 2005.

*NanoResearch and Industry*

The $35.0 million, or 26.9%, increase inNanoResearch and Industry sales in 2006 compared to 2005 was due primarily toan approximately $33.6 million increase related to sales of our TEMs, dueprimarily to a shift in mix to our higher-priced TEMs, including the *Titan*, as well as a slight increase in unit sales. Worldwidenanotechnology research funding remains strong. In addition, sales of oursmall-stage *DualBeam* systems increased by $3.0million in 2006 compared to 2005 as a result of increased unit sales.

We built backlog in this segment in 2006for each of our major product lines.

The $25.8 million, or 24.8%, increase inNanoResearch and Industry sales in 2005 compared to 2004 was due primarily toincreased unit sales of our small-stage *DualBeam* systems, as well as our new *Titan*S/TEM and other TEM products, which have higher average selling prices thanother products in this segment. In addition, unit sales of our ESEM productsalso increased. These increases were partially offset by decreased demand dueto a slow-down in growth of United States government funding for nanotechnologyresearch.

*NanoBiology*

The $5.6 million, or 15.8%, increase inNanoBiology sales in 2006 compared to 2005 was due primarily to a shift in mixto higher-priced TEMs. We also realized an increase in the number of TEMs soldin 2006 compared to 2005. NanoBiology is an emerging application area for ourequipment, and a significant portion of the tools we sell in this market haverelatively high unit prices. As a result, quarter-to-quarter growth rates inthis market are likely to be volatile, although we expect long-term growth.

We built backlog in this segment in 2006,primarily for our TEMs.

The $9.7 million, or 21.5%, decrease inNanoBiology sales in 2005 compared to 2004 was due primarily to decreasedvolume in TEM sales, partially offset by increased use of our TEMs for researchapplications.

*Service and Components*

The $10.0 million, or 9.2%, increase inService and Component sales in 2006 compared to 2005 was due primarily to alarger installed base and strong service contract renewals in the second halfof 2006. Component sales include sales ofindividual components as well as equipment refurbishment and contributed $0.8million to the increase in 2006 compared to 2005.

The $8.3 million, or8.2%, increase in Service and Component sales in 2005 compared to 2004 wasprimarily due to an increase in service sales as our installed base grew, aswell as an increase in the number of service contracts sold, partially offsetby the slow-down in the semiconductor equipment business and increased productreliability, which has caused refurbishment revenue to decline.

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***Net Sales by Geographic Region***

A significant portion of our revenue hasbeen derived from customers outside of the United States, which we expect tocontinue. The following table shows our net sales by geographic location(dollars in thousands):
| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| North America        |       | $                                          | 167,389    |   | 34.9 | % | $ | 125,875 |   | 30.0 | % | $ | 169,011 |   | 36.9 | % |
| Europe               |       | 187,229                                    |       | 39.0 | % | 160,891 |   | 38.3 | % | 144,098 |   | 31.5 | % |
| Asia-Pacific  Region |       | 124,873                                    |       | 26.1 | % | 133,331 |   | 31.7 | % | 144,416 |   | 31.6 | % |
|                 |       | $                                          | 479,491    |   | 100.0 | % | $ | 420,097 |   | 100.0 | % | $ | 457,525 |   | 100.0 | % |

 

*NorthAmerica*

Sales in NorthAmerica increased $41.5 million, or 33.0%, in 2006 compared to 2005. Thisincrease was primarily due to increased data storage sales as the conversion toperpendicular recording accelerated, as well as increased TEM sales, includingthe *Titan,*and**increasedsmall-stage *DualBeam* sales. These improvements werepartially driven by improvements in the semiconductor capital equipment anddata storage markets in 2006 compared to 2005. In 2005, we reorganized oursales management team in North America, which also contributed to the improvednet sales in 2006 compared to 2005.

Sales in NorthAmerica decreased $43.1 million, or 25.5%, in 2005 compared to 2004 primarilydue to softness in the semiconductor industry, a slow-down in growth of UnitedStates government funding for nanotechnology research in the NanoResearch andIndustry market and inefficiencies in our sales force due to organizationalchanges. These declines were partially offset by growth in our servicerevenues.

*Europe*

Sales in Europe increased $26.3 million,or 16.4%, in 2006 compared to 2005. Thisincrease was primarily due to increased TEM sales, including the *Titan*, partially offset by unusually high volume sales ofour small-stage *DualBeam*systems in the firsthalf of 2005 compared to 2006. In 2005, we reorganized our sales managementteam in Europe, which also contributed to the improved net sales in 2006compared to 2005. European sales were also increased by the strength of theeuro compared with the U.S. dollar.

The $16.8 million, or 11.7%, increase insales in Europe in 2005 compared to 2004 was primarily due to sales of our *Titan* S/TEM products, which began shipping in the thirdquarter of 2005, sales of our ESEM products, which began shipping in the firstquarter of 2005, and increases in our other SEM products. Increased servicerevenue also contributed to the growth. There were no appreciable effects onrevenue in Europe from currency exchange rates.

*Asia-PacificRegion*

Sales in the Asia-Pacific regiondecreased $8.5 million, or 6.3%, in 2006 compared to 2005. This decreaseresulted from lower volume sales of ourwafer-level *DualBeam* systems and small-stage *DualBeam* systems in 2006 due to unusually high volumes in2005 and a decrease in SEM sales, partially offset by an increase in TEM sales,including the *Titan*. We expect to focusinvestment on additional sales and service resources in 2007 in theAsia-Pacific region.

Sales in the Asia-Pacific regiondecreased $11.1 million, or 7.7%, in 2005 compared to 2004 primarily due to adecline in wafer-level *DualBeam* systemsales as a result of the weakness in the semiconductor industry during 2005 andour exit from the SIMS business in the second quarter of 2005. Service revenueincreases offset these declines in part.

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***Cost of Sales and GrossMargin***

Cost of sales includes manufacturingcosts, such as materials, labor (both direct and indirect) and factoryoverhead, as well as all of the costs of our customer service function such aslabor, materials, travel and overhead. We see four primary drivers affectinggross margin: product mix (including the effect of price competition), volume,cost reduction efforts (including material cost and manufacturing efficiency)and currency fluctuations.

Cost of sales increased $8.1 million, or3.0%, to $283.0 million in 2006 compared to $274.9 million in 2005. Theincrease in cost of sales in 2006 was primarily due to the increased sales in2006 compared to 2005 and $0.8 million of stock-based compensation in 2006compared to none for 2005. These increases were partially offset by $14.2million of charges incurred to write-off inventory and capitalized softwarerelated to the closure of our Peabody, Massachusetts facility in 2005, as wellas an increase in our overall gross margin as detailed below.

Cost of sales remained relatively flatwith a decrease of $1.2 million, or 0.4%, to $274.9 million in 2005 compared to$276.1 million in 2004 compared to a year over year revenue decrease of approximately8.2%. Expected volume related cost of sales decreases were more than offset bythe following additional expenses:

·                  an$11.0 million charge for the write-down of inventory in 2005 related toportions of our semiconductor businesses and to the closure of our Peabody,Massachusetts facility, which primarily manufactured and supported productssold to semiconductor markets. In response to the declining product demand,which continued throughout 2005, management decided to restructure thesebusinesses, which included lowering demand expectations and accepting asignificant price adjustment below cost to complete a sale on a product that wewere de-emphasizing in the marketplace. By comparison, there were $1.7 millionof inventory write-downs in 2004;

·                  a$3.2 million impairment charge for capitalized software in 2005 related tosemiconductor products compared to no such charge in 2004;

·                  realizedlosses from our cash flow hedges totaling $2.2 million in 2005, which hadlimited offsetting benefit from currency movements in cost of sales compared toa realized gain of $1.8 million in 2004, which partially offset the impact ofcurrency movements on cost of sales in 2004; and

·                  anapproximately $4.1 million increase in cost of sales due to an increase in serviceparts costs in 2005 compared to 2004.

Our gross margin (gross profit as apercentage of net sales) by segment was as follows:

|                            | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| NanoElectronics            |       | 49.2                                       | %          | 35.9 | % | 46.5 | % |
| NanoResearch and  Industry |       | 42.5                                       | %          | 38.9 | % | 36.2 | % |
| NanoBiology                |       | 40.7                                       | %          | 35.2 | % | 32.5 | % |
| Service and  Components    |       | 28.2                                       | %          | 27.3 | % | 32.3 | % |
| Overall                    |       | 41.0                                       | %          | 34.6 | % | 39.6 | % |

 

Our overall gross margin in 2006 improvedas we increased the unit volume and benefited from improved product mix.Overall gross margins decreased in 2005 by approximately 3.4 percentage pointsdue to the $14.2 million of charges related to the write-down of inventory andcapitalized software as discussed above and the NanoElectronics marginsdecreased by approximately 9.7 percentage points.

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*NanoElectronics*

The NanoElectronics gross margin improvedsignificantly in 2006 compared to 2005, primarily due to the impact in 2005 ofthe inventory and capitalized software write-offs discussed above.Additionally, gross margins in 2006 increased due to improvements in ourproduct mix for both *DualBeam*systems and TEM products, including the *Titan*.

The decrease in gross margin in theNanoElectronics segment in 2005 compared to 2004 primarily was due to thecharges related to asset impairment and write-downs discussed above. Thesedecreases were partially offset by a shift in mix to our *Titan*S/TEM products and our ESEM products, which have higher margins than otherproducts in this segment.

*NanoResearch and Industry*

The increase in the NanoResearch andIndustry gross margin in 2006 compared to 2005 was primarily due toimprovements in the TEM product mix, partially offset by the shift to thelower-margin small-stage *DualBeam*systems.

The increase in the NanoResearch and Industrygross margin in 2005 compared to 2004 was primarily due to an increase in TEMsales, which have higher margins than other products in this segment.

*NanoBiology*

The increase in the NanoBiology grossmargin in 2006 compared to 2005 was primarily due to improvements in marginsachieved on our TEMs, due in part to sales of the *Titan*.

The increase in the NanoBiology grossmargin in 2005 compared to 2004 was primarily due to an increase in TEM sales,which have higher margins than other products in this segment.

*Service and Components*

The increase in the Service andComponents gross margin in 2006 compared to 2005 was primarily due toefficiencies gained as net sales increased and a reduction in inventorywrite-downs in 2006 compared to 2005, partially offset by higher repair costsand material usage.

The decrease in the Service andComponents gross margin in 2005 compared to 2004 was primarily due to higherparts costs in the service organization as a percentage of revenues in 2005compared to 2004. The increase in parts costs was the result of general priceincreases, increased inventory write-offs and increased parts usage forproducts under service contracts. In addition, a shift in mix between newcomponent sales versus component refurbishments, as well as an overall decreasein component volume contributed to the decrease in gross margins. The marginson our refurbishment work are typically greater than those on our newcomponents.

***Research and DevelopmentCosts***

Research and development (“R&D”)costs include labor, materials, overhead and payments to Philips and otherthird parties for research and development of new products and new software orenhancements to existing products and software and are presented net ofsubsidies received for such efforts.

R&D costs were $57.5 million (12.0%of net sales) in 2006, $56.6 million (13.5% of net sales) in 2005 and $51.7million (11.3% of net sales) in 2004.

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R&D costs are reported net ofsubsidies and capitalized software development costs as follows (in thousands):

|                            | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Gross spending             |       | $                                          | 61,420     |   | $ | 61,130 |   | $ | 61,213 |   |
| Less subsidies             |       | (3,892                                     | )          | (4,553 | ) | (8,802 | ) |
| Less capitalized  software |       | —                                     |       | — |   | (674 | ) |
| Net expense                |       | $                                          | 57,528     |   | $ | 56,577 |   | $ | 51,737 |   |

 

R&D costs increased $1.0 million in2006 compared to 2005. This increase was primarily due to a $0.9 millionincrease in stock-based compensation, a $1.6 million increase in employee cashbonuses and a $0.7 million decrease in subsidies received, partially offset by$2.5 million in savings from restructuring activities, mainly due to theclosing of our Peabody, Massachusetts operations and $0.5 million in projectcost savings. Subsidies have decreased as the projects available for subsidies,primarily in the Netherlands and the U.S., have decreased.

R&D costs increased approximately$4.8 million in 2005 compared to 2004. The increase was a result of a decreasein subsidies and capitalizations of $4.2 million and $0.7 million,respectively, and an increase in facilities and outside services of $0.4million and $0.2 million, respectively. These factors were partially offset bydecreases in labor and related expenses of $0.9 million.

We anticipate that we will continue toinvest in R&D at a similar percentage of revenue for the foreseeablefuture. Accordingly, as revenues increase, we currently anticipate that R&Dexpenditures also will increase.  Actualfuture spending, however, will depend on market conditions.

***Selling, General andAdministrative Costs***

Selling, general and administrative (“SG&A”)costs include labor, travel, outside services and overhead incurred in oursales, marketing, management and administrative support functions. SG&Acosts also include sales commissions paid to our employees as well as to ouragents.

SG&A costs were $100.3 million (20.9%of net sales) in 2006, $97.5 million (23.2% of net sales) in 2005 and $92.5million (20.2% of net sales) in 2004.

SG&A costs increased $2.8 million in2006 compared to 2005. The increase in SG&A costs was primarily due to $5.6million of profit sharing and management incentive pay as a result of theachievement of corporate profitability targets in 2006 compared to none in2005. In addition, commissions increased approximately $0.8 million due to theincrease in net sales and stock-based compensation increased $4.0 million.These increases were partially offset by a $1.5 million gain related to thesale of certain intellectual property rights to a privately-heldcompany, approximately $2.1 million of savings related to our 2005restructuring activities, a $1.6 million decrease in legal and audit fees,excluding the merger costs discussed below, a $0.9 million decrease in bad debtexpense and a $1.2 million decrease in labor and related costs due primarily tolower headcount.

SG&A costs increased $5.0 million in2005 compared to 2004. Increased compensation and related payroll costscontributed $4.9 million to the increase in 2005 compared to 2004. Increases ininformation technology costs contributed $1.8 million and increased consultingcharges contributed $1.1 million to the increase in 2005 compared to 2004.These increases were partially offset by a $0.8 million gain on the sale of ourSIMS product line in the second quarter of 2005, a corresponding decrease inSG&A related to SIMS of $0.4 million, a $0.6 million decrease inadvertising and other selling costs and a $1.2 million decrease in IT equipmentrental expense.

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***Merger Costs***

Merger costs of $0.5 million in 2006related to legal and board of directors’ costs incurred primarily in the firstquarter of 2006 for activities related to a merger proposal. The proposed transaction was not pursued and,accordingly, we do not expect additional costs related to this proposal infuture periods.

***Amortization of PurchasedTechnology***

Amortization of purchased technology was$2.0 million in 2006, $3.8 million in 2005 and $5.4 million in 2004.

In 2005, we recorded an impairment chargeof $9.3 million against our purchased technology balance, which led to thedecrease in amortization in 2006 compared to 2005. See also Note 5 of Notes toConsolidated Financial Statements.

Our purchased technology balance atDecember 31, 2006 was $4.5 million and current amortization of purchasedtechnology is approximately $0.4 million per quarter, which could increase ifwe acquire additional technology.

***Asset Impairment***

Asset impairment charges of $0.5 millionin 2006 were primarily for the write-off of the remaining costs related to theabandonment of our enterprise resource planning system, which were incurredduring the first quarter of 2006.

In 2005, we tookcertain actions to align our cost structure with the current prevailing marketconditions, primarily in the semiconductor markets. The actions taken to date,which were necessary as a result of reduced business volumes, have resulted indecreases in our global workforce and also required us to evaluate our goodwilland other long-lived assets for impairment.

We recorded assetimpairment charges and write-offs totaling $25.4 million in 2005. These chargesare summarized as follows (in thousands):

|                                      | ** ** | **Year Ended  December 31,  2005** | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|
| Purchased  technology                |       | $                                            | 9,328      |   |
| Property, plant  and equipment       |       | 7,479                                        |       |
| ERP system  abandonment              |       | 7,634                                        |       |
| Patents and  other intangible assets |       | 911                                          |       |
|                                 |       | $                                            | 25,352     |   |

 

Our goodwill impairment analysis wasfocused on goodwill related to our former microelectronics segment, which soldto the semiconductor market. Based on our analysis of current and projectedoperating results, we concluded that the goodwill allocated to this segment wasnot impaired. However, we evaluated the recoverability of the segment’slong-lived assets and concluded impairments existed. Accordingly, we recordedimpairment charges based on the amounts by which the carrying amounts of theseassets exceeded their fair value. Additionally, certain assets were abandonedand, accordingly, written off, including a charge for costs capitalized for theterminated ERP project.

***Restructuring, Reorganization,Relocation and Severance***

Restructuring,reorganization, relocation and severance in 2006 included a charge of $3.3million for facilities and severance charges related to the closure of certainof our European field offices, closure of a research and development facilityin Tempe, Arizona, as well as residual costs related to the Peabody,Massachusetts plant closure and the downsizing of the related semiconductorbusinesses.

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Effective April 1, 2006, our Chairman, President and Chief ExecutiveOfficer (“CEO”) was terminated. Our CEO was a party to an existingExecutive Severance Agreement dated February 1, 2002. Termination of hisservice was deemed a termination without cause under the agreement. Pursuant tothe terms of this agreement, and following his execution and non-revocation ofa standard release, our CEO was entitled to certain severance benefits. Theseincluded:

·                  alump sum payment equaling three years of base salary (approximately $1.6million);

·                  alump sum payment equal to 100% of his target bonus for 2006 (approximately$583,000);

·                  accelerationof all of his stock options and restricted stock awards;

·                  permittinghim to exercise his options until the earlier of three years after hisdeparture date or the option expiration date as set forth in the applicableoption agreement;

·                  alump sum payment equaling two times what his reasonably expected healthinsurance coverage costs would be for 18 months; and

·                  lifeinsurance premium payments not to exceed $5,000.

Accordingly, inthe first quarter of 2006, we recordeda charge of $9.3 million, of which $2.2 million related to the cash severancepayments and $7.1 million related to the non-cash expense associated with thefair market value of the modified stock options, which modified the originalawards to:

·                  accelerate all unvested stock options;

·                  waive the cancellation clause upontermination of employment; and

·                  extend their legal lives as discussed above.

During 2005, weinitiated global restructuring activities to realign our cost structure withcurrent prevailing market conditions. These actions included reductions inworkforce, reorganization and relocation of employees as well as closure of ourPeabody, Massachusetts facility and certain field offices around the world.Some of these actions were initiated in the second quarter of 2005 with theremainder continuing through the first half of 2006. These costs were accountedfor in accordance with SFAS No. 146, “*Accounting for Costs Associated with Exit or Disposal Activities.*”Under SFAS No. 146, liabilities for costs associated with exit or disposalactivities are recognized and measured at fair value in the period theliability is incurred.

In 2005, we also expensed $4.6 million in severance and relocationcosts related to workforce reductions and reallocation of personnelgeographically. We also incurred $3.9 million of restructuring expense forfacility closures, largely related to the Peabody, Massachusetts facility(inclusive of $0.2 million in reserve releases related to prior accruals foranother facility lease that was terminated).

***Thefollowing tables summarize the charges, expenditures and write-offs andadjustments in 2006, 2005 and 2004 related to our accrual for restructuring,reorganization, relocation and severance charges (in thousands):***
| **Year Ended  December 31, 2006**                       | ** ** | **Beginning  Accrued  Liability** | ** ** | **Charged  to  Expense** | ** ** | **Expenditures** | ** ** | **Write-Offs  and  Adjustments** | ** ** | **Ending  Accrued  Liability** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| Severance,  outplacement and related benefits for terminated employees |       | $                                 | 1,778      |                     | $          | 2,619            |       | $                                | (4,343     | )                              | $          | 124 |   | $ | 178 |   |
| Abandoned leases,  leasehold improvements and facilities               |       | 3,496                             |       | 665                      |       | (1,906           | )          | 6                                |       | 2,261                          |       |
| CEO severance,  excluding stock-based compensation                     |       | —                            |       | 2,235                    |       | (2,235           | )          | —                           |       | —                         |       |
|                                                                   |       | $                                 | 5,274      |                     | $          | 5,519            |       | $                                | (8,484     | )                              | $          | 130 |   | $ | 2,439 |   |

 

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| **Year Ended  December 31, 2005**                       | ** ** | **Beginning  Accrued  Liability** | ** ** | **Charged  to  Expense** | ** ** | **Expenditures** | ** ** | **Write-Offs  and  Adjustments** | ** ** | **Ending  Accrued  Liability** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| Severance,  outplacement and related benefits for terminated employees |       | $                                 | 150        |                     | $          | 4,606            |       | $                                | (2,958     | )                              | $          | (20 | ) | $ | 1,778 |   |
| Abandoned  leases, leasehold improvements and facilities               |       | 870                               |       | 3,938                    |       | (1,254           | )          | (58                              | )          | 3,496                          |       |
|                                                                   |       | $                                 | 1,020      |                     | $          | 8,544            |       | $                                | (4,212     | )                              | $          | (78 | ) | $ | 5,274 |   |

*** ***
| **Year Ended  December 31, 2004**                       | ** ** | **Beginning  Accrued  Liability** | ** ** | **Charged  to  Expense** | ** ** | **Expenditures** | ** ** | **Write-Offs  and  Adjustments** | ** ** | **Ending  Accrued  Liability** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| Severance, outplacement  and related benefits for terminated employees |       | $                                 | 570        |                     | $          | —           |       | $                                | (314       | )                              | $          | (106 | ) | $ | 150 |   |
| Abandoned  leases, leasehold improvements and facilities               |       | 1,534                             |       | 458                      |       | (989             | )          | (133                             | )          | 870                            |       |
|                                                                   |       | $                                 | 2,104      |                     | $          | 458              |       | $                                | (1,303     | )                              | $          | (239 | ) | $ | 1,020 |   |

 

The restructuring charges werebased on estimates that are subject to change. Workforce related charges couldchange because of shifts in timing, redeployment or changes in amounts ofseverance and outplacement benefits. Facilities charges could change due tochanges in sublease income. Our ability to generate sublease income isdependent upon lease market conditions at the time we negotiate the subleasearrangements. Variances from these estimates could alter our ability to achieveanticipated expense reductions in the planned timeframe and modify our expectedcash outflows and working capital.

***In 2006, the $7.1 million non-cash charge for stock-based compensationwas recorded as a component of restructuring, reorganization, relocation andseverance. In 2004, the $0.2 million for relocation costs was recorded as acomponent of restructuring, reorganization, relocation and severance.***

***Other Income (Expense),Net***

Other income (expense)items include interest income, interest expense, foreign currency gains andlosses and other miscellaneous items.

Interest incomerepresents interest earned on cash and cash equivalents, investments inmarketable securities and, in 2004, a shareholder note receivable. Interestincome was $13.2 million in 2006, $7.8 million in 2005 and $5.2 million in 2004.

The increase in2006 compared to 2005 was the result of an increase in our invested balances,primarily due to cash generated by operations in 2006, as well as net proceedsfrom our sale of $115.0 million principal amount of 2.875% convertible debt inMay 2006.

The increase in2005 compared to 2004 was the result of higher interest rates on investmentsand a higher percent of investments to cash in 2005 compared to 2004. Ourrepurchase of $70.0 million of our 5.5%convertible subordinated notes during the second quarter of 2005 decreasedinterest income in the second half of 2005 compared to what it would have beenwithout the repurchase.

Interest expense for 2006, 2005 and 2004includes interest related to our 5.5% convertible debt issued in August 2001.Interest expense in 2006 also includes interest related to our $115.0 millionprincipal amount of 2.875% convertible debt, which was issued in May 2006. Theamortization of capitalized note issuance costs related to our convertible noteissuances is also included as a component of interest expense in all periods.

 

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Interest expense in 2006 and 2005included premiums and commissions paid on the repurchase of a portion of our5.5% convertible subordinated notes as well as the write-off of deferred noteissuance costs totaling $0.5 million and $1.8 million, respectively.

Assuming no additional note repurchases,amortization of our remaining convertible note issuance costs, including thoserelated to our 2.875% convertible notes, will total approximately $0.4 millionper quarter through 2008 and $0.1 million per quarter thereafter through thesecond quarter of 2013.

Other, net includedcharge of $3.9 million and $6.4 million in 2006 and 2005, respectively, relatedto impairment charges and realized losses of certain of our cost-methodinvestments. Our cost-method investments are minority-interest holdings insmall, privately-held entities where it is not practical to estimate fairvalues. We evaluate our cost-method investments for impairment whenever eventsindicate that the carrying amount of the investment may not be recoverablewithin a reasonable period of time. This evaluation is based on review ofinterim financial statements and informal discussions with the seniormanagement of the investee entities. Given the nature of these holdings and theenvironment in which they operate, we may identify additional “other-than-temporary”impairments in subsequent periods, which would require us to write one or moreinvestments down to fair market value. Additionally, in 2006, we recorded a$5.2 million gain related to the sale of one of our cost-method investments. AtDecember 31, 2006, we did not have any cost-method investments on our balancesheet.

The $3.1 million loss in 2004 primarily relates to a loss on ourforward extra contracts in the first quarter of 2004, which was prior to ourachieving hedge treatment of such contracts. Currency related losses totaled $1.9 million in 2006, $1.5 million in2005 and $3.1 million in 2004.

***Income Tax Expense***

We recorded tax expense of $10.5 million, $22.1million and $7.2 million, respectively, in 2006, 2005 and 2004.

Our 2006 taxprovision consisted primarily of taxes accrued in foreign jurisdictions andreflects a benefit of $1.5 million related to the release of valuationallowances against a portion of United States deferred tax assets utilizedduring the period. We continue to record a valuation allowance against theremaining United States deferred tax assets as we do not believe it is morelikely than not that the benefit of the deferred tax assets will be realized infuture periods.

Our 2005 tax expense primarily consisted of $15.1million in expense related to the establishment of valuation allowances againstthe United States deferred tax assets, which offset the benefit from UnitedStates net operating losses generated in 2005. Additionally, we hadapproximately $10.9 million of foreign tax expense, which was offset by a netcurrent tax benefit of $4.1 million primarily related to tax audit settlementsin the United States.

Valuation allowances on deferred tax assets totaled$33.5 million and $35.0 million as of December 31, 2006 and 2005, respectively.

For 2005, we experienced an abnormallyhigh effective tax rate as we had profits and related tax expense from ourinternational operations, but losses in the United States for which we did notrecord a tax benefit.

***Discontinued Operations***

In the fourthquarter of 2006, we sold the assets and operations related to KnightsTechnology. We recognized a gain on the disposal of the discontinued operationsof $3.3 million and received cash proceeds of $7.8 million. An additional $0.2million has been held in escrow and will be released when all contingenciessurrounding the transaction are resolved. All historical balance sheet andstatement of operations data has been restated to reflect the discontinuedoperations.

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Certain financialinformation related to discontinued operations was as follows (in thousands):
| **Year Ended December 31,**                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                                                         |       | $        | 5,245      |     | $          | 7,132    |       | $ | 8,180 |   |
| Pre-tax (loss)  income                                          |       | (905     | )          | 606      |       | 1,450    |       |
| Income tax expense                                              |       | 42       |       | 304      |       | 593      |       |
| Gain (loss) on  disposal of discontinued operations, net of tax |       | 3,335    |       | —   |       | —   |       |
| Amount of goodwill and  other intangible assets disposed of     |       | 3,133    |       | —   |       | —   |       |
|                                                                 |            |          |            |          |            |          |            |  |  |  |

 

In accordance with SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” we recordedthe related assets and liabilities as current assets and liabilities on ourbalance sheet at the lower of their carrying amount or fair value, less cost tosell as of December 31, 2005. No impairment charge was recorded related to theassets of the discontinued operations.

Assets of discontinuedoperations included the following (in thousands):

| December 31,              | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Cash and cash  equivalents     |       | $        | —     |     | $          | 410 |   |
| Accounts  receivable           |       | —   |       | 2,100    |       |
| Other current  assets          |       | —   |       | 44       |       |
| Property, plant  and equipment |       | —   |       | 205      |       |
| Purchased  technology          |       | —   |       | 1,800    |       |
| Goodwill                       |       | —   |       | 500      |       |
| Other                          |       | —   |       | 1,283    |       |
|                           |       | $        | —     |     | $          | 6,342 |   |

 

Liabilities ofdiscontinued operations included the following (in thousands):

| December 31,                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|
| Accrued payroll  and related liabilities |       | $        | —     |     | $          | 28 |   |
| Accrued agent  commission                |       | —   |       | 98       |       |
| Deferred revenue                         |       | —   |       | 1,205    |       |
| Other current  liabilities               |       | —   |       | 102      |       |
| Other  liabilities                       |       | —   |       | 496      |       |
|                                     |       | $        | —     |     | $          | 1,929 |   |

 

***LIQUIDITY AND CAPITAL RESOURCES***

Our sources of liquidity and capitalresources as of December 31, 2006 consisted of $365.0 million of cash, cashequivalents, short-term restricted cash and short-term investments, $34.9million in non-current investments, $6.1 million of long-term restricted cash,$30.0 million of available borrowings under our existing credit facilities, aswell as potential future cash flows from operations. Restricted cash relates todeposits to back bank guarantees for customer prepayments that expire through2013. We believe that these sources of liquidity and capital will be sufficientto meet our expected operational and capital needs for at least the nexttwelve-months.

In 2006, cash and cash equivalents andshort-term restricted cash increased $51.9 million to $130.8 million as ofDecember 31, 2006 from $78.9 million as of December 31, 2005 primarily as aresult of $23.3 million provided by operations, net proceeds of $111.9 millionfrom the issuance of $115.0 million principal amount of 2.875% convertible subordinatednotes, $13.1 million of proceeds from the exercise of employee stock optionsand employee stock purchases, $7.8 million from the disposal of discontinuedoperations, $4.8 million from the disposal of investments in unconsolidatedaffiliates and a $8.9 million favorable effect of exchange rate changes. Theseincreases were partially offset by the use of $29.1 million for the repurchaseof a portion of our 5.5% subordinated notes, $11.1 million used for therepurchase of 500,000 shares of our common stock, $6.5 million used for thepurchase of property, plant and equipment and the net purchase of $67.5 millionof marketable securities.

Accounts receivable increased $48.8million to $145.0 million as of December 31, 2006 from $96.2 millionas of December 31, 2005, primarily due to increased sales in the fourthquarter of 2006 compared with 

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the fourth quarter of 2005. This balancewas also affected by a $5.8 million decrease related to changes in currencyexchange rates. Our days sales outstanding, calculated on a quarterly basis,was 94 days at December 31, 2006 compared to 88 days at December 31, 2005.

Inventories increased$12.6 million to $97.5 million as of December 31, 2006 compared to$84.9 million as of December 31, 2005. The increase primarily was dueto increases in finished goods and increases in our current service inventoryrequirements, partially offset by a decrease related to currency movements ofapproximately $8.3 million. Our annualized inventory turnover rate, calculatedon a quarterly basis, was 3.5 times for the quarter ended December 31, 2006 and3.1 times for the quarter ended December 31, 2005.

Assets andliabilities of discontinued operations at December 31, 2005 reflect the assetsand liabilities of Knights Technology, which was sold in the fourth quarter of2006 as discussed above.

Expenditures for property, plant and equipment of $6.5 million in 2006primarily consisted of expenditures formachinery and equipment, including instruments used for demonstration as partof our marketing programs. We expect to continue to invest in capitalequipment, customer evaluation systems and research and development equipmentfor applications development. We estimate our total capital expenditures in2007 to be approximately $25.0 million, primarily for the development andintroduction of new products, demonstration equipment and upgrades andincremental improvements to our ERP system.

Accounts payable increased $18.9 millionto $45.1 million as of December 31, 2006 compared to $26.2 million as ofDecember 31, 2005. The increase resulted primarily from increased inventorypurchases to support sales levels and the timing of various other payments.

Accrued payroll liabilities increased$11.5 million to $20.7 million as of December 31, 2006 compared to $9.2 millionas of December 31, 2005. The increase resulted primarily from 2006 bonusaccruals compared to no accruals at December 31, 2005.

Other current liabilities increased $6.8million to $29.3 million as of December 31, 2006 compared to $22.5 million asof December 31, 2005. The increase resulted primarily from accruals for valueadded taxes, withholding taxes and other miscellaneous liabilities.

On May19, 2006, we sold $115.0 million principal amount of 2.875% convertiblesubordinated notes due June 1, 2013. Net proceeds from the issuance were $111.9million. We used approximately $11.1 million of the proceeds to repurchase500,000 shares of our common stock. The remaining proceeds will be used forgeneral corporate purposes, including capital expenditures, research anddevelopment, repurchase of our existing convertible subordinated notes, otherstock buybacks and potential investments in and acquisitions of complementarybusinesses, partnerships, minority investments, products or technologies, tofund further enhancements of our operating infrastructure and for workingcapital.

We maintain a$30.0 million uncommitted bank borrowing facility in the United States (andoutside the United States for our international subsidiaries under theguarantee of the parent company), of which $5.0 million is available on anunsecured basis. We also have a 50.0 million yen unsecured and uncommitted bankborrowing facility in Japan and various limited facilities in select foreigncountries. At December 31, 2006, a total of $30.0 million was availableunder these facilities. As part of our contracts with certain customers, we arerequired to provide letters of credit or bank guarantees which these customerscan draw against in the event we do not perform in accordance with ourcontractual obligations. At December 31, 2006, we had $33.0 million of theseguarantees and letters of credit outstanding, of which approximately $26.3million were secured by restricted cash deposits. Restricted cash balancessecuring bank guarantees that expire within twelve months of the balance sheetdate are recorded as a current asset on our consolidated balance sheets.Restricted cash balances securing bank guarantees that 

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expire beyondtwelve months from the balance sheet date are recorded as long-term restrictedcash on our consolidated balance sheet.

**CONTRACTUAL PAYMENT OBLIGATIONS**

A summary of our contractual commitments andobligations as of December 31, 2006 was as follows (in thousands):
| ** **                            | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**       | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2008 and  2009** | ** ** | **2010 and  2011** | ** ** | **2012 and  beyond** | ** ** |
| Convertible Debt                      |       | $                                         | 310,882    |   | $ | — |   | $ | 195,882 |   | $ | — |   | $ | 115,000 |   |
| Convertible Debt Interest             |       | 27,843                                    |       | 5,831 |   | 10,715 |   | 6,613 |   | 4,684 |   |
| Letters of Credit and Bank Guarantees |       | 32,952                                    |       | 27,087 |   | 5,805 |   | — |   | 60 |   |
| Purchase Order Commitments            |       | 67,541                                    |       | 67,541 |   | — |   | — |   | — |   |
| Pension Related Obligations           |       | 2,253                                     |       | 100 |   | 114 |   | 168 |   | 1,871 |   |
| Deferred Compensation Liability       |       | 1,948                                     |       | — |   | — |   | — |   | 1,948 |   |
| Capital Leases                        |       | 2,809                                     |       | 1,473 |   | 1,284 |   | 52 |   | — |   |
| Operating Leases                      |       | 61,292                                    |       | 7,104 |   | 12,803 |   | 11,405 |   | 29,980 |   |
|  Total                           |       | $                                         | 507,520    |   | $ | 109,136 |   | $ | 226,603 |   | $ | 18,238 |   | $ | 153,543 |   |

 

**OFF-BALANCESHEET ARRANGEMENTS**

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have amaterial current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

***RECENTLYISSUED ACCOUNTING PRONOUNCEMENTS***

See Note 2 of Notes to Consolidated Financial Statementsincluded in Part II, Item 8 of this Form 10-K.

***CRITICAL ACCOUNTING POLICIES AND THEUSE OF ESTIMATES***

The preparation of financial statementsin conformity with accounting principles generally accepted in the UnitedStates requires management to make estimates and assumptions. These estimatesand assumptions affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amount of revenues and expenses during the reportingperiod.

Significant accounting policies andestimates underlying the accompanying consolidated financial statementsinclude:

·                  thetiming of revenue recognition;

·                  theallowance for doubtful accounts;

·                  valuationsof excess and obsolete inventory;

·                  valuationof investments in privately-held companies;

·                  thelives and recoverability of equipment and other long-lived assets such asgoodwill and existing technology intangibles;

·                  restructuring,reorganization, relocation and severance costs;

·                  accountingfor income taxes;

·                  warrantyliabilities;

·                  stock-basedcompensation; and

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·                  accountingfor derivatives.

It is reasonably possible that theestimates we make may change in the future.

***RevenueRecognition***

For products produced according to ourpublished specifications, revenue is recognized when the title to the productand the risks and rewards of ownership pass to the customer. For productsproduced according to a particular customer’s specifications, revenue isrecognized when the product meets the customer’s specifications and when thetitle and the risks and rewards of ownership have passed to the customer. Ineach case, the portion of revenue applicable to installation and customeracceptance is recognized upon meeting specifications at the installation site.For new applications of our products where performance cannot be assured priorto meeting specifications at the installation site, no revenue is recognizeduntil such specifications are met. Revenue, from time and materials basedservice arrangements, is recognized as the service is performed.

Our billing terms on TEM, SEM, FIB and *DualBeam* systems generally include aholdback of 10% to 20% of the total purchase price subject to completion ofinstallation and final acceptance at the customer site. The portion of revenuerelated to installation and final acceptance, which is generally 4%, isdeferred until such installation and final acceptance are completed.

We generally provide consulting and training serviceson a time and materials basis and provide maintenance and support servicesunder renewable, term maintenance agreements. Maintenance and support feerevenue is recognized ratably over the contractual term, which is generallytwelve months, and commences from contract date.

Deferred revenue represents customerdeposits on equipment orders, orders awaiting customer acceptance and prepaidservice contract revenue. Deferred revenue is recognized in accordance with ourrevenue recognition policies described above.

***Allowance forDoubtful Accounts***

The allowance for doubtful accounts isestimated based on collection experience and known trends with currentcustomers. The large number of entities comprising our customer base and theirdispersion across many different industries and geographies somewhat mitigatesour credit risk exposure and the magnitude of our allowance for doubtfulaccounts. Our estimates of the allowance for doubtful accounts are reviewed andupdated on a quarterly basis. Changes to the reserve occur based upon changesin revenue levels and associated balances in accounts receivable and estimatedchanges in credit quality. Historically, we have not incurred significantwrite-offs of accounts receivable, however, an individual loss could besignificant due to the relative size of our sales transactions. Our bad debtexpense totaled $0.7 million, $1.7 million and $22,000, respectively, in 2006,2005 and 2004. Our allowance for doubtful accounts totaled $4.2 million and$3.3 million, respectively, at December 31, 2006 and 2005.

***Valuation ofExcess and Obsolete Inventory***

Inventory isstated at the lower of cost or market, with cost determined by standard costmethods, which approximate the first-in, first-out method. Inventory costsinclude material, labor and manufacturing overhead. Inventory is reviewed forobsolescence and excess quantities on a quarterly basis, based on estimatedfuture use of quantities on hand, which is determined based on past usage,planned changes to products and known trends in markets and technology. Changesin support plans or technology could have a significant impact on obsolescence.Because of the long-lived nature of many of our products, we maintain asubstantial supply of parts for possible use in future repairs and customerfield service. As these service parts become older, we apply a higherpercentage of reserve against the recorded balance, recognizing that the olderthe part, the less likely it is ultimately to be used. Provision for inventoryvaluation adjustments were immaterial in 2006 and totaled $10.1 million and$1.7 million, respectively, 

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during 2005 and2004. Provision for service inventory valuation adjustments totaled $4.2million, $2.9 million and $2.6 million, respectively, in 2006, 2005 and 2004.

***Valuation of Investments inPrivately-Held Companies***

We made investments in several small,privately held technology companies in which we hold less than 20% of thecapital stock or hold notes receivable. We account for these investments attheir cost unless their value has been determined to be other than temporarilyimpaired, in which case, we write the investment down to its estimated fairvalue. We review these investments periodically for impairment and makeappropriate reductions in carrying value when an “other-than-temporary” declineis evident; however, for non-marketable equity securities, the impairmentanalysis requires significant judgment. We evaluate the financial condition ofthe investee, market conditions and other factors providing an indication ofthe fair value of the investments. During 2005, we recorded impairments andlosses on liquidation related to these investments totaling $6.4 million.During 2006, we wrote off certain of our investments, incurring a charge of$3.9 million, and sold our remaining investments, resulting in a gain of $5.2million, and, accordingly, as of December 31, 2006, we did not have anyinvestments in privately-held companies recorded on our balance sheet. See alsoNote 3 of Notes to Consolidated Financial Statements.

***Lives andRecoverability of Equipment and Other Long-Lived Assets***

We evaluate theremaining life and recoverability of equipment and other assets, includingintangible assets, whenever events or changes in circumstances indicate thatthe carrying amount of the asset may not be recoverable in accordance with SFASNo. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*.” Ifthere is an indication of impairment, we prepare an estimate of future,undiscounted cash flows expected to result from the use of the asset and itseventual disposition. If these cash flows are less than the carrying value ofthe asset, we adjust the carrying amount of the asset to its estimated fairvalue.

For information onimpairments recognized in 2006 and 2005, see Note 5 of Notes to ConsolidatedFinancial Statements.  No suchadjustments were made in 2004.

***Goodwill***

Goodwillrepresents the excess purchase price over fair value of net assets acquired.Pursuant to SFAS No. 142, “*Goodwill and OtherIntangible Assets*,” goodwill and other identifiable intangibleassets with indefinite useful lives are no longer amortized, but, instead, atwo-step impairment test is performed at least annually, in accordance with theprovisions of SFAS No. 142. We test goodwill for impairment annually in thefourth quarter. First, the fair value of each reporting unit is compared to itscarrying value. We have defined our reporting units to be our operatingsegments as disclosed under SFAS No. 131, “*Disclosures about Segmentsof an Enterprise and Related Information*.”  If the fair value of the reporting unitexceeds the carrying value, goodwill is not impaired and no further testing isperformed. The second step is performed if the carrying value exceeds the fairvalue. The implied fair value of the reporting unit’s goodwill must bedetermined and compared to the carrying value of the goodwill. If the carryingvalue of a reporting unit’s goodwill exceeds its implied fair value, animpairment loss equal to the difference will be recorded. No impairments wereidentified in the first step of our goodwill impairment analyses performedduring 2006, 2005 or 2004.

***ExistingTechnology Intangible Assets***

Existing technology intangible assetspurchased in business combinations, which represent the estimated value ofproducts utilizing technology existing as of the combination date discounted totheir net present value, are amortized on a straight-line basis over theestimated useful life of the technology. We currently are using amortizationperiods ranging from 5 to 12 years for these assets. Changes in technologycould affect our estimates of the useful lives of such assets. We test ourtechnology intangible assets for 

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impairment whenever events orcircumstances indicate that the carrying amount of assets may not berecoverable in accordance with SFAS No. 144. We evaluate recoverability bycomparing the carrying amount to future net undiscounted cash flows to begenerated by the asset. If such assets are considered to be impaired, theimpairment to be recognized is measured as the amount by which the carryingamount of the assets exceeds the fair value of the assets.**Such reviews assess the fair value of theassets based upon estimates of future cash flows that the assets are expectedto generate. We review the estimated useful lives of the assets on an annualbasis. During 2005, we recorded impairmentcharges related to these assets totaling $9.3 million, which were included as acomponent of asset impairment on our consolidated statement of operations. Foradditional information on these impairments, see Note 5 of Notes toConsolidated Financial Statements. We did not change estimated usefullives or recognize impairment charges relatedto our technology intangible assets during 2006 or 2004.

***Restructuring,Reorganization, Relocation and Severance Costs***

Restructuring, reorganization, relocationand severance costs are recognized and recorded at fair value as incurred inaccordance with SFAS No. 146, “*Accounting for Costs Associated with Exit or DisposalActivities.*” Such costs include severance and other costsrelated to employee terminations as well as facility costs related to futureabandonment of various leased office and manufacturing sites. Changes in ourestimates could occur, and have occurred, due to fluctuations in exchangerates, the sublease of unused space, unanticipated voluntary departures beforeseverance was required and unanticipated redeployment of employees to vacantpositions.

***Income Taxes***

We account forincome taxes using the asset and liability method, which requires therecognition of deferred tax assets and liabilities for the expected future taxconsequences of temporary differences between the carrying amounts and taxbases of the assets and liabilities. In accordance with the provisions of SFASNo. 109, “*Accounting for Income Taxes,*”**we record a valuation allowance to reduce deferredtax assets to the amount expected to “more likely than not” be realized in ourfuture tax returns.  During 2006, wereleased approximately $1.5 million in valuation allowance relating to UnitedStates deferred tax assets utilized during the year to offset United Statestaxable income generated in 2006. During 2005, we recorded valuation allowancesagainst deferred tax assets that existed prior to January 1, 2005 and UnitedStates deferred tax assets originated in 2005. Should we determine that wewould not be able to realize all or part of our remaining net deferred taxassets in the future, additional increases to the valuation allowance fordeferred tax assets may be required. Conversely, if we determine that certaintax assets that have been reserved for may be realized in the future, we mayreduce our valuation allowance in future periods. Our net deferred tax assetstotaled $0.5 million and $3.9 million, respectively, at December 31, 2006 and2005 and our valuation allowance totaled $33.5 million and $35.0 million,respectively.

We maintainreserves for estimated tax exposures in jurisdictions of operation, includingpotential interest and penalties on such exposures. These tax jurisdictionsinclude federal, state and various international tax jurisdictions. Significant income tax exposures include potentialchallenges of net operating loss carry-back claims, permanent establishment,capitalization of certain costs and intercompany pricing. Exposures are settled primarily throughresolution of audits within these tax jurisdictions, but can also be affectedby changes in applicable tax law or other factors, which could cause managementto believe a revision of past estimates is appropriate. Management believesthat an appropriate liability has been established for estimated exposures;however, actual results may differ materially from these estimates.

***WarrantyLiabilities***

Our products generally carry a one-yearwarranty. A reserve is established at the time of sale to cover estimatedwarranty costs and certain commitments for product upgrades. Our estimate ofwarranty cost is primarily based on our history of warranty repairs andmaintenance, as applied to systems currently under warranty. For our newproducts without a history of known warranty costs, we estimate the expected 

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costs based on our experience withsimilar product lines and technology. While most new products are extensions ofexisting technology, the estimate could change if new products require asignificantly different level of repair and maintenance than similar productshave required in the past. Our estimated warranty costs are reviewed andupdated on a quarterly basis. Changes to the reserve occur as volume, productmix and warranty costs fluctuate. Our warranty reserve totaled $5.7 million and$5.2 million, respectively, at December 31, 2006 and 2005. Warranty expensetotaled $11.7 million, $9.3 million and $11.7 million, respectively, during2006, 2005 and 2004. The 2005 expense is net of a $1.0 million positiveadjustment to warranty expense based on an analysis of our actual warrantycosts incurred compared to our reserve estimate. No such adjustments wererecorded in 2006 or 2004.

***Stock-Based Compensation***

On January 1, 2006,we adopted SFAS No. 123(R), “*Share-Based Payment*,”which requires the measurement and recognition of compensation expense for allshare-based payment awards granted to our employees and directors, includingemployee stock options, non-vested stock and stock purchases related to ouremployee share purchase plan based on the estimated fair value of the award onthe grant date. Upon the adoption of SFAS No. 123(R), we maintained ourmethod of valuation for stock option awards using the Black-Scholes valuationmodel, which has historically been used for the purpose of providing pro-formafinancial disclosures in accordance with SFAS No. 123, “*Accountingfor Stock-Based Compensation*.”

The use of the Black-Scholesvaluation model to estimate the fair value of stock option awards requires usto make judgments on assumptions regarding the risk-free interest rate,expected dividend yield, expected term and expected volatility over theexpected term of the award. The assumptions used in calculating the fairvalue of share-based payment awards represent management’s best estimates atthe time they are made, but these estimates involve inherent uncertainties andthe application of expense could be materially different in the future.

Compensationexpense is only recognized on awards that ultimately vest. Therefore, wehave reduced the compensation expense to be recognized over the vesting periodfor anticipated future forfeitures. Forfeiture estimates are based onhistorical forfeiture patterns. We update our forfeiture estimatesquarterly and recognize any changes to accumulated compensation expense in theperiod of change. If actual forfeitures differ significantly from ourestimates, our results of operations could be materially impacted.

Compensation expense, net of tax,calculated pursuant to SFAS No. 123 totaled $34.4 million and $12.4 million,respectively, in 2005 and 2004.

***Accounting for Derivatives***

We use foreignforward extra contracts (a combination of forward exchange and optioncontracts) to hedge certain anticipated foreign currency exchange transactions.When specific criteria required by SFAS No. 133, “*Accountingfor Derivative Instruments and Hedging Activities*,” have been met,changes in fair values of hedge contracts relating to anticipated transactionsare recorded in other comprehensive income rather than net income until theunderlying hedged transaction affects net income. One of the criteria for thisaccounting treatment is that the forward exchange contract amount should not bein excess of specifically identified anticipated transactions. By their nature,our estimates of anticipated transactions may fluctuate over time and mayultimately vary from actual transactions. When anticipated transactionestimates or actual transaction amounts decrease below hedged levels, or whenthe timing of transactions changes significantly, we reclassify a portion ofthe cumulative changes in fair values of the related hedge contracts from othercomprehensive income to other income (expense) during the quarter in which suchchanges occur.

We also useforeign forward exchange contracts to mitigate the foreign currency exchangeimpact of our cash, receivables and payables denominated in foreign currencies.These derivatives do not meet the 

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criteria for hedgeaccounting. Changes in fair value for derivatives not designated as hedginginstruments are recognized in net income in the current period.

**Item 7A.   Quantitativeand Qualitative Disclosures About Market Risk**

**ForeignCurrency Exchange Rate Risk**

A large portion ofour business is conducted outside of the United States through a number offoreign subsidiaries. Each of the foreign subsidiaries keeps its accountingrecords in its respective local currency. These local-currency-denominatedaccounting records are translated at exchange rates that fluctuate up or downfrom period to period and consequently affect our consolidated results ofoperations and financial position. The major foreign currencies in which weexperience periodic fluctuations are the euro, the Czech koruna, the Japaneseyen and the British pound sterling. Although for each of the last three yearsmore than 62% of our sales occurred outside of the United States, a largeportion of these foreign sales were denominated in United States dollars andeuros.

In addition,because of our substantial research, development and manufacturing operationsin Europe, we incur a greater proportion of our costs in Europe than therevenue we derive from sales in that geographic region. Our raw materials,labor and other manufacturing costs are primarily denominated in United Statesdollars, euros and Czech korunas. This situation negatively affects our gross marginsand results of operations when the dollar weakens in relation to the euro orkoruna. A strengthening of the dollar in relation to the euro or koruna wouldhave a positive effect on our gross margins and results of operations. Movementof Asian currencies in relation to the dollar and euro also can affect ourreported sales and results of operations because we derive more revenue than weincur costs from the Asia-Pacific region. In addition, several of ourcompetitors are based in Japan and a weakening of the Japanese yen has theeffect of lowering their prices relative to ours.

Assets andliabilities of foreign subsidiaries are translated using the exchange rates ineffect at the balance sheet date. Revenues and expenses are translated usingthe average exchange rate during the period. The resulting translationadjustments increased shareholders’ equity and comprehensive income in 2006 by$18.3 million. Holding other variables constant, if the United States dollarweakened by 10% against all currencies that we translate, shareholders’ equitywould increase by approximately $20.0 million as of December 31, 2006. Holdingother variables constant, if the United States dollar strengthened by 10%against all currencies that we translate, shareholders’ equity would decreaseby approximately $16.4 million as of December 31, 2006.

**RiskMitigation**

We use derivativesto mitigate financial exposure resulting from fluctuations in foreign currencyexchange rates. When specific accounting criteria have been met, changes infair values of derivative contracts relating to anticipated transactions arerecorded in other comprehensive income, rather than net income, until theunderlying hedged transaction affects net income. Changes in fair value forderivatives not designated as hedging instruments are recognized in net incomein the current period. As of December 31, 2006, the aggregate notional amountof our outstanding derivative contracts was $56 million, which contracts havevarying maturities through September 28, 2007. We do not enter into derivativefinancial instruments for speculative purposes.

Holding othervariables constant, if the United States dollar weakened by 10%, the marketvalue of our foreign currency contracts outstanding as of December 31, 2006would increase by approximately $3.6 million. The increase in value relating tothe forward sale or purchase contracts would, however, be substantially offsetby the revaluation of the transactions being hedged. A 10% increase in theUnited States dollar relative to the hedged currencies would have a similar,but negative, effect on the value of our foreign currency contracts,substantially offset again by the revaluation of the transactions being hedged.

 

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***BalanceSheet Related***

We attempt tomitigate our currency exposures for recorded transactions by using forwardexchange contracts to reduce the risk that our future cash flows will beadversely affected by changes in exchange rates. We enter into forward sale orpurchase contracts for foreign currencies to hedge specific cash, receivablesor payables positions denominated in foreign currencies. Changes in fair valueof derivatives entered into to mitigate the foreign exchange risks related tothese balance sheet items are recorded in other income (expense) currentlytogether with the transaction gain or loss from the hedged balance sheetposition.

The hedging transactions we undertake limit our exposureto changes in the dollar/euro exchange rate. Foreign currency losses recordedin other income (expense), inclusive of the impact of derivatives, totaled $1.9million, $1.5 million and $3.1 million, respectively, in 2006, 2005 and 2004.

***CashFlow Hedges***

We use foreignforward extra contracts (a combination of forward exchange and optioncontracts) and also option contracts to hedge certain anticipated foreigncurrency exchange transactions. The foreign exchange hedging structure is setup generally on a twelve-month time horizon. The hedging transactions we undertakeprimarily limit our exposure to changes in the U.S. dollar/euro exchange rate.The forward extra contract hedges are designed to protect us as the UnitedStates dollar weakens, but also provide us with some flexibility if the dollarstrengthens.

These derivativesmeet the criteria to be designated as hedges and, accordingly, we record thechange in fair value of these hedge contracts relating to anticipatedtransactions in other comprehensive income rather than net income until theunderlying hedged transaction affects net income. We recognized realized gainsof $2.0 million in 2006 in cost of sales related to hedge results, compared torealized losses of $2.2 million in 2005. As of December 31, 2006, $1.7 millionof deferred unrealized net gains on outstanding derivatives have been recordedin other comprehensive income and are expected to be reclassified to net incomeduring the next twelve months as a result of the underlying hedged transactionsalso being recorded in net income. We did not record any charges related tohedge dedesignations or ineffectiveness in 2006. In 2005, we recorded chargestotaling $0.5 million in other income (expense) related to hedge dedesignationsand ineffectiveness. We continually monitor our hedge positions and forecastedtransactions and, in the event changes to our forecast occur, we may havededesignations of our cash flow hedges in the future.

Prior to thesecond quarter of 2004, we did not meet the criteria to treat these derivativesas hedges and, accordingly, the changes in fair value were recorded in netincome. We recorded unrealized losses of $2.7 million and realized gains of$1.4 million related to these contracts in 2004 as a component of other income.

**InterestRate Risk**

Our exposure tomarket risk for changes in interest rates primarily relates to our investments.Since we had no variable interest rate debt outstanding at December 31, 2006,our interest expense is relatively fixed and not affected by changes ininterest rates. In the event we issue any new debt in the future, increases ininterest rates will increase the interest expense associated with the debt.

The primaryobjective of our investment activities is to preserve principal whilemaximizing yields without significantly increasing risk. This objective isaccomplished by making diversified investments, consisting only of investmentgrade securities.

***Cash,Cash Equivalents and Restricted Cash***

As of December 31,2006, we held cash and cash equivalents of $110.7 million and short-termrestricted cash of $20.2 million that consisted of cash and highly liquidshort-term investments having maturity dates of no more than 90 days at thedate of acquisition. Declines of interest rates over time would reduce ourinterest income from our highly liquid short-term investments. A decrease ininterest rates of one 

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percentage pointwould cause a corresponding decrease in annual interest income of approximately$1.3 million assuming our cash and cash equivalent balances at December 31,2006 remained constant. Due to the nature of our highly liquid cashequivalents, an increase in interest rates would not materially change the fairmarket value of our cash and cash equivalents.

***FixedRate Debt Securities***

As of December 31,2006, we held short- and long-term fixed rate investments of $133.8 millionthat consisted of corporate notes and bonds and government-backed securities.These investments are recorded on our balance sheet at fair value based onquoted market prices. Unrealized gains/losses resulting from changes in thefair value are recorded, net of tax, in shareholders’ equity as a component ofother comprehensive income (loss). Interest rate fluctuations impact the fairvalue of these investments, however, given our ability to hold theseinvestments until maturity or until the unrealized losses recover, we do notexpect these fluctuations to have a material impact on our results ofoperations, financial position or cash flows. Declines in interest rates overtime would reduce our interest income from our short-term investments, as ourshort-term portfolio is re-invested at current market interest rates. Adecrease in interest rates of one percentage point would cause a correspondingdecrease in our annual interest income from these items of approximately $1.3million assuming our investment balances at December 31, 2006 remainedconstant.

***VariableRate-Notes***

As of December 31,2006, we held variable-rate notes of $133.4 million. Given the highly liquidnature of variable-rate notes, cost is considered to approximate fair value forthese securities and their fair value is not significantly impacted by interestrate fluctuations. Declines in interest rates over time would reduce ourinterest income from our investments in variable-rate notes, as interest ratesare reset periodically to current market interest rates. A decrease in interestrates of one percentage point would cause a corresponding decrease in ourannual interest income from these items of approximately $1.3 million assumingour investment balances at December 31, 2006 remained constant.

**FairValue of Convertible Debt**

The fair marketvalue of our fixed rate convertible debt is subject to interest rate risk.Generally, the fair market value of fixed interest rate debt will increase asinterest rates fall and decrease as interest rates rise. The interest ratechanges affect the fair market value of our long-term debt, but do not impactearnings or cash flows. At December 31, 2006, we had $310.9 million of fixedrate convertible debt outstanding. Based on open market trades, we havedetermined that the fair market value of our long-term fixed interest rate debtwas approximately $341.1 million at December 31, 2006.

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

Unauditedquarterly financial data**for each ofthe eight quarters in the two-year period ended December 31, 2006 is asfollows: 
| **In thousands, except per share data** | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| **2006**                                                         |       |                 |       |                 |       |                 |       |                 |       |
| Net sales                                                        |       | $                    | 112,266    |                 | $          | 111,339              |       | $                    | 115,602    |   | $ | 140,284 |   |
| Cost of sales                                                    |       | 66,516               |       | 66,483               |       | 68,667               |       | 81,379               |       |
| Gross profit                                                     |       | 45,750               |       | 44,856               |       | 46,935               |       | 58,905               |       |
| Total operating  expenses(1)                                     |       | 49,732               |       | 39,536               |       | 39,100               |       | 45,031               |       |
| Operating (loss)  income                                         |       | (3,982               | )          | 5,320                |       | 7,835                |       | 13,874               |       |
| Other income  (expense), net(2)                                  |       | 203                  |       | 994                  |       | 2,369                |       | 1,506                |       |
| (Loss) income  from continuing operations before income taxes    |       | (3,779               | )          | 6,314                |       | 10,204               |       | 15,380               |       |
| Income tax  expense (benefit)(6)                                 |       | 1,397                |       | 2,305                |       | 3,284                |       | 3,481                |       |
| (Loss) income  from continuing operations                        |       | (5,176               | )          | 4,009                |       | 6,920                |       | 11,899               |       |
| (Loss) income  from discontinued operations, net of tax(7)       |       | (45                  | )          | 90                   |       | (412                 | )          | (580                 | )          |
| Gain on disposal  of discontinued operations, net of tax(7)      |       | —               |       | —               |       | —               |       | 3,335                |       |
| Net (loss)  income                                               |       | $                    | (5,221     | )                    | $          | 4,099                |       | $                    | 6,508      |   | $ | 14,654 |   |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| Basic (loss)  income per share from continuing operations        |       | $                    | (0.15      | )                    | $          | 0.12                 |       | $                    | 0.20       |   | $ | 0.35 |   |
| Basic (loss)  income per share from discontinued operations      |       | —               |       | —               |       | (0.01                | )          | 0.08                 |       |
| Basic net (loss)  income per share                               |       | $                    | (0.15      | )                    | $          | 0.12                 |       | $                    | 0.19       |   | $ | 0.43 |   |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| Diluted (loss)  income per share from continuing operations      |       | $                    | (0.15      | )                    | $          | 0.11                 |       | $                    | 0.18       |   | $ | 0.30 |   |
| Diluted (loss)  income per share from discontinued operations    |       | —               |       | —               |       | (0.01                | )          | 0.06                 |       |
| Diluted net  (loss) income per share                             |       | $                    | (0.15      | )                    | $          | 0.11                 |       | $                    | 0.17       |   | $ | 0.36 |   |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| Shares used in  basic per share calculations                     |       | 33,867               |       | 33,770               |       | 33,752               |       | 33,886               |       |
| Shares used in  diluted per share calculations                   |       | 33,867               |       | 39,691               |       | 39,572               |       | 44,079               |       |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| **2005**                                                         |       |                 |       |                 |       |                 |       |                 |       |
| Net sales                                                        |       | $                    | 119,315    |                 | $          | 105,645              |       | $                    | 95,369     |   | $ | 99,768 |   |
| Cost of sales(3)                                                 |       | 71,973               |       | 70,790               |       | 60,658               |       | 71,482               |       |
| Gross profit                                                     |       | 47,342               |       | 34,855               |       | 34,711               |       | 28,286               |       |
| Total operating  expenses(4)                                     |       | 41,242               |       | 57,999               |       | 41,408               |       | 51,103               |       |
| Operating income  (loss)                                         |       | 6,100                |       | (23,144              | )          | (6,697               | )          | (22,817              | )          |
| Other (expense)  income, net(5)                                  |       | (908                 | )          | (3,070               | )          | 75                   |       | (5,928               | )          |
| Income (loss)  from continuing operations before income taxes    |       | 5,192                |       | (26,214              | )          | (6,622               | )          | (28,745              | )          |
| Income tax  expense (benefit)(6)                                 |       | 1,730                |       | 19,682               |       | (1,450               | )          | 2,109                |       |
| Income (loss)  from continuing operations                        |       | 3,462                |       | (45,896              | )          | (5,172               | )          | (30,854              | )          |
| (Loss) income  from discontinued operations, net of tax(7)       |       | (39                  | )          | 111                  |       | 69                   |       | 161                  |       |
| Net income  (loss)                                               |       | $                    | 3,423      |                 | $          | (45,785              | )          | $                    | (5,103     | ) | $ | (30,693 | ) |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| Basic income  (loss) per share from continuing operations        |       | $                    | 0.10       |                 | $          | (1.37                | )          | $                    | (0.16      | ) | $ | (0.92 | ) |
| Basic income per  share from discontinued operations             |       | —               |       | 0.01                 |       | 0.01                 |       | 0.01                 |       |
| Basic net income  (loss) per share                               |       | $                    | 0.10       |                 | $          | (1.36                | )          | $                    | (0.15      | ) | $ | (0.91 | ) |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| Diluted income  (loss) per share from continuing operations      |       | $                    | 0.09       |                 | $          | (1.37                | )          | $                    | (0.16      | ) | $ | (0.92 | ) |
| Diluted income  per share from discontinued operations           |       | —               |       | 0.01                 |       | 0.01                 |       | 0.01                 |       |
| Diluted net  income (loss) per share                             |       | $                    | 0.09       |                 | $          | (1.36                | )          | $                    | (0.15      | ) | $ | (0.91 | ) |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| Shares used in  basic per share calculations                     |       | 33,456               |       | 33,544               |       | 33,644               |       | 33,718               |       |
| Shares used in diluted  per share calculations                   |       | 39,878               |       | 33,544               |       | 33,644               |       | 33,718               |       |

 

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(1)          Included in quarterly operating expenses were the following that affectcomparability:

·                  restructuring,reorganization, relocation and severance charges of $11.6 million, $0.8million, $0.2 million, respectively, in the first, second and third quarters of2006;

·                  mergercosts of $0.5 million in the first quarter of 2006;

·                  assetimpairment charges of $0.5 million in the first quarter of 2006; and

·                  a$1.5 million gain related to the  sale ofcertain intellectual property rights to a privately-held company in the thirdquarter of 2006.

(2)          Included in other (expense) income were the following that affectcomparability:

·                  interest expense of $0.4 million and $0.1million, respectively, in the first and second quarters of 2006 related to therepurchase of $29.0 million face value of our 5.5% convertible notes;

·                  a $5.2 million gain related to the sale of ourentire ownership interest in a privately-held company in the third quarter of2006; and

·                  a $3.9 million charge related to the write-offof our equity and debt investment in a privately-held company in the thirdquarter of 2006.

(3)          Included in quarterly cost of sales were the following that affectcomparability:

·                  inventory and capitalized software write-downstotaling $6.4 million in the second quarter of 2005;

·                  inventory write-downs totaling $2.4 million inthe third quarter of 2005;

·                  a $1.0 million positive adjustment to ourwarranty reserve due to favorable cost experience compared to our originalwarranty reserve estimates; and

·                  inventory write-downs totaling $5.4 million inthe fourth quarter of 2005.

(4)          Included in quarterly total operating expenses were the following thataffect comparability:

·                  charges for restructuring, reorganization andrelocation expenses totaling $1.1 million, $2.8 million and $4.6 million,respectively, in the second, third and fourth quarters of 2005;

·                  asset impairment charges totaling $15.9million, $0.8 million and $8.7 million, respectively, in the second, third andfourth quarters of 2005; and

·                  a gain of $0.8 million related to the sale thenet assets of our secondary ion mass spectrometer (“SIMS”) product line in thesecond quarter of 2005.

(5)          Included in other expense (income), net were the following charges thataffect comparability:

·                  a charge of $1.8 million related to therepurchase and retirement of $70 million face value of our 5.5% convertiblenotes, included as a component of interest expense in the second quarter of2005; and

·                  charges of $0.8 million and $5.6 million, respectively,for “other-than-temporary” impairments in the carrying value of investments innon-public companies in the second and fourth quarters of 2005.

(6)          Income tax expense (benefit) includes charges for valuation allowancesplaced on our deferred tax assets, offsetting benefits related to our UnitedStates losses in each quarter of 2006 and 2005.

(7)          Represents the results of Knights Technology, which was classified as adiscontinued operation in 2006 and sold in the fourth quarter of 2006.

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

**To the Board of Directors andShareholdersFEI CompanyHillsboro, Oregon**

We have auditedthe accompanying consolidated balance sheets of FEI Company and subsidiaries(the “Company”) as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, comprehensive income (loss), shareholders’ equity,and cash flows for each of the three years in the period ended December 31,2006. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted ouraudits in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion,such consolidated financial statements present fairly, in all materialrespects, the financial position of FEI Company and subsidiaries as of December31, 2006 and 2005, and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2006, in conformitywith accounting principles generally accepted in the United States of America.

As discussed inNote 1 to the consolidated financial statements the Company adopted Statementof Financial Accounting Standards No. 123R, “Share-Based Payment,” effectiveJanuary 1, 2006.

We have alsoaudited, 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, 2006, based on criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission,and our report dated March 1, 2007 expressed unqualified opinion on management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting and an unqualified opinion on the effectiveness of theCompany’s internal control over financial reporting.

DELOITTE & TOUCHE LLPPortland, OregonMarch 1, 2007

 

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**FEI Company and Subsidiaries**

**ConsolidatedBalance Sheets**

**(In thousands)**
| ** **                                                                                               | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                               | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                                                                                     |       |                  |       |   |   |
| **Assets**                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current Assets:                                                                                          |       |                  |       |   |   |
| Cash and cash  equivalents                                                                               |       | $                     | 110,656    |   | $ | 58,766 |   |
| Short-term  investments in marketable securities                                                         |       | 234,202               |       | 156,049 |   |
| Short-term  restricted cash                                                                              |       | 20,172                |       | 20,140 |   |
| Receivables, net  of allowances for doubtful accounts of $4,181 and $3,305                               |       | 144,955               |       | 96,230 |   |
| Inventories                                                                                              |       | 97,470                |       | 84,879 |   |
| Deferred tax  assets                                                                                     |       | 4,386                 |       | 5,157 |   |
| Other current  assets                                                                                    |       | 33,474                |       | 32,284 |   |
| Assets of  discontinued operations                                                                       |       | —                |       | 6,342 |   |
| Total Current  Assets                                                                                    |       | 645,315               |       | 459,847 |   |
|                                                                                                     |       |                  |       |   |   |
| Non-current investments  in marketable securities                                                        |       | 34,900                |       | 44,602 |   |
| Long-term restricted  cash                                                                               |       | 6,131                 |       | 519 |   |
| Property, plant and  equipment, net of accumulated depreciation of $68,420 and $65,783                   |       | 60,394                |       | 58,807 |   |
| Purchased technology,  net of accumulated amortization of $41,568 and $39,433                            |       | 4,494                 |       | 6,354 |   |
| Goodwill                                                                                                 |       | 40,900                |       | 40,902 |   |
| Deferred tax assets                                                                                      |       | 542                   |       | 1,095 |   |
| Non-current service  inventories                                                                         |       | 37,920                |       | 33,869 |   |
| Other assets, net                                                                                        |       | 7,483                 |       | 10,036 |   |
| Total Assets                                                                                             |       | $                     | 838,079    |   | $ | 656,031 |   |
|                                                                                                     |       |                  |       |   |   |
| **Liabilities and Shareholders’  Equity**                                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current Liabilities:                                                                                     |       |                  |       |   |   |
| Accounts payable                                                                                         |       | $                     | 45,118     |   | $ | 26,186 |   |
| Current account  with Philips                                                                            |       | —                |       | 1,964 |   |
| Accrued payroll  liabilities                                                                             |       | 20,736                |       | 9,177 |   |
| Accrued warranty  reserves                                                                               |       | 5,716                 |       | 5,193 |   |
| Accrued agent  commissions                                                                               |       | 6,175                 |       | 8,387 |   |
| Deferred revenue                                                                                         |       | 48,992                |       | 42,442 |   |
| Income taxes  payable                                                                                    |       | 9,203                 |       | 9,021 |   |
| Accrued  restructuring, reorganization, relocation and severance                                         |       | 2,439                 |       | 5,274 |   |
| Other current  liabilities                                                                               |       | 29,276                |       | 22,485 |   |
| Liabilities of  discontinued operations                                                                  |       | —                |       | 1,929 |   |
| Total Current  Liabilities                                                                               |       | 167,655               |       | 132,058 |   |
|                                                                                                     |       |                  |       |   |   |
| Convertible debt                                                                                         |       | 310,882               |       | 225,000 |   |
| Deferred tax  liabilities                                                                                |       | 4,062                 |       | 1,947 |   |
| Other liabilities                                                                                        |       | 5,572                 |       | 4,583 |   |
|                                                                                                     |       |                  |       |   |   |
| Commitments and  contingencies                                                                           |       |                  |       |   |   |
|                                                                                                     |       |                  |       |   |   |
| Shareholders’ Equity:                                                                               |       |                  |       |   |   |
| Preferred stock  - 500 shares authorized; none issued and outstanding                                    |       | —                |       | — |   |
| Common stock -  70,000 shares authorized; 34,052 and 33,800 shares issued and outstanding, no  par value |       | 348,479               |       | 332,125 |   |
| Accumulated  deficit                                                                                     |       | (36,041               | )          | (56,081 | ) |
| Accumulated  other comprehensive income                                                                  |       | 37,470                |       | 16,399 |   |
| Total  Shareholders’ Equity                                                                         |       | 349,908               |       | 292,443 |   |
| Total Liabilities and  Shareholders’ Equity                                                         |       | $                     | 838,079    |   | $ | 656,031 |   |

 

See accompanying Notes toConsolidated Financial Statements.

53

----

**FEI Company and Subsidiaries**

**ConsolidatedStatements of Operations**

**(Inthousands, except per share amounts)**
| ** **                                                     | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net Sales:                                                     |       |                                                         |       |   |   |   |   |
| Products                                                       |       | $                                                            | 358,137    |   | $ | 308,521 |   | $ | 353,040 |   |
| Products - related party                                       |       | 2,506                                                        |       | 2,830 |   | 4,002 |   |
| Service and components                                         |       | 116,702                                                      |       | 107,708 |   | 99,271 |   |
| Service and components - related party                         |       | 2,146                                                        |       | 1,038 |   | 1,212 |   |
| Total net sales                                                |       | 479,491                                                      |       | 420,097 |   | 457,525 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Cost of Sales:                                                 |       |                                                         |       |   |   |   |   |
| Products                                                       |       | 197,742                                                      |       | 195,834 |   | 208,132 |   |
| Service and components                                         |       | 85,303                                                       |       | 79,069 |   | 67,999 |   |
| Total cost of sales                                            |       | 283,045                                                      |       | 274,903 |   | 276,131 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Gross Profit                                                   |       | 196,446                                                      |       | 145,194 |   | 181,394 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Operating  Expenses:                                           |       |                                                         |       |   |   |   |   |
| Research and development                                       |       | 57,528                                                       |       | 56,577 |   | 51,737 |   |
| Selling, general and administrative                            |       | 100,279                                                      |       | 97,460 |   | 92,497 |   |
| Merger costs                                                   |       | 484                                                          |       | — |   | — |   |
| Amortization of purchased technology                           |       | 2,034                                                        |       | 3,819 |   | 5,368 |   |
| Asset impairment                                               |       | 465                                                          |       | 25,352 |   | — |   |
| Restructuring, reorganization, relocation and  severance       |       | 12,609                                                       |       | 8,544 |   | 607 |   |
| Total operating expenses                                       |       | 173,399                                                      |       | 191,752 |   | 150,209 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Operating Income  (Loss)                                       |       | 23,047                                                       |       | (46,558 | ) | 31,185 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Other Income  (Expense):                                       |       |                                                         |       |   |   |   |   |
| Interest income                                                |       | 13,150                                                       |       | 7,819 |   | 5,212 |   |
| Interest expense                                               |       | (7,355                                                       | )          | (9,342 | ) | (10,332 | ) |
| Other, net                                                     |       | (723                                                         | )          | (8,308 | ) | (3,144 | ) |
| Total other expense, net                                       |       | 5,072                                                        |       | (9,831 | ) | (8,264 | ) |
|                                                           |       |                                                         |       |   |   |   |   |
| Income (loss)  from continuing operations before income taxes  |       | 28,119                                                       |       | (56,389 | ) | 22,921 |   |
| Income tax  expense                                            |       | 10,467                                                       |       | 22,071 |   | 7,205 |   |
| Income (loss)  from continuing operations                      |       | 17,652                                                       |       | (78,460 | ) | 15,716 |   |
| (Loss) income  from discontinued operations, net of income tax |       | (947                                                         | )          | 302 |   | 857 |   |
| Gain on disposal  of discontinued operations, net of tax       |       | 3,335                                                        |       | — |   | — |   |
| Net income  (loss)                                             |       | $                                                            | 20,040     |   | $ | (78,158 | ) | $ | 16,573 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Basic income  (loss) per share from continuing operations      |       | $                                                            | 0.52       |   | $ | (2.34 | ) | $ | 0.47 |   |
| Basic income per  share from discontinued operations           |       | 0.07                                                         |       | 0.01 |   | 0.03 |   |
| Basic net income  (loss) per share                             |       | $                                                            | 0.59       |   | $ | (2.33 | ) | $ | 0.50 |   |
|                                                           |       |                                                         |       |   |   |   |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Diluted income  (loss) per share from continuing operations    |       | $                                                            | 0.47       |   | $ | (2.34 | ) | $ | 0.41 |   |
| Diluted income  per share from discontinued operations         |       | 0.06                                                         |       | 0.01 |   | 0.02 |   |
| Diluted net  income (loss) per share                           |       | $                                                            | 0.53       |   | $ | (2.33 | ) | $ | 0.43 |   |
|                                                           |       |                                                         |       |   |   |   |   |
| Shares used in  per share calculations:                        |       |                                                         |       |   |   |   |   |
| Basic                                                          |       | 33,818                                                       |       | 33,595 |   | 33,253 |   |
| Diluted                                                        |       | 39,752                                                       |       | 33,595 |   | 39,668 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

54

----

**FEI Company and Subsidiaries**

**ConsolidatedStatements of Comprehensive Income (Loss)**

**(Inthousands)**
| ** **                                                                                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income  (loss)                                                                                                    |       | $                                                            | 20,040     |   | $ | (78,158 | ) | $ | 16,573 |   |
| Other  comprehensive income (loss):                                                                                   |       |                                                         |       |   |   |   |   |
| Change in cumulative translation adjustment, zero  taxes provided                                                     |       | 18,313                                                       |       | (22,194 | ) | 16,895 |   |
| Change in unrealized loss on available-for-sale  securities                                                           |       | 793                                                          |       | (928 | ) | (276 | ) |
| Change in minimum pension liability, net of taxes                                                                     |       | (603                                                         | )          | — |   | — |   |
| Changes due to cash flow hedging instruments:                                                                         |       |                                                         |       |   |   |   |   |
| Net gain (loss) on hedge instruments                                                                                  |       | 4,542                                                        |       | (5,219 | ) | 2,541 |   |
| Reclassification to net income (loss) of previously  deferred gains (losses) related to hedge derivatives instruments |       | (1,974                                                       | )          | 2,879 |   | (1,085 | ) |
| Comprehensive  income (loss)                                                                                          |       | $                                                            | 41,111     |   | $ | (103,620 | ) | $ | 34,648 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

55

----

**FEI Company and Subsidiaries**

**ConsolidatedStatements of Shareholders’ Equity**

**For The Years Ended December 31,2006, 2005 and 2004**

**(Inthousands)**
| ** **                                                                                                | ** ** | ** **            | ** ** | ** ** | ** ** | ** **      | ** ** | ** **    | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|-----------------|------------|---------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                | ** ** | ** **            | ** ** | ** ** | ** ** | **Note**        | ** ** | ** **    | ** ** | **Other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** **            | ** ** | ** ** | ** ** | **Receivable**  | ** ** | **Retained**  | ** ** | **Comprehensive**      | ** ** | **Total**  | ** ** |
| ** **                                                                                                | ** ** | **Common Stock** | ** ** | **From**   | ** ** | **Earnings**    | ** ** | **Income**    | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                                | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Shareholder** | ** ** | **(Deficit)** | ** ** | **(Loss)**             | ** ** | **Equity** | ** ** |
|                                                                                                      |       |                  |       |       |       |            |       |          |       |                   |       |       |       |
| **Balance  at December 31, 2003**                                                                         |       | 33,153                |       | $          | 308,509    |            | $          | (1,506        | )          | $                      | 5,504      |       | $          | 23,786 |   | $ | 336,293 |   |
|                                                                                                      |       |                  |       |       |       |            |       |          |       |                   |       |       |       |
| Net income                                                                                                |       | —                |       | —     |       | —          |       | 16,573        |       | —                 |       | 16,573     |       |
| Accrual of  interest on shareholder note receivable                                                       |       | —                |       | —     |       | (87             | )          | —        |       | —                 |       | (87        | )          |
| Repayment of  shareholder note                                                                            |       | —                |       | —     |       | 1,593           |       | —        |       | —                 |       | 1,593      |       |
| Employee  purchases of common stock through  employee share purchase plan                            |       | 143                   |       | 2,421      |       | —          |       | —        |       | —                 |       | 2,421      |       |
| Stock options  exercised                                                                                  |       | 104                   |       | 1,055      |       | —          |       | —        |       | —                 |       | 1,055      |       |
| Shares issued to  Philips for pre-merger options exercised                                                |       | 14                    |       | —     |       | —          |       | —        |       | —                 |       | —     |       |
| Shares returned  from escrow                                                                              |       | (1                    | )          | (47        | )          | —          |       | —        |       | —                 |       | (47        | )          |
| Tax benefit of  non-qualified stock options exercised                                                     |       | —                |       | 415        |       | —          |       | —        |       | —                 |       | 415        |       |
| Tax benefit of  convertible hedge                                                                         |       | —                |       | 3,279      |       | —          |       | —        |       | —                 |       | 3,279      |       |
| Translation  adjustment                                                                                   |       |                  |       |       |       |            |       |          |       | 16,895                 |       | 16,895     |       |
| Unrealized loss  on available for sale securities                                                         |       | —                |       | —     |       | —          |       | —        |       | (276                   | )          | (276       | )          |
| Adjustment for  fair value of hedge derivatives                                                           |       | —                |       | —     |       | —          |       | —        |       | 1,456                  |       | 1,456      |       |
| **Balance  at December 31, 2004**                                                                         |       | 33,413                |       | 315,632    |       | —          |       | 22,077        |       | 41,861                 |       | 379,570    |       |
|                                                                                                      |       |                  |       |       |       |            |       |          |       |                   |       |       |       |
| Net loss                                                                                                  |       | —                |       | —     |       | —          |       | (78,158       | )          | —                 |       | (78,158    | )          |
| Employee  purchases of common stock through employee share purchase plan                                  |       | 207                   |       | 3,591      |       | —          |       | —        |       | —                 |       | 3,591      |       |
| Stock options  exercised                                                                                  |       | 180                   |       | 2,287      |       | —          |       | —        |       | —                 |       | 2,287      |       |
| Stock-based  compensation expense                                                                         |       | —                |       | 58         |       | —          |       | —        |       | —                 |       | 58         |       |
| Reversal of tax  benefit of non-qualified stock options exercised                                         |       | —                |       | (400       | )          | —          |       | —        |       | —                 |       | (400       | )          |
| Termination of  convertible note hedge                                                                    |       | —                |       | 10,957     |       | —          |       | —        |       | —                 |       | 10,957     |       |
| Translation  adjustment                                                                                   |       | —                |       | —     |       | —          |       | —        |       | (22,194                | )          | (22,194    | )          |
| Unrealized loss  on available for sale securities                                                         |       | —                |       | —     |       | —          |       | —        |       | (928                   | )          | (928       | )          |
| Net adjustment  for fair value of hedge derivatives                                                       |       | —                |       | —     |       | —          |       | —        |       | (2,340                 | )          | (2,340     | )          |
| **Balance  at December 31, 2005**                                                                         |       | 33,800                |       | 332,125    |       | —          |       | (56,081       | )          | 16,399                 |       | 292,443    |       |
|                                                                                                      |       |                  |       |       |       |            |       |          |       |                   |       |       |       |
| Net income                                                                                                |       | —                |       | —     |       | —          |       | 20,040        |       | —                 |       | 20,040     |       |
| Employee  purchases of common stock through employee share purchase plan                                  |       | 187                   |       | 3,516      |       | —          |       | —        |       | —                 |       | 3,516      |       |
| Restricted  shares issued and stock options exercised related to employee stock-based  compensation plans |       | 565                   |       | 9,631      |       | —          |       | —        |       | —                 |       | 9,631      |       |
| Shares  repurchased                                                                                       |       | (500                  | )          | (11,075    | )          | —          |       | —        |       | —                 |       | (11,075    | )          |
| Stock-based  compensation expense                                                                         |       | —                |       | 12,860     |       | —          |       | —        |       | —                 |       | 12,860     |       |
| Tax benefit of  non-qualified stock options exercised                                                     |       | —                |       | 1,422      |       | —          |       | —        |       | —                 |       | 1,422      |       |
| Translation  adjustment                                                                                   |       | —                |       | —     |       | —          |       | —        |       | 18,313                 |       | 18,313     |       |
| Unrealized gain  on available for sale securities                                                         |       | —                |       | —     |       | —          |       | —        |       | 793                    |       | 793        |       |
| Minimum pension  liability, net of taxes                                                                  |       | —                |       | —     |       | —          |       | —        |       | (603                   | )          | (603       | )          |
| Net adjustment  for fair value of hedge derivatives                                                       |       | —                |       | —     |       | —          |       | —        |       | 2,568                  |       | 2,568      |       |
| **Balance at December 31, 2006**                                                                          |       | 34,052                |       | $          | 348,479    |            | $          | —        |       | $                      | (36,041    | )          | $          | 37,470 |   | $ | 349,908 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

56

----

**FEI Company and Subsidiaries**

**ConsolidatedStatements of Cash Flows**

**(Inthousands)**
| ** **                                                                                   | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                         |       |                                                         |       |   |   |   |   |
| **Cash  flows from operating activities:**                                                   |       |                                                         |       |   |   |   |   |
| Net income (loss)                                                                            |       | $                                                            | 20,040     |   | $ | (78,158 | ) | $ | 16,573 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities:    |       |                                                         |       |   |   |   |   |
| Depreciation                                                                                 |       | 13,356                                                       |       | 15,023 |   | 15,272 |   |
| Amortization                                                                                 |       | 4,436                                                        |       | 9,253 |   | 12,654 |   |
| Stock-based compensation                                                                     |       | 12,820                                                       |       | 58 |   | — |   |
| Asset impairments and write-offs of property, plant  and equipment and other assets          |       | 4,311                                                        |       | 25,352 |   | — |   |
| (Gain) loss on disposal of investments, property,  plant and equipment and intangible assets |       | (6,726                                                       | )          | 22 |   | 125 |   |
| Gain on disposal of discontinued operations                                                  |       | (3,335                                                       | )          | — |   | — |   |
| Write-off of deferred bond offering costs                                                    |       | 404                                                          |       | — |   | — |   |
| Premium on bond redemption                                                                   |       | —                                                       |       | 1,108 |   | — |   |
| Write-off of capitalized software                                                            |       | —                                                       |       | 3,223 |   | — |   |
| Write-down of cost method investments                                                        |       | —                                                       |       | 6,408 |   | — |   |
| Gain on sale of SIMS product line                                                            |       | —                                                       |       | (797 | ) | — |   |
| Gain on non-monetary transaction                                                             |       | —                                                       |       | — |   | (636 | ) |
| Deferred income taxes                                                                        |       | 1,704                                                        |       | 15,810 |   | (7,952 | ) |
| Tax benefit of convertible hedge                                                             |       | —                                                       |       | — |   | 3,279 |   |
| Tax (reversal) benefit for non-qualified stock  options exercised                            |       | 1,422                                                        |       | (400 | ) | 415 |   |
| (Increase) decrease in:                                                                      |       |                                                         |       |   |   |   |   |
| Receivables                                                                                  |       | (41,833                                                      | )          | 53,872 |   | (52,510 | ) |
| Current account with Accurel                                                                 |       | —                                                       |       | 515 |   | 17 |   |
| Inventories                                                                                  |       | (9,831                                                       | )          | (16,906 | ) | 21,395 |   |
| Income taxes receivable                                                                      |       | 2,012                                                        |       | (9,033 | ) | — |   |
| Other assets                                                                                 |       | (1,476                                                       | )          | 11,961 |   | (19,422 | ) |
| Increase (decrease) in:                                                                      |       |                                                         |       |   |   |   |   |
| Accounts payable                                                                             |       | 15,915                                                       |       | (7,511 | ) | (2,046 | ) |
| Current account with Philips                                                                 |       | (2,598                                                       | )          | (1,363 | ) | (1,612 | ) |
| Accrued payroll liabilities                                                                  |       | 10,466                                                       |       | (4,620 | ) | 5,957 |   |
| Accrued warranty reserves                                                                    |       | 313                                                          |       | (1,697 | ) | (942 | ) |
| Deferred revenue                                                                             |       | 2,919                                                        |       | 3,953 |   | 12,695 |   |
| Income taxes payable                                                                         |       | (112                                                         | )          | (4,734 | ) | 4,063 |   |
| Accrued restructuring, reorganization, relocation and  severance costs                       |       | (2,369                                                       | )          | 4,259 |   | (1,096 | ) |
| Other liabilities                                                                            |       | 1,453                                                        |       | (5,183 | ) | 17,100 |   |
| Net cash provided by operating activities                                                    |       | 23,291                                                       |       | 20,415 |   | 23,329 |   |
|                                                                                         |       |                                                         |       |   |   |   |   |
| **Cash  flows from investing activities:**                                                   |       |                                                         |       |   |   |   |   |
| Increase in restricted cash                                                                  |       | (4,965                                                       | )          | (2,160 | ) | (7,088 | ) |
| Acquisition of property, plant and equipment                                                 |       | (6,514                                                       | )          | (14,983 | ) | (14,813 | ) |
| Proceeds from disposal of property, plant and equipment  and intangible assets               |       | 1,532                                                        |       | 3,023 |   | — |   |
| Proceeds from disposal of discontinued operations                                            |       | 7,750                                                        |       | — |   | — |   |
| Investment in software development                                                           |       | —                                                       |       | — |   | (659 | ) |
| Purchase of investments in marketable securities                                             |       | (298,216                                                     | )          | (172,623 | ) | (70,386 | ) |
| Redemption of investments in marketable securities                                           |       | 230,707                                                      |       | 177,796 |   | 74,141 |   |
| Proceeds from disposal of (investment in)  unconsolidated affiliate                          |       | 4,829                                                        |       | (2,408 | ) | (2,256 | ) |
| Other                                                                                        |       | (259                                                         | )          | (109 | ) | (414 | ) |
| Net cash used in investing activities                                                        |       | (65,136                                                      | )          | (11,464 | ) | (21,475 | ) |
|                                                                                         |       |                                                         |       |   |   |   |   |
| **Cash  flows from financing activities:**                                                   |       |                                                         |       |   |   |   |   |
| Redemption of 5.5% convertible notes                                                         |       | (29,118                                                      | )          | (70,000 | ) | — |   |
| Issuance of 2.875% convertible notes, net of offering  costs                                 |       | 111,868                                                      |       | — |   | — |   |
| Termination of convertible note hedge                                                        |       | —                                                       |       | 10,957 |   | — |   |
| Repurchase of common stock                                                                   |       | (11,075                                                      | )          | — |   | — |   |
| Proceeds from exercise of stock options and employee  stock purchases                        |       | 13,147                                                       |       | 5,878 |   | 3,476 |   |
| Repayment of shareholder note receivable                                                     |       | —                                                       |       | — |   | 1,593 |   |
| Net cash provided by (used in) financing activities                                          |       | 84,822                                                       |       | (53,165 | ) | 5,069 |   |
|                                                                                         |       |                                                         |       |   |   |   |   |
| Effect of  exchange rate changes                                                             |       | 8,913                                                        |       | (9,182 | ) | 8,131 |   |
| Increase  (decrease) in cash and cash equivalents                                            |       | 51,890                                                       |       | (53,396 | ) | 15,054 |   |
|                                                                                         |       |                                                         |       |   |   |   |   |
| **Cash and  cash equivalents:**                                                              |       |                                                         |       |   |   |   |   |
| Beginning of year                                                                            |       | 58,766                                                       |       | 112,162 |   | 97,108 |   |
| End of year                                                                                  |       | $                                                            | 110,656    |   | $ | 58,766 |   | $ | 112,162 |   |
|                                                                                         |       |                                                         |       |   |   |   |   |
| **Supplemental  Cash Flow Information:**                                                     |       |                                                         |       |   |   |   |   |
| Cash paid for income taxes                                                                   |       | $                                                            | 5,387      |   | $ | 16,482 |   | $ | 13,244 |   |
| Cash paid for  interest                                                                      |       | 5,783                                                        |       | 8,765 |   | 7,975 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

57

----

**FEI COMPANY AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                                      SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES

***Nature of Business***

We are a leading supplier of products that enable the research, developmentand manufacturing of nanoscale features by helping our customers understandtheir three-dimensional (“3D”) structures. Beginning in 2006, we arereporting our revenue based on a market-focused organization. Our semiconductorand data storage markets are being reported together as the NanoElectronicsmarket and our Industry and Institute market is being broken down into theNanoResearch and Industry market and the NanoBiology market. See additionaldisclosure in Note 21, “*Segment and GeographicInformation*.”

Our products and systems include hardware and software for focused ion beamsystems, or FIBs, scanning electron microscopes, or SEMs, transmission electronmicroscopes, or TEMs, and *DualBeam*systems, which combine a FIB and SEM on a single platform.

Our *DualBeam* systems include models that have wafer handlingcapability that are purchased by semiconductor and data storage manufacturers (“wafer-level*DualBeam*systems”) and models that havesmall stages and are sold to customers in several markets (“small-stage *DualBeam*systems”).

We have research, developmentand manufacturing operations in Hillsboro, Oregon; Eindhoven, the Netherlands;and Brno, Czech Republic.

Sales and serviceoperations are conducted in the United States and approximately 50 othercountries around the world. We also sell our products through independentagents, distributors and representatives in additional countries.

***Basis of Presentation***

The consolidated financial statementsinclude the accounts of FEI Company and our majority-controlled subsidiaries.All significant intercompany balances and transactions have been eliminated inconsolidation.

***Use of Estimates inFinancial Reporting***

The preparation of financial statementsin conformity with accounting principles generally accepted in the UnitedStates requires management to make estimates and assumptions. These estimatesand assumptions affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amount of revenues and expenses during thereporting period. Significant accounting policies and estimates underlying theaccompanying consolidated financial statements include:

·                  thetiming of revenue recognition;

·                  theallowance for doubtful accounts;

·                  valuationsof excess and obsolete inventory;

·                  valuationof investments in privately-held companies;

·                  thelives and recoverability of equipment and other long-lived assets such asgoodwill, existing technology intangibles;

·                  restructuring,reorganization, relocation and severance costs;

·                  accountingfor income taxes;

·                  warrantyliabilities;

·                  stock-basedcompensation; and

·                  accountingfor derivatives.

It is reasonably possible that theestimates we make may change in the future.

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***Concentration of CreditRisk***

Instruments that potentially subject usto concentration of credit risk consist principally of cash and cashequivalents, short-term investments and receivables. Our investment policylimits investments with any one issuer to 10% or less of the total investmentportfolio, with the exception of money market funds and securities issued bythe United States government or its agencies which may comprise up to 100% ofthe total investment portfolio. Our exposure to credit risk concentrationswithin our receivables balance is limited due to the large number of entitiescomprising our customer base and their dispersion across many differentindustries and geographies.

***Dependence on KeySuppliers***

Failure of critical suppliers of parts, components andmanufacturing equipment to deliver sufficient quantities to us in a timely andcost-effective manner could negatively affect our business. We currently usenumerous vendors to supply parts, components and subassemblies for themanufacture and support of our products. Some key parts, however, may only beobtained from a single supplier or a limited group of suppliers. In particular,we rely on VDL Enabling Technologies Group, B.V., or ETG, and FrenckenMechatronics B.V. for our supply of mechanical parts and subassemblies;Gatan, Inc. for critical accessory products; and Neways Electronics, N.V.and Benchmark Electronics for some of our electronic subassemblies. Inaddition, some of our suppliers rely on sole suppliers. As a result of thisconcentration of key suppliers, our results of operations may be materially andadversely affected if we do not timely and cost-effectively receive asufficient quantity of parts to meet our production requirements or if we arerequired to find alternative suppliers for these supplies. We may not be ableto expand our supplier group or to reduce our dependence on single suppliers.From time to time, we have experienced supply constraints with respect to themechanical parts and subassemblies produced by ETG. If ETG is not able to meetour supply requirements, these constraints may affect our ability to deliverproducts to customers in a timely manner, which could have an adverse effect onour results of operations.

In addition, werely on a limited number of equipment manufacturers to develop and supply theequipment we use to manufacture our products. The failure of thesemanufacturers to develop or deliver quality equipment on a timely basis couldhave a material adverse effect on our business and results of operations. Inaddition, because we only have a few equipment suppliers, we may be moreexposed to future cost increases for this equipment.

***Cash and CashEquivalents***

Cash and cash equivalents include cashdeposits in banks, money market funds and other highly liquid marketablesecurities with maturities of three months or less at the date of acquisition.

***Restricted Cash***

Our restricted cash balances are held indeposit accounts with banks that have issued guarantees and letters of creditto our customers for system sales transactions and customer advance depositsrelating to prepayments for service contracts, mainly in Europe and Asia. Thisrestricted cash can be drawn on by the bank if goods are not delivered orservices are not properly performed. In addition, while the restricted cash isheld in the bank it is earning interest. Given these deposit accounts requiresatisfaction of conditions other than a withdrawal demand for us to receive areturn of principal, are interest bearing and are held for extended periods oftime, we have concluded these balances are similar in nature to our otherinvestments and that inclusion in investing activities on our statement of cashflows is appropriate and consistent with our treatment of other investments.

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***AccountsReceivable***

The roll-forward ofour accounts receivable allowance was as follows (in thousands):

 

| **Balance, December 31, 2003**  |   | $      | 4,985  |   |
|---------------------------------|--------|--------|--------|--------|
| Expense                         |   | 22     |   |
| Write-offs                      |   | (1,962 | )      |
| Translation  adjustments        |   | 177    |   |
| **Balance,  December 31, 2004** |   | 3,222  |   |
| Expense                         |   | 1,654  |   |
| Write-offs                      |   | (1,237 | )      |
| Translation  adjustments        |   | (334   | )      |
| **Balance,  December 31, 2005** |   | 3,305  |   |
| Expense                         |   | 729    |   |
| Write-offs                      |   | (110   | )      |
| Translation  adjustments        |   | 257    |   |
| **Balance, December 31, 2006**  |   | $      | 4,181  |   |

 

Write-offs includeamounts written off for specifically identified bad debts.

***Marketable Securities***

We account for our investments in marketablesecurities in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 115, “*Accounting for Certain Investments in Debt andEquity Securities*.” Our investments include marketable debtsecurities, corporate notes and bonds and government-backed securities withmaturities greater than 90 days at the time of purchase. Our fixed maturitysecurities are classified as available-for-sale securities and, accordingly,are carried at fair value, based on quoted market prices, with the unrealizedgains or losses reported, net of tax, in shareholders’ equity as component ofaccumulated other comprehensive income (loss). Given the highly liquid natureof variable-rate notes, cost is considered to approximate fair value for thesesecurities.

Certain equity securities held in short-term and long-terminvestments related to the executive deferred compensation plan are classifiedas trading securities. Investments designated as trading securities are carriedat fair value on the balance sheet, based on quoted market prices, with theunrealized gains or losses recorded in interest and other income in the periodincurred.

Realized gains and losses on all investments arerecorded on the specific identification method and are included in interest andother income. Investments with maturities greater than twelve months from thebalance sheet date are classified as non -current investments, unless they areexpected to be liquidated within the next twelve months; in which case, theinvestment is classified as current.

***Inventories***

***I***nventoriesare stated at the lower of cost or market, with cost determined by standardcost methods, which approximate the first-in, first-out method. Inventory costsinclude material, labor and manufacturing overhead. Service inventories thatexceed the estimated requirements for the next twelve months based on recentusage levels are reported as other long-term assets. Management has establishedinventory reserves based on estimates of excess and/or obsolete current and non-currentinventory.

***Income Taxes***

We account forincome taxes using the asset and liability method, which requires therecognition of deferred tax assets and liabilities for the expected future taxconsequences of temporary differences between the carrying amounts and taxbases of the assets and liabilities. In accordance with the provisions of SFASNo. 109, “*Accounting for Income Taxes,*”**we record a valuation allowance to reduce deferredtax assets to the amount expected to “more likely than not” be realized in ourfuture tax returns.  During 2006, wereleased a portion of the valuation allowance recorded against United Statesdeferred tax assets which were utilized during the period to offset 2006 UnitedStates taxable income. During 2005, we recorded valuation allowances againstUnited States deferred tax assets which originated during 2005 and also thosewhich existed prior to January 1, 2005.

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Should wedetermine that we would not be able to realize all or part of our remaining netdeferred tax assets in the future, additional increases to the valuationallowance for deferred tax assets may be required. Conversely, if we determinethat certain tax assets that have been reserved for may be realized in thefuture, we may reduce our valuation allowance in future periods. Our netdeferred tax assets totaled $0.5 million and $3.9 million, respectively, atDecember 31, 2006 and 2005 and our valuation allowance totaled $33.5 millionand $35.0 million, respectively.

We maintainreserves for estimated tax exposures in jurisdictions of operation, includingpotential interest and penalties on such exposures. These tax jurisdictionsinclude federal, state and various international tax jurisdictions. Significantincome tax exposures include potential challenges of net operating loss carry-backclaims, permanent establishment, capitalization of certain costs andintercompany pricing. Exposures are settled primarily through resolution ofaudits within these tax jurisdictions, but can also be affected by changes inapplicable tax law or other factors, which could cause management to believe arevision of past estimates is appropriate. Management believes that anappropriate liability has been established for estimated exposures; however,actual results may differ materially from these estimates.

***Property, Plant andEquipment***

Land is stated at cost. Buildings andimprovements are stated at cost and depreciated over estimated useful lives ofapproximately thirty-five years using the straight-line method. Machinery andequipment, including systems used in research and development activities,production and in demonstration laboratories, are stated at cost anddepreciated over estimated useful lives of approximately three to seven yearsusing the straight-line method. Leasehold improvements are amortized over theshorter of their economic lives or the lease term. Maintenance and repairs areexpensed as incurred. See Note 5 “*Asset Impairment Charges*”for a discussion of property, plant and equipment impairment charges incurredin 2006 and 2005.

Demonstrationsystems consist primarily of internally manufactured products and relatedaccessories that we use for marketing purposes in our demonstrationlaboratories (“NanoPorts”) or for trade shows. These systems are not held for sale and accordingly are recorded as acomponent of property, plant and equipment and depreciated using the straight-linemethod over their expected useful lives of approximately three to seven yearswith the expense being reflected as a component of selling, general andadministrative.

On occasion weloan systems to customers on a temporary basis while they wait for their toolto be manufactured or for evaluation. These systems are included in ourfinished goods inventories and the lending/evaluation periods are typically fora time period of less than one year. The sale of disposable products orservices is not typically included in these arrangements.  Any expense associated with these systems isrecorded as a component of cost of sales.

***Purchased Technology***

Purchased technology represents theestimated value of products utilizing technology existing as of the purchasedate, discounted to its net present value. Purchased technology is amortized ona straight-line basis over the estimated useful life of the technology,typically five to twelve years. See Note 5 “*Asset Impairment Charges*”for a discussion of purchased technology impairment charges incurred in 2005.

***Long-Lived AssetImpairment***

We evaluate, in accordance with SFAS No.144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets,*” theremaining life and recoverability of equipment and other assets that are to beheld and used, including purchased technology and other intangible assets withdefinite useful lives, whenever events or changes in circumstances indicatethat the carrying amount of the asset may not be recoverable. If there is anindication of impairment, we prepare an estimate of future, undiscounted cashflows expected to result from the use of the asset and its eventualdisposition. If these cash flows are less than the carrying value of the asset,we adjust the carrying amount of the asset to its estimated fair value. Long-livedassets to be disposed of by sale are valued at the lower of book value or fairvalue less cost to

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sell. See Note 5 “*AssetImpairment Charges*” for a discussion of long-lived asset impairmentcharges incurred in 2005.

***Investments in Privately-HeldCompanies***

We made investments in several small,privately held technology companies in which we hold less than 20% of thecapital stock or hold notes receivable. We account for these investments attheir cost unless their value has been determined to be other-than-temporarilyimpaired, in which case we write the investment down to its estimated fairvalue. We review these investments periodically for impairment and makeappropriate reductions in carrying value when an “other-than-temporary” declineis evident. However, for non-marketable equity securities, the impairmentanalysis requires significant judgment. We evaluate the financial condition ofthe investee, market conditions and other factors providing an indication ofthe fair value of the investments. Based on these actions, in 2006 and 2005, weconcluded that certain of these investments had “other-than-temporary”impairments and, accordingly, we recorded impairment charges totaling $3.9million and $2.9 million, respectively, as a component of other income(expense). As of December 31, 2006, all cost-method investments have beenwritten down to zero. See also Note 3 “*Investments*.”

***Goodwill***

Goodwillrepresents the excess purchase price over fair value of net assets acquired.Pursuant to SFAS No. 142, “*Goodwill and OtherIntangible Assets*,” goodwill and other identifiable intangibleassets with indefinite useful lives are no longer amortized, but, instead, atwo-step impairment test is performed at least annually, in accordance with theprovisions of SFAS No. 142. We test goodwill for impairment annually in thefourth quarter. First, the fair value of each reporting unit is compared to itscarrying value. We have defined our reporting units to be our operatingsegments as disclosed under SFAS No. 131, “*Disclosures about Segmentsof an Enterprise and Related Information*.”  If the fair value of the reporting unitexceeds the carrying value, goodwill is not impaired and no further testing isperformed. The second step is performed if the carrying value exceeds the fairvalue. The implied fair value of the reporting unit’s goodwill must bedetermined and compared to the carrying value of the goodwill.  If the carrying value of a reporting unit’sgoodwill exceeds its implied fair value, an impairment loss equal to thedifference will be recorded. No impairments were identified in step one of ourannual analysis during the fourth quarter of 2006, 2005 or 2004 as a result ofthis test.

Additionally, inthe second quarter of 2005, based on our then-current and projected operatingresults, we concluded that there were sufficient indicators to require us toassess whether the portion of our goodwill balance recorded within, what wasthen, our microelectronics reporting unit was impaired. We applied the two-stepimpairment test described above. In determining the fair value used in step oneof the impairment analysis for the microelectronics reporting unit, we employedthe market approach, consisting of the market comparable methodology. Themarket comparable methodology involves comparing the reporting unit to similarpublicly held companies whose equity securities are actively traded on a publicmarket. Financial multiples of the comparable public companies are computed andthese multiples were then applied to the reporting unit’s operating results toestimate their fair value.  The estimatedfair value of the reporting unit exceeded its carrying value and, accordingly,no further impairment analysis was required.

***Segment Reporting***

Based upondefinitions contained within SFAS No. 131, “*Disclosuresabout Segments of an Enterprise and Related Information*,” we havedetermined that we operate in four reportable operating segments:NanoElectronics, NanoResearch and Industry, NanoBiology and Service andComponents. There are no differences between the accounting policies used forour business segments compared to those used on a consolidated basis.

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***Revenue Recognition***

For products produced according to ourpublished specifications, revenue is recognized when title to the product andthe risks and rewards of ownership pass to the customer. For products producedaccording to a particular customer’s specifications, revenue is recognized whenthe product meets the customer’s specifications and when title and the risksand rewards of ownership have passed to the customer. In each case, the portionof revenue applicable to installation and customer acceptance is recognizedupon meeting specifications at the installation site. For new applications ofour products where performance cannot be assured prior to meetingspecifications at the installation site, no revenue is recognized until suchspecifications are met.

Our billing terms on TEM, SEM, FIB and *DualBeam* systems generally include aholdback of 10% to 20% of the total purchase price subject to completion ofinstallation and final acceptance at the customer site. The estimated fairvalue of revenue related to installation and final acceptance, which wasapproximately 4% as of December 31, 2006, is deferred until such installationand final acceptance are completed.

We recognize software license and support revenues inaccordance with AICPA Statement of Position (“SOP”) 97-2, “*SoftwareRevenue Recognition,*” or SOP 97-2, as amended by SOP 98-9. SOP 97-2provides specific industry guidance and stipulates that revenue recognized fromsoftware arrangements is to be allocated to each element of the arrangementbased on the relative fair value of the elements. Under SOP 97-2, thedetermination of fair value is based on objective evidence that is specific tothe vendor. We utilize the residual method under which revenue is allocated tothe undelivered element, based on vendor specific evidence of fair value, andthe residual amount of revenue is allocated to the delivered element. Werecognize license revenues upon delivery of the software.

We generally provide consulting and training serviceson a time and materials basis and provide maintenance and support servicesunder renewable, term maintenance agreements. Maintenance and support feerevenue is recognized ratably over the contractual term, which is generallytwelve months, and commences from contract date.

***Deferred Revenue***

Deferred revenue represents customerdeposits on equipment orders, orders awaiting customer acceptance and prepaidservice contract revenue. Deferred revenue is recognized in accordance with ourrevenue recognition policies described above.

***Product Warranty Costs***

Our products generally carry a one-yearwarranty. A reserve is established at the time of sale to cover estimatedwarranty costs as a component of cost of sales on our consolidated statementsof operations. Our estimate of warranty cost is based on our history ofwarranty repairs and maintenance. While most new products are extensions ofexisting technology, the estimate could change if new products require asignificantly different level of repair and maintenance than similar productshave required in the past. Our estimated warranty costs are reviewed andupdated on a quarterly basis. Historically, we have not made significantadjustments to our estimates; however, in the third quarter of 2005, we reducedour warranty reserve by approximately $1.0 million as a result of our continualreview of the actual warranty repair and maintenance activity, which was belowour initial reserve estimates. No significant adjustments have been made to ourestimates in 2006.

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A roll-forwardof our warranty liability for the years ended December 31, 2006, 2005 and 2004was as follows (in thousands):

 

| **Balance, December 31, 2003**          |   | $       | 9,205  |   |
|-----------------------------------------|--------|---------|--------|--------|
| Reductions for  warranty costs incurred |   | (12,729 | )      |
| Warranties  issued                      |   | 11,683  |   |
| Translation  adjustments                |   | 914     |   |
| **Balance,  December 31, 2004**         |   | 9,073   |   |
| Reductions for  warranty costs incurred |   | (13,998 | )      |
| Warranties  issued                      |   | 9,336   |   |
| Translation  adjustments                |   | 782     |   |
| **Balance,  December 31, 2005**         |   | 5,193   |   |
| Reductions for  warranty costs incurred |   | (11,143 | )      |
| Warranties  issued                      |   | 11,686  |   |
| Translation  adjustments                |   | (20     | )      |
| **Balance, December 31, 2006**          |   | $       | 5,716  |   |

 

***Research and Development***

Research and development costs areexpensed as incurred. We periodically receive funds from various organizationsto subsidize our research and development. These funds are reported as anoffset to research and development expense. These subsidies totaled $3.9million, $4.6 million and $8.8 million in 2006, 2005 and 2004, respectively.Subsidies have decreased as the projects available for subsidies, primarily inthe Netherlands and the U.S., have decreased.

***Advertising***

Advertising costs are expensed asincurred and are included as a component of selling, general and administrativecosts on our consolidated statements of operations. Advertising expense totaled$2.9 million, $2.6 million and $2.9 million in 2006, 2005 and 2004,respectively.

***Computation of Per Share Amounts***

Basic earnings pershare (“EPS”) and diluted EPS are computed using the methods prescribed by SFASNo. 128, “*Earnings per Share*.”  Following is a reconciliation of basic EPSand diluted EPS (in thousands, except per share amounts):

 
| ** **                                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                                                                                        | ** ** | **Net Income**                        | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
| **Basic  EPS**                                                                                    |       | $                                          | 20,040     |   | 33,818 |   | $ | 0.59 |   | $ | (78,158 | ) | 33,595 |   | $ | (2.33 | ) |
| Dilutive effect  of zero coupon convertible subordinated notes                                    |       | 968                                        |       | 5,529 |   | (0.06 | ) |  — |   |  — |   |  — |   |
| Dilutive effect  of stock options calculated using the treasury stock method                      |       |  —                               |       | 142 |   |  — |   |  — |   |  — |   |  — |   |
| Dilutive effect  of restricted shares                                                             |       |  —                               |       | 78 |   |  — |   |  — |   |  — |   |  — |   |
| Dilutive effect  of shares issuable to Philips                                                    |       |  —                               |       | 185 |   |  — |   |  — |   |  — |   |  — |   |
| Diluted EPS                                                                                       |       | 21,008                                     |       | 39,752 |   | $ | 0.53 |   | $ | (78,158 | ) | 33,595 |   | $ | (2.33 | ) |
|                                                                                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| **Potential  common shares excluded from diluted EPS since their effect would be  antidilutive:** |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Stock options,  restricted shares and restricted stock units                                      |       |                                       |       | — |   |   |   |   |   | 3,543 |   |   |   |
| Convertible Debt                                                                                  |       |                                       |       | 4,845 |   |   |   |   |   | 7,043 |   |   |   |
|                                                                                                   |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                                                                                        | ** ** | **Year Ended December 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                        | ** ** | **Net Income**                                  | ** ** | **Shares** | ** ** | **Per Share   Amount** | ** ** |
| **Basic  EPS**                                                                                    |       | $                                                    | 16,573     |   | 33,253 |   | $ | 0.50 |   |
| Dilutive effect  of zero coupon convertible subordinated notes                                    |       | 351                                                  |       | 5,529 |   | (0.06 | ) |
| Dilutive effect  of stock options calculated using the treasury stock method                      |       | —                                               |       | 690 |   | (0.01 | ) |
| Dilutive effect  of shares issuable to Philips                                                    |       | —                                               |       | 196 |   | — |   |
| **Diluted  EPS**                                                                                  |       | $                                                    | 16,924     |   | 39,668 |   | $ | 0.43 |   |
|                                                                                              |       |                                                 |       |   |   |   |   |
| **Potential  common shares excluded from diluted EPS since their effect would be  antidilutive:** |       |                                                 |       |   |   |   |   |
| Stock options,  restricted shares and restricted stock units                                      |       |                                                 |       | 2,361 |   |   |   |
| Convertible Debt                                                                                  |       |                                                 |       | 2,928 |   |   |   |

 

***Stock-Based Compensation***

Effective January1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No.123R, “Share-Based Payment.” We elected to use the modified prospectivetransition method as provided by SFAS No. 123R and, accordingly, financialstatement amounts for the prior periods presented in this Form 10-K have notbeen restated to reflect the fair value method of expensing stock-basedcompensation.  Under this method, theprovisions of SFAS No. 123R apply to all awards granted or modified after thedate of adoption. In addition, the unrecognized expense of awards not yetvested at the date of adoption is recognized in net income in the periods afterthe date of adoption over the remainder the requisite service period. Thecumulative effect of the change in accounting principle from AccountingPrinciples Board (“APB”) Opinion No. 25, “*Accounting for StockIssued to Employees*” to SFAS No. 123R was not material.

Prior to January 1,2006, we accounted for stock-based compensation using the intrinsic valuemethod as prescribed by APB Opinion No. 25 and related interpretations.  We provided disclosures of net loss and netloss per share as prescribed by SFAS No. 123, “*Accountingfor Stock-Based Compensation*,”as if it had been applied in measuring compensation expense as follows (inthousands, except per share amounts):

 
| **Year Ended December 31,**                                                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net (loss)  income, as reported                                                                                                                         |       | $        | (78,158    | )        | $          | 16,573 |   |
| Deduct — total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (34,379  | )          | (12,403  | )          |
| Net (loss)  income, pro forma                                                                                                                           |       | $        | (112,537   | )        | $          | 4,170 |   |
| Basic net (loss)  income per share:                                                                                                                     |       |     |       |     |       |
| As reported                                                                                                                                             |       | $        | (2.33      | )        | $          | 0.50 |   |
| Pro forma                                                                                                                                               |       | $        | (3.35      | )        | $          | 0.13 |   |
| Diluted net  (loss) income per share:                                                                                                                   |       |     |       |     |       |
| As reported                                                                                                                                             |       | $        | (2.33      | )        | $          | 0.43 |   |
| Pro forma                                                                                                                                               |       | $        | (3.35      | )        | $          | 0.11 |   |

 

We did not record any tax benefit for United Stateslosses generated in 2005. Accordingly, the only tax benefit reflected in thepro forma stock-based employee compensation expense in 2005 was for non-UnitedStates based awards.

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Certaininformation regarding our stock-based compensation was as follows (inthousands):
| **Year Ended December 31,**                                                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Weighted average  grant-date fair value of share options granted                              |       | $        | 6,069      |     | $          | 18,751   |       | $ | 27,845 |   |
| Weighted average  grant-date fair value of restricted shares and restricted stock units       |       | 7,458    |       | 432      |       | —   |       |
| Total intrinsic value  of share options exercised                                             |       | 3,711    |       | 1,699    |       | 1,326    |       |
| Fair value of  restricted shares vested                                                       |       | 57       |       | —   |       | —   |       |
| Stock-based  compensation recognized in statement of operations                               |       | 12,860   |       | 58       |       | —   |       |
| Cash received from  options exercised and shares purchased under all share-based arrangements |       | 13,147   |       | 5,878    |       | 3,476    |       |
| Tax benefit realized (reversed) for stock options                                             |       | 1,422    |       | (400     | )          | 415      |       |
|                                                                                               |            |          |            |          |            |          |            |  |  |  |

 

Our stock-based compensation expense was included inour statements of operations as follows (in thousands):
| **Year Ended December 31,**                                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cost of sales                                                                |       | $        | 825        |     | $          | —   |       | $ | — |   |
| Research and  development                                                    |       | 852      |       | —   |       | —   |       |
| Selling, general and  administrative                                         |       | 4,053    |       | 58       |       | —   |       |
| Restructuring, reorganization,  relocation and CEO severance related         |       | 7,090    |       | —   |       | —   |       |
|                                                                         |       | 12,820   |       | 58       |       | —   |       |
| Stock-based  compensation included as a component of discontinued operations |       | 40       |       | —   |       | —   |       |
|                                                                         |       | $        | 12,860     |     | $          | 58       |       | $ | — |   |

 

Compensation expense related to restricted shares andrestricted stock units is based on the fair value of the underlying shares onthe date of grant as if the shares were vested. Compensation expense related tooptions granted pursuant to our stock incentive plans and shares purchasedpursuant to our employee share purchase plan was determined based on theestimated fair values using the Black-Scholes option pricing model and thefollowing weighted average assumptions:
| **Year Ended December 31,** | ** ** | **2006**   | ** ** | **2005**    | ** ** | **2004**         | ** ** |
|--------------------------------------------|------------|------------|------------|-------------|------------|------------------|------------|
| Risk-free interest rate                    |       | 2.8% - 5.1 | %          | 2.8% - 4.36 | %          | 2.75% to 3.70%   |       |
| Dividend yield                             |       | 0.0        | %          | 0.0         | %          | 0.0              | %          |
| Expected lives:                            |       |       |       |        |       |             |       |
| Option plans                               |       | 4.8 years  |       | 5.5 years   |       | 5.5 to 5.8 years |       |
| Employee share  purchase plan              |       | 6 months   |       | 6 months    |       | 6 months         |       |
| Volatility                                 |       | 69% - 74   | %          | 71% - 74    | %          | 74% to 77%       |       |
| Discount for post vesting restrictions     |       | 0.0        | %          | 0.0         | %          | 0.0              | %          |

 

The risk-free rate used is based on the U.S. Treasuryyield over the estimated term of the options granted. Expected lives wereestimated based on the average between the stock option awards’ vest date andtheir contractual life. The expected volatility is calculated based on thehistorical volatility of our common stock.

We amortize stock-based compensation expense relatedto options granted prior to the adoption of SFAS No. 123R on a ratable basisand related to options granted after the adoption of SFAS No. 123R andrestricted shares and restricted stock units on a straight-line basis over thevesting period of the individual award with estimated forfeitures considered.Vesting periods are generally four years. Shares to be issued upon the exerciseof stock options will come from newly issued shares. The exercise price ofissued options equals the grant date fair value of the underlying shares andthe options generally have a legal life of seven years. Stock-based compensationcosts related to inventory or fixed assets were not significant in the yearended December 31, 2006.

***Foreign CurrencyTranslation***

Assets and liabilities denominated in aforeign currency, where the local currency is the functional currency, are translatedto U.S. dollars at the exchange rate in effect on the respective balance sheetdate. Gains and losses resulting from the translation of assets, liabilitiesand equity are included in accumulated other comprehensive income on theconsolidated balance sheet. Transactions representing revenues, costs andexpenses are translated using an average rate of exchange for the period, andthe

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related gains and losses are reported asother income (expense) on our consolidated statement of operations.

***Reclassifications***

The following reclassifications were madeto the prior year financial statements to conform to the current yearpresentation:

·                  otherreceivables and product-related liabilities were reclassified within line itemsin net cash provided by operating activities;

·                  assetsand liabilities of discontinued operations were reclassified out of thecorresponding asset and liability classifications to reflect discontinuedoperations; and

·                  ourresults of operations were reclassified to reflect discontinued operations.

**2.**                                      RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

***SFAS No. 159***

In February2007,******the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 159, “*The FairValue Option for Financial Assets and Financial Liabilities*,” whichpermits entities to choose to measure many financial instruments and certainother items at fair value. SFAS No. 159 is effective as of the beginning of anentity’s first fiscal year that begins after November 15, 2007. We arecurrently analyzing the effects of adopting SFAS No. 159.

***SFAS No. 158***

In September2006,******the FASB issuedSFAS No. 158, “*Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans*,” which requires employers torecognize on their balance sheets the funded status of pension and other postretirementbenefit plans, effective December 31, 2006 for calendar year-end companies. Inaddition SFAS No. 158 requires fiscal year-end measurement of plan assets andbenefit obligations, eliminating the use of earlier measurement dates currentlypermissible, effective for fiscal years ending after December 15, 2008. Weadopted SFAS No. 158 in the fourth quarter of 2006. The adoption of SFAS No.158 did not have a material effect on our financial position or results ofoperations.

***SFAS No. 157***

In September2006, the FASB issued SFAS No. 157, “*Fair Value Measurements*,”which establishes a single authoritative definition of fair value, sets out aframework for measuring fair value and requires additional disclosures aboutfair-value measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007.  While we arestill analyzing the effects of applying SFAS No. 157, we believe that theadoption of SFAS No. 157 will not have a material effect on our financialposition or results of operations.

***Staff AccountingBulletin No. 108***

In September2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”)No. 108, “*Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*,”which addresses how the effects of prior-year uncorrected misstatements shouldbe considered when quantifying misstatements in current-year financialstatements. SAB No. 108 requires companies to quantify misstatements using boththe balance sheet and income statement approaches and to evaluate whethereither approach results in quantifying an error that is material in light ofrelevant quantitative and qualitative factors. SAB No. 108 is effective forannual financial statements covering the first fiscal year ending afterNovember 15, 2006. We adopted SAB No. 108 in the fourth quarter of 2006. Theadoption of SAB No. 108 did not have a material effect on our financialposition or results of operations.

*** FASB Interpretation No. 48***

In July 2006,the FASB issued Interpretation No. 48, “*Accounting for Uncertaintyin Income Taxes*,” which defines the threshold for recognizing thebenefits of tax return positions in the financial statements as “more-likely-than-not”to be sustained by the taxing authority. Interpretation No. 48 applies to alltax

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positionsaccounted for under SFAS No. 109, “*Accounting for IncomeTaxes*.” Interpretation No. 48 is effective as of the beginning ofthe first fiscal year beginning after December 15, 2006. Upon adoption, we willadjust our financial statements to reflect only those tax positions that aremore-likely-than-not to be sustained as of the adoption date. Any adjustmentwill be recorded directly to our beginning retained earnings balance in theperiod of adoption and reported as a change in accounting principle. We arecurrently analyzing the effects of adopting Interpretation No. 48.

**3.**                                      INVESTMENTS

Investments held atDecember 31, 2006 consisted of the following (in thousands):
| ** **                    | ** ** | **Cost  basis** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair  value(1)** | ** ** | **Short  term  investments** | ** ** | **Long  term  investments** | ** ** |
|-------------------------------|------------|-----------------|------------|-----------------------|------------|------------------------|------------|-------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Fixed  Maturities**         |       |            |       |                  |       |                   |       |                          |       |                         |       |                        |       |
| Corporate notes  and bonds    |       | $               | 34,578     |                  | $          | 2                      |       | $                             | (22        | )                            | $          | 34,558                      |       | $ | 34,558 |   | $ | — |   |
| Government-backed  securities |       | 98,882          |       | 5                     |       | (491                   | )          | 98,396                        |       | 65,444                       |       | 32,952                      |       |
| Variable-rate  notes          |       | 133,400         |       | —                |       | —                 |       | 133,400                       |       | 133,400                      |       | —                      |       |
| Other                         |       | 800             |       | —                |       | —                 |       | 800                           |       | 800                          |       | —                      |       |
| Fixed maturity securities     |       | 267,660         |       | 7                     |       | (513                   | )          | 267,154                       |       | 234,202                      |       | 32,952                      |       |
|                          |       |            |       |                  |       |                   |       |                          |       |                         |       |                        |       |
| **Equity  Securities**        |       |            |       |                  |       |                   |       |                          |       |                         |       |                        |       |
| Common stock and  equivalents |       | —          |       | —                |       | —                 |       | —                        |       | —                       |       | —                      |       |
| Preferred stock               |       | —          |       | —                |       | —                 |       | —                        |       | —                       |       | —                      |       |
| Other  investments            |       | 1,857           |       | 91                    |       | —                 |       | 1,948                         |       | —                       |       | 1,948                       |       |
| Equity securities             |       | 1,857           |       | 91                    |       | —                 |       | 1,948                         |       | —                       |       | 1,948                       |       |
|                          |       | $               | 269,517    |                  | $          | 98                     |       | $                             | (513       | )                            | $          | 269,102                     |       | $ | 234,202 |   | $ | 34,900 |   |

 

Investments held atDecember 31, 2005 consisted of the following (in thousands):
| ** **                    | ** ** | **Cost  basis** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair  value(1)** | ** ** | **Short  term  investments** | ** ** | **Long  term  investments** | ** ** | **Other  assets (1)** | ** ** |
|-------------------------------|------------|-----------------|------------|-----------------------|------------|------------------------|------------|-------------------------------|------------|------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **Fixed  Maturities**         |       |            |       |                  |       |                   |       |                          |       |                         |       |                        |       |                       |       |
| Corporate notes  and bonds    |       | $               | 9,863      |                  | $          | —                 |       | $                             | (118       | )                            | $          | 9,745                       |       | $                          | 6,532      |   | $ | 1,987 |   | $ | 1,226 |   |
| Government-backed  securities |       | 62,006          |       | —                |       | (1,252                 | )          | 60,754                        |       | 19,817                       |       | 40,937                      |       | —                     |       |
| Variable-rate  notes          |       | 129,700         |       | —                |       | —                 |       | 129,700                       |       | 129,700                      |       | —                      |       | —                     |       |
| Fixed maturity securities     |       | 201,569         |       | —                |       | (1,370                 | )          | 200,199                       |       | 156,049                      |       | 42,924                      |       | 1,226                      |       |
|                          |       |            |       |                  |       |                   |       |                          |       |                         |       |                        |       |                       |       |
| **Equity  Securities**        |       |            |       |                  |       |                   |       |                          |       |                         |       |                        |       |                       |       |
| Common stock and  equivalents |       | 250             |       | —                |       | —                 |       | 250                           |       | —                       |       | —                      |       | 250                        |       |
| Preferred stock               |       | 1,810           |       | —                |       | —                 |       | 1,810                         |       | —                       |       | —                      |       | 1,810                      |       |
| Other  investments            |       | 1,662           |       | 27                    |       | (11                    | )          | 1,678                         |       | —                       |       | 1,678                       |       | —                     |       |
| Equity securities             |       | 3,722           |       | 27                    |       | (11                    | )          | 3,738                         |       | —                       |       | 1,678                       |       | 2,060                      |       |
|                          |       | $               | 205,291    |                  | $          | 27                     |       | $                             | (1,381     | )                            | $          | 203,937                     |       | $                          | 156,049    |   | $ | 44,602 |   | $ | 3,286 |   |

 

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(1)          Investments for which it is not practical to estimate fair value areincluded at cost and primarily consist of investments in privately-held companies.

Realized gains andlosses on sales of marketable securities were insignificant in 2006, 2005 and2004.

We reviewinvestments in debt and equity securities for other than temporary impairmentwhenever the fair value of an investment is less than amortized cost andevidence indicates that an investment’s carrying amount is not recoverablewithin a reasonable period of time. In the evaluation of whether an impairmentis “other-than-temporary,” we consider our ability and intent to hold theinvestment until the market price recovers, the reasons for the impairment,compliance with our investment policy, the severity and duration of theimpairment and expected future performance. As of December 31, 2006, $98.9million of government-backed securities and $34.6 million of corporate notesand bonds had unrealized losses of $22,000 and $0.5 million, respectively.These unrealized losses are mainly due to interest rate movements, and nounrealized losses of any significance existed for a period in excess of twelvemonths.

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For investments insmall privately-held companies, which are recorded at cost, it is often notpractical to estimate fair value. In order to assess if impairments exist thatare “other-than-temporary,” we reviewed recent interim financial statements andheld discussions with these entities’ management about their current financialconditions and future economic outlooks. We also considered our willingness tosupport future funding requirements as well as our intention and/or ability tohold these investments long-term. Based on these actions, in 2006 and 2005, weconcluded that certain of these investments had “other-than-temporary”impairments and, accordingly, we recorded impairment charges totaling $3.9million and $2.9 million, respectively, as a component of other income(expense). Additionally, we recorded a loss of $3.5 million in 2005 as acomponent of other income (expense) related to the liquidation of a portion ofa convertible note investment.

Following the 2005charges discussed above, at December 31, 2005, our cost-method investments inprivately-held companies totaled $2.1 million and the convertible debentures weheld with one of these privately-held companies totaled $1.2 million. During2006, we sold one cost-method investment for a gain of $5.2 million and wroteoff our last remaining cost-method investment, incurring a charge of $3.9million, and, accordingly, at December 31, 2006, all cost-method investmentshave been written down to zero.

Contractualmaturities or expected liquidation dates of long-term marketable securities atDecember 31, 2006 were as follows (in thousands):

|                               | ** ** | **1 - 2 years** | ** ** | **3 years** | ** ** | **Total** | ** ** |
|-------------------------------|------------|--------------------------------|------------|------------------|------------|-----------|------------|
| Government-backed  securities |       | $                              | 32,952     |             | $          | —    |       | $ | 32,952 |   |
| Corporate notes  and bonds    |       | —                         |       | —           |       | —    |       |
|                          |       | $                              | 32,952     |             | $          | —    |       | $ | 32,952 |   |

 

**4.             FACTORING OF ACCOUNTS RECEIVABLE**

In 2006 and 2005,we entered into agreements under which we sold a total of $2.0 million and $3.4million, respectively, of our accounts receivable at a discount to unrelatedthird party financiers without recourse. The transfer qualified for salestreatment under SFAS No. 140, “*Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.”Discounts related to the sale of the receivables, which were immaterial, wererecorded on our statements of operations as other expense.

**5.             ASSET IMPAIRMENT CHARGES**

We initiatedrestructuring actions in the second quarter of 2005, which continued into 2006,to align our cost structure with the current prevailing market conditions,primarily in the semiconductor markets. The actions taken to date, which werenecessary as a result of reduced business volumes, resulted in decreases in ourglobal workforce and also required us to evaluate our goodwill and long-lived assetsfor impairment in components of our segment previously known as our microelectronicssegment.

As a result ofthese evaluations, we recorded asset impairment charges and write-downstotaling $39.6 million in 2005 as either components of asset impairment or costof sales on our consolidated statements of operations.  These charges are summarized as follows (inthousands):

| Year Ended December 31, 2005 | ** ** | **Asset  Impairment** | ** ** | **Cost of   Sales** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------|------------|
| Inventory                                        |       | $                     | —     |                          | $          | 11,016    |       | $ | 11,016 |   |
| Purchased  technology                            |       | 9,328                 |       | —                        |       | 9,328     |       |
| Property, plant  and equipment                   |       | 7,479                 |       | —                        |       | 7,479     |       |
| Capitalized  software                            |       | —                |       | 3,223                         |       | 3,223     |       |
| ERP system  abandonment                          |       | 7,634                 |       | —                        |       | 7,634     |       |
| Patents and  other intangibles                   |       | 911                   |       | —                        |       | 911       |       |
|                                             |       | $                     | 25,352     |                          | $          | 14,239    |       | $ | 39,591 |   |

 

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In addition, in2006, we recorded an additional $0.5 million charge as asset impairments on ourconsolidated statements of operations related to the write-off of additionalcosts for our enterprise resource planning (“ERP”) system abandonment.

*Inventory*

Write-downs ofinventory in 2005 related to portions of our semiconductor businesses and tothe closure of our Peabody, Massachusetts facility, which primarilymanufactured and supported products sold to semiconductor markets. In responseto the declining product demand which continued throughout 2005, managementdecided to restructure these businesses, which included lowering demandexpectations and accepting a significant price adjustment of approximately $1.0million below cost to complete a sale on a product that we were deemphasizingin the market place.

*Goodwill*

We test goodwillannually in the fourth quarter, however, in the second quarter of 2005, basedon our current and projected operating results, we concluded that there weresufficient indicators to require us to assess whether a portion of our recordedgoodwill balance within our microelectronics segment was impaired at thisinterim date. The impairment review was performed in accordance with SFAS No.142, *“Goodwill and Other Intangible Assets.”*Based on these analyses, we concluded that the goodwill allocated to thissegment was not impaired.

*Long-LivedAssets*

As a result of theinitiation of our restructuring actions and due to the weakness in thesemiconductor market, our projected future revenues and cash flows for certainasset groupings were revised downward in the second quarter of 2005. Thesefactors led to indications that the carrying value of certain of our long-livedassets, including purchased intangibles recorded in various acquisitions, property,plant and equipment and patents and other intangibles, may not be recoverableand we performed impairment reviews as of July 3, 2005. The impairment reviewswere performed in accordance with SFAS No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets.*”  Weevaluated the recoverability of the long-lived assets and concluded thatimpairments existed. Accordingly, we recorded impairment charges based on theamounts by which the carrying amounts of these assets exceeded their fair value.Fair value was determined based on discounted cash flows for the operatingentities that had separately identifiable cash flows. In addition, in thefourth quarter of 2005, we decided to abandon our ERP system project and,accordingly, wrote off all costs related to this project. In total, impairmentcharges for long-lived assets were $25.4 million in 2005.

**6.             INVENTORIES**

Inventories consisted of the following (inthousands):

|                                                      | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Raw materials  and assembled parts                   |       | $                     | 28,475     |   | $ | 22,295 |   |
| Service  inventories, estimated current requirements |       | 15,237                |       | 12,339 |   |
| Work-in-process                                      |       | 35,459                |       | 36,954 |   |
| Finished goods                                       |       | 18,299                |       | 13,291 |   |
| Total  inventories                                   |       | $                     | 97,470     |   | $ | 84,879 |   |
|                                                 |       |                  |       |   |   |
| Non-current service  inventories                     |       | $                     | 37,920     |   | $ | 33,869 |   |

 

Provision forinventory valuation adjustments were immaterial in 2006 and totaled $10.1million and $1.7 million, respectively, during 2005 and 2004 (inclusive of thewrite-downs discussed in Note 5). Provision for service inventory valuationadjustments totaled $4.2 million, $2.9 million and $2.6 million, respectively,in 2006, 2005 and 2004.

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**7.             PROPERTY,PLANT AND EQUIPMENT**

Property, plant and equipment consistedof the following (in thousands):

 

|                                           | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Land                                      |       | $                     | 7,769      |   | $ | 7,769 |   |
| Buildings and  improvements               |       | 17,493                |       | 17,244 |   |
| Leasehold improvements                    |       | 5,431                 |       | 5,484 |   |
| Machinery and equipment                   |       | 56,110                |       | 37,435 |   |
| Demonstration systems                     |       | 22,345                |       | 35,842 |   |
| Other fixed assets                        |       | 19,666                |       | 20,816 |   |
|                                      |       | 128,814               |       | 124,590 |   |
| Accumulated  depreciation                 |       | (68,420               | )          | (65,783 | ) |
| Total property, plant  and equipment, net |       | $                     | 60,394     |   | $ | 58,807 |   |

 

Seealso Note 5 for a discussion of long-lived asset impairments.

**8.             GOODWILL, PURCHASED TECHNOLOGY AND OTHER INTANGIBLEASSETS**

Theroll-forward of our goodwill was as follows (in thousands):

|                             | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Balance, beginning of  year |       | $                                          | 40,902     |   | $ | 40,986 |   |
| Adjustments to goodwill     |       | (2                                         | )          | (84 | ) |
| Balance, end of year        |       | $                                          | 40,900     |   | $ | 40,902 |   |

 

Adjustments to goodwillinclude translation adjustments resulting from a portion of our goodwill beingrecorded on the books of our foreign subsidiaries.

At December 31, 2006 and2005, our other intangible assets included purchased technology, capitalizedsoftware and patents, trademarks and other and note issuance costs. Thegross amount of our other intangible assets and the related accumulatedamortization were as follows (in thousands):

 

|                                                            | ** ** | **Amortization** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **Period**       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Purchased technology                                       |       | 5  to 12 years   |       | $                     | 46,062     |   | $ | 45,787 |   |
| Accumulated  amortization                                  |       |             |       | (41,568               | )          | (39,433 | ) |
|                                                       |       |             |       | $                     | 4,494      |   | $ | 6,354 |   |
|                                                       |       |             |       |                  |       |   |   |
| Capitalized software                                       |       | 3  years         |       | $                     | 9,921      |   | $ | 11,517 |   |
| Accumulated  amortization                                  |       |             |       | (9,921                | )          | (11,391 | ) |
|                                                       |       |             |       | —                |       | 126 |   |
|                                                       |       |             |       |                  |       |   |   |
| Patents, trademarks and  other                             |       | 2  to 15 years   |       | 3,118                 |       | 2,919 |   |
| Accumulated  amortization                                  |       |             |       | (2,034                | )          | (1,628 | ) |
|                                                       |       |             |       | 1,084                 |       | 1,291 |   |
|                                                       |       |             |       |                  |       |   |   |
| Note issuance costs                                        |       | 5  to 7 years    |       | 13,887                |       | 10,858 |   |
| Accumulated  amortization                                  |       |             |       | (9,175                | )          | (7,353 | ) |
|                                                       |       |             |       | 4,712                 |       | 3,505 |   |
| Total intangible assets included in other long-term assets |       |             |       | $                     | 5,796      |   | $ | 4,922 |   |

 

See Note 5 for a discussion of impairmentcharges and write-offs related to purchased software, capitalized software andpatents recognized during 2005.

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See Note 10 for a discussion of noteissuance cost write-offs totaling $0.3 million and $1.1 million, respectively,related to the convertible note redemptions in 2006 and 2005.

Amortization expense, excludingimpairment charges and note issuance cost write-offs, was as follows (inthousands):

 

|                                | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Purchased technology           |       | $                                          | 2,034      |   | $ | 3,819 |   | $ | 5,368 |   |
| Capitalized software           |       | 131                                        |       | 2,100 |   | 4,268 |   |
| Patents, trademarks and  other |       | 502                                        |       | 519 |   | 670 |   |
| Note issuance costs            |       | 1,490                                      |       | 1,447 |   | 1,655 |   |
|                           |       | $                                          | 4,157      |   | $ | 7,885 |   | $ | 11,961 |   |

 

Expectedamortization, without consideration for foreign currency effects, is as follows(in thousands):

 

|            | ** ** | **Purchased   Technology** | ** ** | **Patents,   Trademarks  and Other** | ** ** | **Note   Issuance   Costs** | ** ** |
|------------|------------|---------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| 2007       |       | $                               | 1,761      |                                           | $          | 475                                   |       | $ | 1,639 |   |
| 2008       |       | 1,761                           |       | 177                                            |       | 1,082                                 |       |
| 2009       |       | 616                             |       | 131                                            |       | 451                                   |       |
| 2010       |       | 356                             |       | 127                                            |       | 451                                   |       |
| 2011       |       | —                          |       | 68                                             |       | 451                                   |       |
| Thereafter |       | —                          |       | 106                                            |       | 638                                   |       |
|            |            |                                 |            |                                                |            |                                       |            |  |  |  |

** **

**9.**                                      CREDITFACILITIES

We maintain a$30.0 million uncommitted bank borrowing facility in the United States (andoutside the United States for our international subsidiaries under the guaranteeof the parent company), of which $5.0 million is available on an unsecuredbasis. We also have a 50.0 million Yen unsecured and uncommitted bank borrowingfacility in Japan and various limited facilities in select foreigncountries. At December 31, 2006, a total of $30.0 million was availableunder these facilities. As part of our contracts with certain customers, we arerequired to provide letters of credit or bank guarantees which these customerscan draw against in the event we do not perform in accordance with ourcontractual obligations. At December 31, 2006, we had $33.0 million of theseguarantees and letters of credit outstanding, of which approximately $26.3million were secured by restricted cash deposits. Restricted cash balancessecuring bank guarantees that expire within twelve months of the balance sheetdate are recorded as a current asset on our consolidated balance sheets.Restricted cash balances securing bank guarantees that expire beyond twelvemonths from the balance sheet date are recorded as long-term restricted cash onour consolidated balance sheet.

**10.**                               CONVERTIBLENOTES

***2.875%Convertible Subordinated Notes***

On May 19, 2006,we issued $115.0 million aggregate principal amount of convertible subordinatednotes. The interest rate on the notes is 2.875%, payable semi-annually. Thenotes are due on June 1, 2013, are subordinated to all previously existing andfuture senior indebtedness, are effectively subordinated to all indebtednessand other liabilities of our subsidiaries, and rank pari passu in right ofpayment with our zero coupon convertible subordinated notes and our 5.5%convertible subordinated notes. The cost of this transaction, includingunderwriting discounts and commissions and offering expenses, totaled $3.1million and is recorded on our balance sheet in other long-term assets and isbeing amortized over the life of the notes. The amortization of these coststotals $0.1 million per quarter and is reflected as additional interest expensein our statements of operations. The notes are convertible into 3,918,395shares of our common stock, at the note holder’s option, at a price of $29.35per share.

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***5.5%Convertible Subordinated Notes***

On August 3, 2001, we issued $175.0million of convertible subordinated notes, due August 15, 2008, through aprivate placement.  The notes arecurrently redeemable at our option. The notes bear interest at 5.5%, payablesemi-annually. The notes are convertible into shares of our common stock, atthe noteholder’s option, at a price of $49.52 per share. We have made thefollowing redemptions of these notes:

 

| Date          | ** ** | **Amount   Redeemed** | ** **   | **Redemption   Price** | ** **      | **Redemption   Premium** | ** ** | **Related Note   Issuance Costs   Written Off** | ** ** |
|---------------|------------|----------------------------|--------------|-----------------------------|-----------------|-------------------------------|------------|--------------------------------------------------------------------------|------------|
| June 2003     |       | $                          | 30.0 million |                        | 102.75%         |                          | $          | 0.8 million                                                              |       | $ | 0.7 million |   |
| May 2005      |       | $                          | 70.0 million |                        | 101.0%          |                          | $          | 0.7 million                                                              |       | $ | 1.1 million |   |
| February 2006 |       | $                          | 24.9 million |                        | 100.375%        |                          | $          | 0.1 million                                                              |       | $ | 0.3 million |   |
| June 2006     |       | $                          | 4.2 million  |                        | 100.4% - 100.5% |                          | $          | 0.1 million                                                              |       | — |   |

 

The redemption premium and write-off ofrelated note issuance costs were included as a component of interest expense inthe period of redemption.

The $45.9 million of currentlyoutstanding notes are convertible into approximately 926,534 shares of ourcommon stock.

***Zero CouponConvertible Subordinated Notes***

On June 13, 2003, we issued $150.0 million aggregateprincipal amount of zero coupon convertible subordinated notes. The interestrate on the notes is zero and the notes will not accrete interest. The notesare due on June 15, 2023 and are first putable to us at the noteholder’s option(in whole or in part) for cash on June 15, 2008, at a price equal to 100.25% ofthe principal amount, and on June 15, 2013 and 2018, at a price equal to 100%of the principal amount. The notes are also putable to us at the noteholder’soption upon a change of control at a price equal to 100% of the principalamount. We can redeem the notes (in whole or in part) for cash on June 15,2008, at a price equal to 100.25% of the principal amount, or thereafter at aprice equal to 100% of the principal amount. The notes are subordinated to allpreviously existing and future senior indebtedness and are effectivelysubordinated to all indebtedness and other liabilities of our subsidiaries. Thecost of this transaction, including underwriting discounts and commissions andoffering expenses, totaled $4.8 million and is recorded on our balance sheet inother long-term assets and is being amortized over the life of the notes. Theamortization of these costs totals $240,000 per quarter and is reflected asinterest expense in our statements of operations.

The notes are convertible into shares of our commonstock upon the occurrence of certain events at an initial conversion price of$27.132 per share (subject to adjustment), or approximately 5,528,527 millionshares if the entire $150.0 million is converted. Upon conversion, we have theoption to settle the notes in cash, shares of our common stock, or acombination of cash and shares.

**11.**                               CONVERTIBLENOTE HEDGE AND WARRANT TRANSACTIONS

We used a portion of thenet proceeds from the offering of our zero coupon convertible subordinatednotes to enter into convertible note hedge and warrant transactions withrespect to our common stock, the exposure for which was held at the time thenotes were issued by Credit Suisse First Boston International, an affiliate ofan initial purchaser of the notes. The net cost of the hedging transactions of$23.9 million was included as a reduction of common stock in shareholders’equity in accordance with the guidance in EITF Issue No. 00-19, “*Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock.*”

In November 2005,we terminated the hedge and warrant in return for a cash payment ofapproximately $11.0 million to us from the counterparty to these instruments.The termination of the hedge and warrant eliminate the potential anti-dilutiveeffect of the hedge in the event of future conversions of the zero 

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coupon notes. Thereceipt of the approximately $11.0 million was recorded as an increase tocontributed capital and did not result in any gain or loss in our consolidatedstatement of operations.

**12.**                               LEASEOBLIGATIONS

We have operating leases for certain ofour manufacturing and administrative facilities that extend through 2018. Thelease agreements generally provide for payment of base rental amounts plus ourshare of property taxes and common area costs. The leases generally provide renewal options at current market rates.

Rent expense is recognized on a straight-linebasis over the term of the lease. Rent expense was $7.1 million in 2006, $7.8million in 2005 and $7.1 million in 2004.

The approximate future minimum rentalpayments due under these agreements as of December 31, 2006, were asfollows (in thousands):

 

| Year Ending December 31, | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2007                                    |       | $          | 7,104      |   |
| 2008                                    |       | 6,621      |       |
| 2009                                    |       | 6,182      |       |
| 2010                                    |       | 6,169      |       |
| 2011                                    |       | 5,236      |       |
| Thereafter                              |       | 29,980     |       |
| Total                                   |       | $          | 61,292     |   |

** **

**13.**                               INCOME TAXES

Incometax expense consisted of the following (in thousands):

 

|                             | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                    |       |                                       |       |   |   |   |   |
| Federal                     |       | $                                          | (1,724     | ) | $ | (4,391 | ) | $ | 7,733 |   |
| State                       |       | 211                                        |       | 469 |   | 1,232 |   |
| Foreign                     |       | 10,169                                     |       | 10,911 |   | 6,455 |   |
|                        |       | 8,656                                      |       | 6,989 |   | 15,420 |   |
| Deferred expense  (benefit) |       | 1,811                                      |       | 15,082 |   | (8,215 | ) |
| Total income tax expense    |       | $                                          | 10,467     |   | $ | 22,071 |   | $ | 7,205 |   |

 

The effective income tax rate applied tonet income (loss) varied from the United States federal statutory rate due tothe following (in thousands):

 
| ** **                                    | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Tax expense (benefit)  at statutory rates     |       | $                                          | 9,841      |   | $ | (19,828 | ) | $ | 7,937 |   |
| Increase (decrease)  resulting from:          |       |                                       |       |   |   |   |   |
| State  income taxes, net of federal benefit   |       | 211                                        |       | 469 |   | 1,232 |   |
| Foreign taxes,  including U.S. export benefit |       | 1,265                                      |       | 3,627 |   | 1,845 |   |
| Research and  experimentation credit          |       | (324                                       | )          | (300 | ) | (1,832 | ) |
| Non-deductible  expenses                      |       | 915                                        |       | 260 |   | 347 |   |
| Tax audit  settlements                        |       | —                                     |       | 2,780 |   | (1,553 | ) |
| Change in  valuation allowance                |       | (1,506                                     | )          | 34,386 |   | — |   |
| Other                                         |       | 65                                         |       | 677 |   | (771 | ) |
|                                          |       | $                                          | 10,467     |   | $ | 22,071 |   | $ | 7,205 |   |

 

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The 2006 incometax provision on income from continuing operations consisted primarily of taxesaccrued in foreign jurisdictions and reflects a benefit of $1.5 million relatedto the release of valuation allowance against a portion of deferred tax assetsutilized during the period to offset 2006 United States taxable income. Wecontinue to record a valuation allowance against the remaining United Statesdeferred tax assets as we do not believe it is more likely than not that thebenefit of the deferred tax assets will be realized in future periods.  The 2005 income tax expense includedprovisions for foreign taxable income, but did not reflect a benefit for 2005losses in the United States as we recorded full valuation allowances againstthe United States deferred tax assets generated from such losses. We alsorecorded a charge in 2005 for valuation allowances placed on our United Statesdeferred tax assets recorded as of December 31, 2004.

Current taxespayable were reduced for foreign tax benefits recorded to common stock relatedto stock option deductions of $1.4 million in 2006. No amounts were recorded in2005 or 2004. No tax benefits were recorded in the United States related to theexercise of stock options or the convertible note hedge in 2006 or 2005 due toour current valuation allowance against net operating losses in the UnitedStates.  In 2004, we recorded taxbenefits in the United States of $3.7 million to common stock associated withthe exercise of employee stock options and for deductions related to ourconvertible note hedge. A tax benefit of $4.6 million in the United Statesrelated to the exercise of employee stock options and our convertible notehedge will be allocated to common stock should the related valuation allowancebe released in future periods.

Deferred taxexpense of $1.6 million, $1.1 million and $0.8 million was recorded in othercomprehensive income in 2006, 2005 and 2004, respectively.

Net deferred tax assets and liabilitieswere included in the following consolidated balance sheet accounts:

 

|                                              | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax assets —  current          |       | $                     | 4,386      |   | $ | 5,157 |   |
| Deferred tax assets —  non-current      |       | 542                   |       | 1,095 |   |
| Other current  liabilities                   |       | (351                  | )          | (371 | ) |
| Deferred tax  liabilities — non-current |       | (4,062                | )          | (1,947 | ) |
| Net deferred tax assets                      |       | $                     | 515        |   | $ | 3,934 |   |

 

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The tax effects of temporary differencesthat gave rise to significant portions of deferred tax assets and deferred taxliabilities were as follows (in thousands):

|                                   | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax assets:              |       |                  |       |   |   |
| Accrued  liabilities              |       | $                     | 1,823      |   | $ | 2,215 |   |
| Warranty  reserves                |       | 1,060                 |       | 989 |   |
| Inventory  reserves               |       | 6,452                 |       | 7,052 |   |
| Allowance for  bad debts          |       | 734                   |       | 794 |   |
| Revenue  recognition              |       | 3,106                 |       | 2,776 |   |
| Loss  carryforwards               |       | 13,083                |       | 13,134 |   |
| R&D tax  credit carryforwards |       | 1,747                 |       | 1,055 |   |
| Fixed assets                      |       | 2,303                 |       | 4,250 |   |
| Intangible  assets                |       | 1,155                 |       | 5,995 |   |
| Unrealized  investment            |       | 1,763                 |       | 2,000 |   |
| Stock  compensation               |       | 2,512                 |       | — |   |
| Other assets                      |       | 2,717                 |       | 1,025 |   |
| Gross deferred  tax assets        |       | 38,455                |       | 41,285 |   |
| Valuation  allowance              |       | (33,527               | )          | (35,033 | ) |
| Net deferred tax assets           |       | 4,928                 |       | 6,252 |   |
|                              |       |                  |       |   |   |
| Deferred tax  liabilities:        |       |                  |       |   |   |
| Fixed assets                      |       | (203                  | )          | (257 | ) |
| Other  liabilities                |       | (4,210                | )          | (2,061 | ) |
| Total deferred tax  liabilities   |       | (4,413                | )          | (2,318 | ) |
| Net deferred tax asset            |       | $                     | 515        |   | $ | 3,934 |   |

 

Valuationallowances on deferred tax assets totaled $33.5 million and $35.0 million as ofDecember 31, 2006 and 2005, respectively. In assessing the realizability ofdeferred tax assets, SFAS No. 109, “*Accountingfor Income Taxes*,” establishes a more likely than not standard. Ifit is determined that it is “more likely than not” that deferred tax assetswill not be realized, a valuation allowance must be established against thedeferred tax assets. The ultimate realization of deferred tax assets isdependent upon the generation of future taxable income during the periods inwhich the associated temporary differences become deductible. We consider thescheduled reversal of deferred tax liabilities, historical operating performance,projected future taxable income and tax planning strategies in making thisassessment. Our “more likely than not” assessment was principally based uponour historical losses in the United States, the impact of the restructuringactivities discussed in Note 14 and our forecast of future profitability incertain tax jurisdictions, primarily the United States.

At December 31,2006, we had approximately $32.8 million of United States net operating losscarryforwards to offset against future income for federal income tax purposes,which expire through 2026, and approximately $31.7 million for Oregon incometax purposes, which expire through 2021. Federal and state research anddevelopment tax credit carryforwards as of December 31, 2006 were $1.3 millionand expire between 2008 and 2026. We also have $.8 million of alternativeminimum tax carryforwards, which do not expire.

As ofDecember 31, 2006, United States income taxes have not been provided forapproximately $134.9 million of cumulative undistributed earnings of severalnon-United States subsidiaries, as our current intention is to reinvest theseearnings indefinitely outside the United States. Foreign tax provisions havebeen provided for these cumulative undistributed earnings. Upon distribution ofthose earnings in the form of dividends or otherwise, we would be subject toboth United States income taxes (subject to an adjustment for foreign taxcredits) and withholding taxes payable to the various foreign countries.Similarly, we have not provided deferred taxes on the cumulative translationadjustment related to those non-United States subsidiaries.

 

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At December 31,2006 and 2005, our tax contingency reserves totaled $10.8 million and $5.5million, respectively. We maintain reserves for estimated tax exposures injurisdictions of operation, including potential interest and penalties on suchexposures. These tax jurisdictions include federal, state and variousinternational tax locations. Significant income tax exposures include potentialchallenges of net operating loss carry-back claims, permanent establishment,capitalization of certain costs and intercompany pricing. Exposures are settledprimarily through resolution of audits within these tax jurisdictions, but canalso be affected by changes in applicable tax law or other factors, which couldcause management to believe a revision of past estimates is appropriate.Management believes that an appropriate liability has been established forestimated exposures; however, actual results may differ materially from theseestimates.

Potential benefitsrelated to favorable tax positions have been deferred until such positions arerealized. Interest and penalties recorded as part of the 2006 and 2005 taxprovision totaled $1.9 million and $3.2 million, respectively. No significantamounts were recorded in 2004.

**14.**                               RESTRUCTURING,REORGANIZATION, RELOCATION AND SEVERANCE

Restructuring,reorganization, relocation and severance costs are accounted for in accordancewith SFAS No. 146, “*Accounting for Costs Associated with Exit or Disposal Activities.*”Under SFAS No. 146, liabilities for costs associated with exit or disposalactivities are recognized and measured at fair value in the period theliability is incurred.

Restructuring,reorganization, relocation and severance in 2006 included charges of $3.3million for facilities and severance charges related to the closure of certainof our European field offices, closure of a research and development facilityin Tempe, Arizona, as well as residual costs related to the Peabody plantclosure and the downsizing of the related semiconductor businesses.

Effective April 1, 2006, our Chairman, President and Chief ExecutiveOfficer (“CEO”) was terminated. Our CEO was a party to an existingExecutive Severance Agreement dated February 1, 2002. Termination of hisservice was deemed a termination without cause under the agreement. Pursuant tothe terms of this agreement, and following his execution and non-revocation ofa standard release, our CEO was entitled to certain severance benefits. Theseincluded: (i) a lump sum payment equaling three years of base salary(approximately $1.59 million); (ii) a lump sum payment equal to 100% of histarget bonus for 2006 (approximately $583,000); (iii) acceleration of all ofhis stock options and restricted stock awards; (iv) permitting him to exercisehis options until the earlier of three years after his departure date or theoption expiration date as set forth in the applicable option agreement;(v) a lump sum payment equaling two times what his reasonably expectedhealth insurance coverage costs would be for 18 months; and (vi) lifeinsurance premium payments not to exceed $5,000.

Accordingly, inthe first quarter of 2006, we recordeda charge of $9.3 million, of which $2.2 million related to the cash severancepayments and $7.1 million related to the non-cash expense associated with thefair market value of the modified stock options, which modified the originalawards to (i) accelerate all unvested stock options; (ii) waive thecancellation clause upon termination of employment; and (iii) extend theirlegal lives as discussed above.

In 2005, we expensed $4.6 million in severance and relocationcosts related to workforce reductions and reallocation of personnelgeographically, which was included as a component of restructuring,reorganization, relocation and severance expense. We also incurred $3.9 millionof restructuring expense for facility closures, largely related to the Peabodyfacility (inclusive of $0.2 million in reserve releases related to prioraccruals for another facility lease that was terminated).

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The $0.5 million restructuring charge in 2004 was toaccrue for costs related to an operating lease for a building we abandoned inthe second quarter of 2004.

In addition to the charges in connectionwith our restructuring and reorganization plans, this line item includes costsrelated to relocating current employees. Relocation costs totaled $0.4 millionin 2006, $0.6 million in 2005 and $0.2 million in 2004.

The following tables summarizethe charges, expenditures and write-offs and adjustments in 2006, 2005 and 2004related to our restructuring, reorganization, relocation and severance accruals(in thousands):

 

| Year Ended December 31, 2006                            | ** ** | **Beginning  Accrued  Liability** | ** ** | **Charged  to  Expense** | ** ** | **Expenditures** | ** ** | **Write-Offs  and  Adjustments** | ** ** | **Ending  Accrued  Liability** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| Severance,  outplacement and related benefits for terminated employees |       | $                                 | 1,778      |                     | $          | 2,619            |       | $                                | (4,343     | )                              | $          | 124 |   | $ | 178 |   |
| Abandoned  leases, leasehold improvements and facilities               |       | 3,496                             |       | 665                      |       | (1,906           | )          | 6                                |       | 2,261                          |       |
| CEO severance,  excluding stock-based compensation                     |       | —                            |       | 2,235                    |       | (2,235           | )          | —                           |       | —                         |       |
|                                                                   |       | $                                 | 5,274      |                     | $          | 5,519            |       | $                                | (8,484     | )                              | $          | 130 |   | $ | 2,439 |   |

 

| Year Ended December 31, 2005                       | ** ** | **Beginning  Accrued  Liability** | ** ** | **Charged  to  Expense** | ** ** | **Expenditures** | ** ** | **Write-Offs  and  Adjustments** | ** ** | **Ending  Accrued  Liability** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| Severance,  outplacement and related benefits for terminated employees |       | $                                 | 150        |                     | $          | 4,606            |       | $                                | (2,958     | )                              | $          | (20 | ) | $ | 1,778 |   |
| Abandoned  leases, leasehold improvements and facilities               |       | 870                               |       | 3,938                    |       | (1,254           | )          | (58                              | )          | 3,496                          |       |
|                                                                   |       | $                                 | 1,020      |                     | $          | 8,544            |       | $                                | (4,212     | )                              | $          | (78 | ) | $ | 5,274 |   |

 

| Year Ended December 31, 2004                       | ** ** | **Beginning  Accrued  Liability** | ** ** | **Charged  to  Expense** | ** ** | **Expenditures** | ** ** | **Write-Offs  and  Adjustments** | ** ** | **Ending  Accrued  Liability** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| Severance,  outplacement and related benefits for terminated employees |       | $                                 | 570        |                     | $          | —           |       | $                                | (314       | )                              | $          | (106 | ) | $ | 150 |   |
| Abandoned  leases, leasehold improvements and facilities               |       | 1,534                             |       | 458                      |       | (989             | )          | (133                             | )          | 870                            |       |
|                                                                   |       | $                                 | 2,104      |                     | $          | 458              |       | $                                | (1,303     | )                              | $          | (239 | ) | $ | 1,020 |   |

 

The current estimate accrued for cash to be paidrelated to abandoned leases is net of estimated sublease payments to bereceived and will be paid over the respective lease terms.

The restructuring charges werebased on estimates that are subject to change. Workforce related charges could change because of shifts in timing,redeployment or changes in amounts of severance and outplacement benefits.  Facilities charges could change due tochanges in sublease income. Our ability to generate sublease income isdependent upon lease market conditions at the time we negotiate the subleasearrangements. Variances from these estimates could alter our ability to achieveanticipated expense reductions in the planned timeframe and modify our expectedcash outflows and working capital.

***In 2006, the $7.1 million non-cash charge for stock-based compensationwas recorded as a component of restructuring, reorganization, relocation andseverance. In 2004, the $0.2 million for relocation costs was recorded as acomponent of restructuring, reorganization, relocation and severance.***

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**15.**                               SHAREHOLDERS’EQUITY

***PreferredStock Rights Plan***

On July 21, 2005,the Board of Directors adopted a Preferred Stock Rights Plan. Pursuant tothe Preferred Stock Rights Plan, we distributed Rights as a dividend at therate of one Right for each share of our common stock held by shareholders of recordas of the close of business on August 12, 2005. The Rights expire on August 12,2015, unless redeemed or exchanged.

The Rights are notexercisable until the earlier of: (1) ten days (or such later date as may bedetermined by the Board of Directors) following an announcement that a personor group has acquired beneficial ownership of 20% of our common stock or (2)ten days (or such later date as may be determined by the Board of Directors)following the announcement of a tender offer which would result in a person orgroup obtaining beneficial ownership of 20% or more of our outstanding commonstock, subject to certain exceptions (the earlier of such dates being calledthe Distribution Date). The Rights are initially exercisable for one-thousandthof a share of our Series A Preferred Stock at a price of $120 perone-thousandth share, subject to adjustment. However, if: (1) after theDistribution Date we are acquired in certain types of transactions, or (2) anyperson or group (with limited exceptions) acquires beneficial ownership of 20%of our common stock, then holders of Rights (other than the 20% holder) will beentitled to receive, upon exercise of the Right, common stock (or in case weare completely acquired, common stock of the acquirer) having a market value oftwo times the exercise price of the Right.  Philips Business ElectronicsInternational B.V., or any of its affiliates, shall not be considered for the20% calculation so long as it does not acquire 30% or more of our commonshares.

We are entitled toredeem the Rights, for $0.001 per Right, at the discretion of the Board ofDirectors, until certain specified times. We may also require the exchange ofRights, at a rate of one share of common stock for each Right, under certaincircumstances. We also have the ability to amend the Rights, subject to certainlimitations.

***PEO Combination***

On February 21, 1997, we acquiredsubstantially all of the assets and liabilities of the electron optics businessof Koninklijke Philips Electronics N.V. (the “PEO Combination”), in atransaction accounted for as a reverse acquisition.  As part of the PEO Combination, we agreed toissue to Philips additional shares of our common stock whenever stock optionsthat were outstanding on the date of the closing of the PEO Combination areexercised.  Any such additional sharesare issued at a rate of approximately 1.22 shares to Philips for each shareissued on exercise of these options. We receive no additional consideration forthese shares issued to Philips under this agreement. We issued no shares in2006 or 2005 and 14,000 shares in 2004 to Philips under this agreement. As ofDecember 31, 2006, 185,000 shares of our common stock are potentiallyissuable and reserved for issuance as a result of this agreement.

***Stock Incentive Plans***

As of December 31, 2006, a total of7,375,935 shares of our common stock were reserved for issuance pursuant to ourstock incentive plans.

***16.          STOCKINCENTIVE PLANS***

***1995Stock Incentive Plan and 1995 Supplemental Stock Incentive Plan***

Our 1995 Stock Incentive Plan, as amended (the “1995Plan”) allows for issuance of a maximum of 9,000,000 shares and our 1995Supplemental Stock Incentive Plan (the “1995 Supplemental Plan”) allows forissuance of a maximum of 500,000 shares.

We maintain stock incentive plans for selecteddirectors, officers, employees and certain other parties that allow the Boardof Directors to grant options (incentive and nonqualified), stock and cashbonuses, stock appreciation rights and restricted stock units and restricted shares.The Board of Directors’ ability to grant options under either the 1995 Plan orthe 1995 Supplemental Plan will terminate, if the plans are not amended, whenall shares reserved for issuance have been issued and all restrictions on suchshares

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have lapsed, or earlier, at the discretion of theBoard of Directors. At December 31, 2006, there were 2,556,827 shares availablefor grant under these plans and 7,375,935 shares of our common stock werereserved for issuance. Activity under these plans was as follows (share amountsin thousands):

|                                  | ** ** | **Shares Subject   to Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **Balances,  December 31, 2005** |       | 5,419                                          |       | $                                              | 20.85      |   |
| Granted                          |       | 212                                            |       | 19.49                                          |       |
| Forfeited                        |       | (99                                            | )          | 18.29                                          |       |
| Expired                          |       | (419                                           | )          | 26.70                                          |       |
| Exercised                        |       | (562                                           | )          | 17.16                                          |       |
| **Balances, December 31, 2006**  |       | 4,551                                          |       | 20.81                                          |       |
|                                  |            |                                                |            |                                                |            |  |

 

|                                  | ** ** | **Restricted  Shares and  Restricted Stock Units** | ** ** | **Weighted Average  Grant Date Per Share  Fair Value** | ** ** |
|----------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| **Balances,  December 31, 2005** |       | 20                                                                |       | $                                                                               | 21.62      |   |
| Granted                          |       | 280                                                               |       | 21.74                                                                           |       |
| Vested                           |       | (3                                                                | )          | 22.73                                                                           |       |
| Forfeited                        |       | (29                                                               | )          | 21.98                                                                           |       |
| **Balances, December 31, 2006**  |       | 268                                                               |       | 21.71                                                                           |       |
|                                  |            |                                                                   |            |                                                                                 |            |  |

 

***Share-BasedAwards Issued Outside of Plans***

In the third quarter of 2006, we issued to ourPresident and Chief Executive Officer, outside of our plans, options topurchase 100,000 shares of our common stock at an exercise price of $19.38 pershare and 75,000 restricted stock units with a per share fair value at grantdate of $19.38. The stock options and 50,000 of the restricted stock units vestover four years and 25,000 of the restricted stock units vest over a one-yearperiod. We reduced the number of shares available for grant under the 1995 Planby a number equal to the option and RSU grants made outside the 1995 Plan.

***Summary***

Certain information regarding all options outstandingas of December 31, 2006 was as follows:

|                                              | ** ** | **Options  Outstanding** | ** **        | **Options  Exercisable** | ** ** |
|----------------------------------------------|------------|--------------------------|-------------------|--------------------------|------------|
| Number                                       |       | 4,651,098                |              | 4,008,468                |       |
| Weighted average  exercise price             |       | $                        | 20.78             |                     | $          | 21.21 |   |
| Aggregate  intrinsic value                   |       | $                        | 30.2 million |                     | $          | 24.9 million |   |
| Weighted average  remaining contractual term |       | 4.6 years                |              | 4.3 years                |       |

 

As of December 31,2006, unrecognized stock-based compensation related to outstanding, butunvested stock options, restricted shares and restricted stock units was $10million, which will be recognized over the weighted average remaining vestingperiod of 2 years.

***Employee Share PurchasePlan***

In 1998, we implemented an Employee Share PurchasePlan (“ESPP”). A total of 1,950,000 shares of our common stock may be issuedpursuant to the ESPP, as amended. Under the ESPP, employees may elect to havecompensation withheld and placed in a designated stock subscription account forpurchase of our common stock. Each ESPP offering period consists of onesix-month purchase period. The purchase price in a purchase period is set at a15% discount to the lower of the market price on either the first day of theapplicable offering period or the purchase date. The ESPP allows a maximumpurchase of 1,000 shares by each employee during any two consecutive offeringperiods. A total of 186,924 shares were purchased pursuant to the ESPP during2006 at a weighted average purchase price of $18.81 per share, whichrepresented a weighted average discount of $5.04 per share compared to the fairmarket value of our common stock on the dates of purchase. At December 31,2006, 724,635 shares of our common stock remained available for purchase andwere reserved for issuance under the ESPP.

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***StockOption Acceleration of Vesting***

On October 19,2005, we accelerated the vesting, effective immediately, of certain “out-of-the-money”unvested options, as determined based on the per share price of our commonstock of $19.34 as of the close of market on that date. Options held by ourthen-Chief Executive Officer and members of our Board of Directors wereexcluded from acceleration.

In making thedecision to accelerate the vesting of these options, our board of directorsconsidered a number of factors, including the interests of our shareholders ineliminating the future amortization of compensation expense represented byunvested options, the accounting impact of vesting acceleration, the potentialimpact on employee morale and the potential benefit to the market value of ourcommon stock.

As a result of theacceleration, options representing approximately 1.4 million shares, whichrepresented approximately 26% of the total outstanding options as of that date,became immediately exercisable. No compensation expense was recognized on ourconsolidated statement of operations related to this modification as theoptions modified had exercise prices greater than the fair value of theunderlying stock at the acceleration date. This action, however, did result inan additional charge of approximately $17.9 million in our stock compensationexpense footnote disclosure pursuant to SFAS No. 123 in 2005. See Note 1 “*Summary of**Significant AccountingPolicies — Stock-Based Compensation*.”

**17.**                               EMPLOYEEBENEFIT PLANS

***Pension Plans***

Employee retirement plans have beenestablished in some foreign countries in accordance with the legal requirementsand customs in the countries involved. The majority of employees in Europe,Asia and Canada are covered by defined benefit, multi-employer or definedcontribution pension plans. The benefits provided by these plans are basedprimarily on years of service and employees’ compensation near retirement.Employees in the United States are covered by a profit sharing 401(k) plan,which is a defined contribution plan.

Employees in the Netherlands participatewith other companies in making collectively-bargained payments to theMetal-Electro Industry pension fund. Pension costs relating to thismulti-employer plan were $6.3 million in 2006, $5.7 million in 2005 and $4.5million in 2004.

Outside the United States and theNetherlands, employees are covered under various defined contribution anddefined benefit plans as required by local law.

Plan costs for our defined contributionplans outside the United States and the Netherlands totaled $0.4 million in2006, $0.2 million in 2005 and $0.2 million in 2004.

Plan costs for our defined benefitpension plans were $0.3 million in 2006, $0.6 million in 2005 and $0.5 millionin 2004. Obligations under the defined benefit pension plans are not funded. Aliability for the projected benefit obligations of these plans of $2.2 millionand $1.8 million was included in other non-current liabilities as of December31, 2006 and 2005, respectively. Unrealized losses recorded in othercomprehensive income related to the additional minimum pension liability forthese plans totaled $0.6 million in 2006. Due to the immateriality of thesedefined benefit pension plan, we have not included all disclosures required bySFAS No. 87, “*Employers Accounting for Pensions,”*and SFAS No. 132 (Revised 2003), “*Employer’s Disclosuresabout Pensions and Other Postretirement Benefits.”*

***Profit Share andVariable Compensation Programs***

In 2006, we modified the Employee ProfitShare Plan that had been in place since 2000. We also have a Management Variable Compensation Planfor management-level employees to reward achievement ofcorporate and individual objectives. The Compensation Committee ofthe board of directors generally determines the structure of the overallincentive program at the beginning of each year. In setting the structure andthe amount of the overall target incentive pool, the Compensation Committeeconsiders

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potential size of the pool in relation toour earnings and other financial estimates, the achievability of the corporatetargets under the plan, historical payouts under the plan and otherfactors.  The total cost of these plans was $9.3 million in 2006, $0in 2005 and $3.4 million in 2004.

***Profit Sharing 401(k)Plan***

We maintain a profit sharing 401(k) planthat covers substantially all United States employees.  Employees may elect to defer a portion oftheir compensation, and we may contribute an amount approved by the Board ofDirectors. Beginning in 2006, we match 100% of employee contributions to the401(k) plan up to 3% of each employee’s eligible compensation. Prior to 2006,we matched 100% of employee contributions up to 11⁄2% with a possiblesupplemental match, if approved by the Board of Directors, based on ourperformance, up to a maximum of an additional 3% of eligible compensation. Employeesmust meet certain requirements to be eligible for the matching contribution. Wecontributed $1.1 million in 2006, $0.6 million in 2005 and $1.1 million in 2004to this plan. Our 401(k) plan does not allow for the investment in shares ofour common stock. No supplemental matching contributions were made in 2005.

***DeferredCompensation Plan***

We maintain a deferred compensation plan(the “Plan”) which permits certain employees to defer payment of a portionof their annual compensation. We do not match deferrals or make any additionalcontributions to the Plan. Distributions from the Plan are generally payable asa lump sum payment or in multi-year installments as directed by the participantaccording to the Plan provisions. Undistributed amounts under the Plan aresubject to the claims of our creditors. As of December 31, 2006 and 2005, theinvested amounts under the Plan totaled $1.9 million and $1.7 million,respectively, and were recorded as non-current investments in marketablesecurities on our balance sheet. As of December 31, 2006 and 2005, we hadrecorded $1.9 million and $1.7 million, respectively, as a long-termliability to recognize undistributed amounts due to employees.

**18.**                               RELATED-PARTYACTIVITY

***Philips***

Until December 2006, Philips Business Electronics International B.V.(“Philips”), a subsidiary of******KoninklijkePhilips Electronics N.V., owned approximately 25% of our common stock. As ofDecember 31, 2006, Philips does not own any of our common stock. However,during 2006, one of our directors, Mr. Jan C. Lobbezoo served as the ExecutiveVice President of Philips International B.V. with responsibility for financialoversight of several minority shareholdings of Koninklijke Philips ElectronicsN.V. For sales to Philips, see “*Other Transactions*”below. The following table summarizes our transactions, other than sales, withPhilips (in thousands):
|                                                                                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Amounts  Paid to Philips**                                                                                                                             | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Subassemblies and other  materials purchased from Philips                                                                                                |       | $                                          | 46,670     |   | $ | 22,497 |   | $ | 19,071 |   |
| Facilities  leased from Philips                                                                                                                          |       | 52                                         |       | 240 |   | 199 |   |
| Various administrative,  accounting, customs, export, human resources, import, information technology,  logistics and other services provided by Philips |       | 323                                        |       | 712 |   | 510 |   |
| Research and  development services provided by Philips                                                                                                   |       | 2,789                                      |       | 3,964 |   | 4,920 |   |
|                                                                                                                                                          |       | $                                          | 49,834     |   | $ | 27,413 |   | $ | 24,700 |   |

 

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The following paragraphs describe thebusiness transactions and relationships between us and Philips which resultedin the above payments.

***Materials Purchased fromPhilips***

A substantial portion of thesubassemblies included in our FIBs, TEMs and SEMs are purchased from Philips.

***Facilities Leased fromPhilips***

We lease sales, service and administrativefacilities from Philips in certain countries.

***Various AdministrativeServices Provided by Philips***

We entered into various servicesagreements with Philips affiliates to continue to provide us certainadministrative, accounting, customs, export, human resources, import,information technology, logistics and other services that had been provided tous since February 1997.

***Development ServicesProvided by Philips***

We purchase research and developmentservices from Philips’ central research facility.

***Intellectual Property***

Prior to May 22, 2001, most of thepatents used by us relating to our electron optics were licensed from Philipsand its affiliates. As part of the PEO Combination, we acquired perpetualrights to certain patents owned by Philips and the right to transfer of titleof those patents upon Philips no longer being a controlling shareholder. During2001, we entered into an agreement with Philips effective as ofDecember 31, 2000 (the “Supplemental Agreement”) that clarified certainrelationships and transactions between us. The Supplemental Agreement confirmedthe transfer of ownership of nearly all of these patents. The SupplementalAgreement specified certain other patents that are jointly owned and may bejointly used by Philips and us, and also provided for the license by us ofcertain patents owned by Philips. The Supplemental Agreement required us to payPhilips $0.6 million from 2001 through 2003 in compensation for thedevelopment efforts related to a specific patented technology, which we may usein future products. We must pay a royalty of 1% of sales on any future sales ofproducts using this technology. To date, we have not sold any products usingthis technology or paid any related royalties. In addition, from February 1997through May 2001, when Philips ceased being a majority shareholder we hadaccess to technology through cross-licenses between Philips affiliates and alarge number of manufacturers in the electronics industry worldwide. Ourpatents were also subject to such cross-licenses. The December 2006 Philipssale of shares had no impact on our intellectual property rights.

***Current Accounts withPhilips***

Current accounts with Philips representedaccounts receivable and accounts payable between us and other Philips units.Most of the current account transactions related to deliveries of goods,materials and services.  Current accountswith Philips consisted of the following (in thousands):

 

| December 31,                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Current accounts  receivable       |       | $        | 22         |     | $          | 231 |   |
| Current accounts  payable          |       | (11      | )          | (2,195   | )          |
| Net current  accounts with Philips |       | $        | 11         |     | $          | (1,964 | ) |

 

***Accurel***

Mr. Sarkissian,our former Chief Executive Officer, President and Chairman of our board of directors,owned a 50% interest in Accurel Systems International Corp. (“Accurel”), ananalytical services provider to the semiconductor and data storage markets. Wesold equipment and related services and provided certain other services toAccurel. In March 2005, Accurel was sold to Implant Sciences Corporation, anunrelated third party. Following the sale, Mr. Sarkissian owned less than 5% ofthe outstanding stock of Implant Sciences Corporation.

In March 2005,Implant Sciences Corporation paid us the $1.2 million that Accurel owed us fora system they purchased in 2002. Subsequent to the acquisition date, neitherImplant Sciences Corporation nor Accurel is considered a related party.

 

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***Other Transactions***

In addition to Philips,we have sold products and services to LSI Logic Corporation, Applied Materials,Nanosys, Inc., Cascade Microtech, Inc. and Accurel. A director of AppliedMaterials, the Former Chairman and Chief Executive Officer of LSI Logic, Inc.and the former Executive Chairman of Nanosys are all members of our board ofdirectors. In addition, Mr. Raymond A. Link, our Executive Vice President andChief Financial Officer, is a member of the board of directors of CascadeMicrotech, Inc.

Sales to Philips,Accurel (prior to being acquired), Applied Materials, LSI Logic, Nanosys andCascade Microtech were as follows (in thousands):

|                      | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Product sales:       |       |                                       |       |   |   |   |   |
| Applied  Materials   |       | $                                          | 1,353      |   | $ | 439 |   | $ | 550 |   |
| LSI Logic            |       | —                                     |       | 4 |   | 740 |   |
| Nanosys              |       | —                                     |       | 289 |   | — |   |
| Philips              |       | 842                                        |       | 2,098 |   | 2,712 |   |
| Cascade  Microtech   |       | 311                                        |       | — |   | — |   |
| Total product  sales |       | 2,506                                      |       | 2,830 |   | 4,002 |   |
|                 |       |                                       |       |   |   |   |   |
| Service sales:       |       |                                       |       |   |   |   |   |
| Accurel              |       | —                                     |       | — |   | 636 |   |
| Applied  Materials   |       | 266                                        |       | 270 |   | — |   |
| LSI Logic            |       | 172                                        |       | 163 |   | 251 |   |
| Nanosys              |       | 23                                         |       | 17 |   | — |   |
| Philips              |       | 1,685                                      |       | 588 |   | 325 |   |
| Total service  sales |       | 2,146                                      |       | 1,038 |   | 1,212 |   |
| Total sales          |       | $                                          | 4,652      |   | $ | 3,868 |   | $ | 5,214 |   |

 

**StockPurchase Loan**

On June 25, 1998, we loaned our formerChief Executive Officer, President and Chairman of our board of directors $1.1million for the purchase of restricted stock. We recorded interest income onthis loan totaling $87,000 in 2004. Mr. Sarkissian repaid the principal andaccrued interest, totaling $1.6 million, in full on December 17, 2004.

**19.**                               RISKMANAGEMENT AND DERIVATIVES

We are exposed toglobal market risks, including the effect of changes in foreign currencyexchange rates. We use derivatives to manage financial exposures that occur inthe normal course of business. We do not hold or issue derivatives for tradingor speculative purposes. We formally document all relationships between hedginginstruments and hedged items, as well as our risk-management objective andstrategy for undertaking hedge transactions. This process includes linking allderivatives either to assets and liabilities recorded on the balance sheet orto forecasted transactions. Derivatives entered into by us that are linked toforecasted transactions have been designated as cash flow hedges commencingApril 5, 2004.

All derivatives are recognized on the balance sheet attheir fair value. Unrealized gain positions are recorded as other currentassets, and unrealized loss positions are recorded as other current liabilitiesas all maturity dates are less than one year. Changes in fair values ofoutstanding derivatives that are designated as cash flow hedges and are highlyeffective are recorded in other comprehensive income until net income isaffected by the variability of cash flows of the hedged transaction. Changes inthe fair value of derivatives either not designated or effective as hedginginstruments are recognized in earnings in the current period and primarilyrelate to derivatives linked to specific non-functional currency denominated assetsand liabilities on the balance sheet. Prior to the second quarter of fiscal2004, the change in fair value of all derivatives was recorded in currentperiod net income as none of our derivatives had been designated as hedginginstruments under SFAS No. 133, “*Accounting for DerivativeInstruments and Hedging Activities*.”

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***CashFlow Hedges***

The purpose of ourforeign currency hedging activities is to protect us from the risk that theeventual cash flows resulting from transactions in foreign currencies will beadversely affected by changes in exchange rates. It is our policy to utilizederivatives to reduce foreign exchange risks where internal netting strategiescannot be effectively employed.

Derivatives usedby us to hedge foreign currency exchange risks are foreign forward extracontracts, which are a combination of foreign exchange contracts and options.These instruments protect against the risk that the eventual net cash inflowsfrom foreign currency denominated transactions will be adversely affected bychanges in exchange rates beyond a range specified at the inception of thehedging relationship. We hedge up to 90% of anticipated United States dollardenominated sales of our foreign subsidiaries for a rolling twelve-monthperiod.

As of April 5,2004, all forward extra contracts entered into by us to hedge forecastedtransactions qualified for, and were designated as, foreign-currency cash flowhedges. Changes in fair values of outstanding cash flow hedge derivatives thatare highly effective are recorded in other comprehensive income until netincome is affected by the variability of the cash flows of the hedgedtransaction. In most cases, amounts recorded in other comprehensive income willbe released to net income in the quarter that the related derivative matures.Results of hedges are recorded as cost of sales when the underlying hedgedtransaction affects net income.

Actual amountsultimately reclassified to net income are dependent on the exchange rates ineffect when derivative contracts that are currently outstanding mature. As ofDecember 31, 2006, the maximum term over which we are hedging exposures to thevariability of cash flows for all forecasted and recorded transactions wastwelve months. We formally assess, both at the inception of the hedge and on anongoing basis, whether the derivatives that are used in hedging transactionshave been highly effective in offsetting changes in the cash flows of hedgeditems and whether those derivatives may be expected to remain highly effectivein future periods. We assess effectiveness of options based on the total cashflows method and record total changes in the options’ fair value to othercomprehensive income to the degree the options are effective.

We prospectivelydiscontinue hedge accounting when (i) we determine that the derivative is nolonger highly effective in offsetting changes in the cash flows of a hedgeditem (including hedged items such as firm commitments or forecastedtransactions); (ii) it is no longer probable that the forecasted transactionwill occur; or (iii) management determines that designating the derivative as ahedging instrument is no longer appropriate. If we discontinue hedgeaccounting, the gains and losses that were accumulated in other comprehensiveincome (loss) will be recognized immediately in net income. In all situationsin which hedge accounting is discontinued and the derivative remainsoutstanding, we will carry the derivative at its fair value on the balancesheet, recognizing future changes in the fair value in current-period netincome (loss).  Any hedge ineffectivenessis recorded in current-period net income.

Net realized gains(losses) related to cash flow hedges recorded in cost of sales were $2.0million in 2006, $(2.2) million in 2005 and $1.8 million in 2004. As ofDecember 31, 2006 and 2005, $1.7 million of deferred net unrealized gains and$0.9 million of deferred net unrealized losses on outstanding derivatives,respectively, were recorded as other comprehensive income. The 2006 deferredunrealized gains are expected to be reclassified to net income during the nexttwelve months as a result of underlying hedged transactions also being recordedin net income.

In 2005, werecorded a charge of $0.5 million in other income (expense) related to bothhedge ineffectiveness and hedge dedesignations. We did not record any gain orloss in other income/expense due to ineffectiveness of derivatives in 2006 or2004, nor did we record any gain or loss due to discontinued hedge accountingduring 2006 or 2004.

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Prior to April 5,2004, realized and unrealized gains and losses related to the foreign forwardextra contracts were recorded in other income (expense) in the current periodas they did not meet the hedge requirements of SFAS No. 133. We recorded anunrealized loss for such contracts of $2.7 million and a realized gain of $1.4million in 2004.

***OtherDerivatives***

Changes in fairvalue of foreign forward exchange contracts entered into to mitigate theforeign exchange risks related to non-functionally denominated cash,receivables and payables are recorded in other income (expense) currentlytogether with the transaction gain or loss from the hedged balance sheetposition. Excluding forward extra contracts and option losses, foreign exchangelosses, net of the balance sheet hedge benefits, were $1.9 million, $1.0million and $1.8 million in 2006, 2005 and 2004, respectively.

**20.**                               COMMITMENTSAND CONTINGENT LIABILITIES

From time to time, we may be a party tolitigation arising in the ordinary course of business. Currently, we are not aparty to any litigation that we believe would have a material adverse effect onour financial position, results of operations or cash flows.

We participate in third party equipmentlease financing programs with United States financial institutions for a smallportion of products sold. In these circumstances, the financial institutionpurchases our equipment and then leases it to a third party. Under thesearrangements, the financial institutions have limited recourse against us on aportion of the outstanding lease portfolio if the lessee defaults on the lease.We did not add to such guarantees during 2006, and, as of December 31, 2006, wehad outstanding guarantees totaling $0.4 million related to these leasetransactions. Under certain circumstances, we are obligated to exercise bestefforts to re-market the equipment should the financial institutions reacquireit. As of December 31, 2006, we did not have any guarantees that require us tore-market the equipment.

We have commitments under non-cancelablepurchase orders, primarily relating to inventory, totaling $67.5 million atDecember 31, 2006. These commitments expire at various times through the thirdquarter of 2007.

**21.**                               SEGMENT ANDGEOGRAPHIC INFORMATION

Operating segments are defined ascomponents of an enterprise about which separate financial information isavailable that is evaluated regularly by the chief operating decision maker, ordecision making group, in deciding how to allocate resources and in assessingperformance. Our chief operating decision maker is our Operating Review Board,which consists of our Chief Executive Officer, our Chief Financial Officer, ourSenior Vice Presidents and other senior management.

Beginning in 2006,we began reporting our segments based on the market-focused organization thatwe put into place at the end of 2005. The Microelectronics and Electron Opticssegments were reallocated to NanoElectronics, NanoResearch and Industry andNanoBiology based on customer markets. Service and Components were combinedinto one segment. Prior period information has been reclassified to conformwith the current period presentation.

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The following tablesummarizes various financial amounts for each of our current business segments(in thousands):
| Year Ended December 31, 2006 | ** ** | **Nano-  Electronics** | ** ** | **Nano-  Research  and  Industry** | ** ** | **Nano-  Biology** | ** ** | **Service  and  Components** | ** ** | **Corporate  and  Eliminations** | ** ** | **Total**  | ** ** |
|---------------------------------------------|------------|------------------------|------------|------------------------------------|------------|--------------------|------------|------------------------------|------------|----------------------------------|------------|------------|------------|
| Sales to external customers                 |       | $                      | 154,648    |                               | $          | 165,067            |       | $                            | 40,928     |                             | $          | 118,848    |       | $ | — |   | $ | 479,491 |   |
| Gross profit                                |       | 76,030                 |       | 70,207                             |       | 16,664             |       | 33,545                       |       | —                           |       | 196,446    |       |
| **Year Ended December 31, 2005**            | ** ** | ** **             | ** ** | ** **                         | ** ** | ** **         | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Sales to external customers                 |       | $                      | 145,951    |                               | $          | 130,045            |       | $                            | 35,355     |                             | $          | 108,746    |       | $ | — |   | $ | 420,097 |   |
| Gross profit                                |       | 52,438                 |       | 50,626                             |       | 12,453             |       | 29,677                       |       | —                           |       | 145,194    |       |
| **Year Ended December 31, 2004**            | ** ** | ** **             | ** ** | ** **                         | ** ** | ** **         | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Sales to external customers                 |       | $                      | 207,760    |                               | $          | 104,236            |       | $                            | 45,046     |                             | $          | 100,483    |       | $ | — |   | $ | 457,525 |   |
| Gross profit                                |       | 96,571                 |       | 37,694                             |       | 14,645             |       | 32,484                       |       | —                           |       | 181,394    |       |
| **December 31, 2006**                       | ** ** | ** **             | ** ** | ** **                         | ** ** | ** **         | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Total assets                                |       | $                      | 93,987     |                               | $          | 105,329            |       | $                            | 20,198     |                             | $          | 111,677    |       | $ | 506,888 |   | $ | 838,079 |   |
| **December 31, 2005**                       | ** ** | ** **             | ** ** | ** **                         | ** ** | ** **         | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Total assets                                |       | $                      | 71,041     |                               | $          | 82,254             |       | $                            | 16,704     |                             | $          | 111,952    |       | $ | 374,080 |   | $ | 656,031 |   |

 

Nano-marketsegment disclosures are presented to the gross profit level as this is theprimary performance measure for which the segment general managers areresponsible. Selling, general and administrative, research and development andother operating expenses are managed and reported at the corporate level and,given allocation to the nano-market segments would be arbitrary, have not beenallocated to the market segments. See our Consolidated Statements of Operationsfor reconciliations from gross profit to income before income taxes. Thesereconciling items are not included in the measure of profit and loss for eachreportable segment. Segment assets as of December 31, 2005 have beenreclassified for consistent presentation with the allocation of segment assetsas of December 31, 2006.

Ourlong-lived assets were geographically located as follows (in thousands):

| December 31, | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| United States     |       | $        | 40,730     |     | $          | 48,625 |   |
| The Netherlands   |       | 17,926   |       | 18,942   |       |
| Other             |       | 8,772    |       | 7,207    |       |
| Total             |       | $        | 67,428     |     | $          | 74,774 |   |

 

The following tablesummarizes sales by geographic region (in thousands):
| ** **                   | ** ** | **North America** | ** ** | **Europe** | ** ** | **Asia-  Pacific** | ** ** | **Total**  | ** ** |
|------------------------------|------------|------------------------|------------|------------|------------|--------------------|------------|------------|------------|
| **2006**                     | ** ** | ** **             | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** |
| Product sales                |       | $                      | 104,879    |       | $          | 150,933            |       | $          | 104,831    |   | $ | 360,643 |   |
| Service and  component sales |       | 62,510                 |       | 36,296     |       | 20,042             |       | 118,848    |       |
| Total sales                  |       | $                      | 167,389    |       | $          | 187,229            |       | $          | 124,873    |   | $ | 479,491 |   |
|                         |       |                   |       |       |       |               |       |       |       |
| **2005**                     | ** ** | ** **             | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** |
| Product sales                |       | $                      | 70,477     |       | $          | 126,831            |       | $          | 114,043    |   | $ | 311,351 |   |
| Service and  component sales |       | 55,398                 |       | 34,060     |       | 19,288             |       | 108,746    |       |
| Total sales                  |       | $                      | 125,875    |       | $          | 160,891            |       | $          | 133,331    |   | $ | 420,097 |   |
|                         |       |                   |       |       |       |               |       |       |       |
| **2004**                     | ** ** | ** **             | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** |
| Product sales                |       | $                      | 115,244    |       | $          | 112,339            |       | $          | 129,459    |   | $ | 357,042 |   |
| Service and  component sales |       | 53,767                 |       | 31,759     |       | 14,957             |       | 100,483    |       |
| Total sales                  |       | $                      | 169,011    |       | $          | 144,098            |       | $          | 144,416    |   | $ | 457,525 |   |

 

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Noneof our customers represented 10% or more of our total sales in 2006, 2005 or2004.

Salesto countries which totaled 10% or more of our total sales were as follows(dollars in thousands):

|               | ** ** | **Dollar  Amount** | ** ** | **% of Total  Sales** | ** ** |
|---------------|------------|--------------------|------------|---------------------------------|------------|
| **2006**      | ** ** | ** **         | ** ** | ** **                      | ** ** |
| United States |       | $                  | 165,130    |                            | 34.4       | % |
| Germany       |       | 49,743             |       | 10.4                            | %          |
|          |       |               |       |                            |       |
| **2005**      | ** ** | ** **         | ** ** | ** **                      | ** ** |
| United States |       | $                  | 123,958    |                            | 29.5       | % |
| Germany       |       | 54,115             |       | 12.9                            | %          |
| Japan         |       | 47,639             |       | 11.3                            | %          |
|          |       |               |       |                            |       |
| **2004**      | ** ** | ** **         | ** ** | ** **                      | ** ** |
| United States |       | $                  | 170,089    |                            | 37.2       | % |
| Hong Kong     |       | 52,550             |       | 11.5                            | %          |

 

**22.  DISPOSAL OF THESIMS PRODUCT LINE**

In the secondquarter of 2005, we sold the net assets of our secondary ion mass spectrometer(“SIMS”) product line, which would have been part of our NanoElectronicssegment, for a net gain of $0.8 million, which was recorded as an offset toselling, general and administrative expenses. Proceeds from the sale totaled$2.5 million in cash and $2.5 million in a note receivable, which was due inJanuary 2006. Of the note receivable, $2.3 million was collected in February 2006upon resolution of the final balance sheet audit. The total adjustment to thepurchase price resulting from the audit was a decrease of $0.2 million, whichwas offset against a contingency reserve of $0.3 million we had recorded in2005. Net assets disposed and the related selling costs totaled $4.0 million.Revenues for this product line totaled $3.1 million in 2005 and $8.9 million in2004.

**23.  DISCONTINUEDOPERATIONS**

In the fourthquarter of 2006, we sold the assets and operations related to Knights Technologythat was included as part of our NanoElectronics operating segment. Werecognized a gain on the disposal of the discontinued operations of $3.3million and received cash proceeds of $7.8 million. An additional $0.2 millionhas been held in escrow and will be released when all contingencies surroundingthe transaction are resolved. All historical balance sheet and statement ofoperations data has been restated to reflect the discontinued operations.

Certain financialinformation related to discontinued operations was as follows (in thousands):
| **Year Ended December 31,**                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                                                         |       | $        | 5,245      |     | $          | 7,132    |       | $ | 8,180 |   |
| Pre-tax (loss)  income                                          |       | (905     | )          | 606      |       | 1,450    |       |
| Income tax expense                                              |       | 42       |       | 304      |       | 593      |       |
| Gain (loss) on  disposal of discontinued operations, net of tax |       | 3,335    |       | —   |       | —   |       |
| Amount of goodwill and  other intangible assets disposed of     |       | 3,133    |       | —   |       | —   |       |
|                                                                 |            |          |            |          |            |          |            |  |  |  |

 

In accordance with SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” we recordedthe related assets and liabilities as current assets and liabilities on ourbalance sheet at the lower of their carrying amount or fair value, less cost tosell as of December 31, 2005. No impairment charge was recorded related to theassets of the discontinued operations.

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Assets of discontinuedoperations included the following (in thousands):

| December 31,              | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Cash and cash  equivalents     |       | $        | —     |     | $          | 410 |   |
| Accounts receivable            |       | —   |       | 2,100    |       |
| Other current assets           |       | —   |       | 44       |       |
| Property, plant and  equipment |       | —   |       | 205      |       |
| Purchased technology           |       | —   |       | 1,800    |       |
| Goodwill                       |       | —   |       | 500      |       |
| Other                          |       | —   |       | 1,283    |       |
|                           |       | $        | —     |     | $          | 6,342 |   |

 

Liabilities ofdiscontinued operations included the following (in thousands):

| December 31,                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|
| Accrued payroll and  related liabilities |       | $        | —     |     | $          | 28 |   |
| Accrued agent  commission                |       | —   |       | 98       |       |
| Deferred revenue                         |       | —   |       | 1,205    |       |
| Other current  liabilities               |       | —   |       | 102      |       |
| Other liabilities                        |       | —   |       | 496      |       |
|                                     |       | $        | —     |     | $          | 1,929 |   |

 

###### **24.  FAIR VALUE OF FINANCIAL ASSETS ANDLIABILITIES**

We estimate the fair value of our monetaryassets and liabilities based upon comparison of such assets and liabilities tothe current market values for instruments of a similar nature and degree ofrisk.

We believe the carrying amounts of cashand cash equivalents, receivables, current accounts with Philips, accountspayable and other current liabilities are a reasonable approximation of thefair value of those financial instruments because of the nature of theunderlying transactions and the short-term maturities involved.

The fair value and cost of certainfinancial assets and liabilities as of December 31, 2006 was as follows (inthousands):

|                       | ** ** | **Fair Value** | ** ** | **Cost** | ** ** |
|-----------------------|------------|---------------------|------------|----------|------------|
| Marketable securities |       | $                   | 269,102    |     | $          | 269,517 |   |
| Convertible notes     |       | $                   | 341,058    |     | $          | 310,882 |   |
| Derivative contracts  |       | $                   | 4,724      |     | $          | — |   |

 

The fair value and cost of certainfinancial assets and liabilities as of December 31, 2005 was as follows (inthousands):

|                       | ** ** | **Fair Value** | ** ** | **Cost** | ** ** |
|-----------------------|------------|---------------------|------------|----------|------------|
| Marketable securities |       | $                   | 201,877    |     | $          | 203,231 |   |
| Convertible notes     |       | $                   | 211,125    |     | $          | 225,000 |   |
| Derivative contracts  |       | $                   | (1,143     | )        | $          | — |   |

 

As of December 31, 2006, the aggregatenotional amount of our outstanding derivative contracts was $56.0 million. Thefair value of these contracts represents our forward extra contracts andforward contracts.  The fair value ofthese contracts was obtained from financial institutions.

89

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**Item 9.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

None.

**Item 9A.  Controls and Procedures**

***Evaluationof Disclosure Controls and Procedures***

Our management evaluated, with the participation and underthe supervision of our President and Chief Executive Officer and ChiefFinancial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this Annual Report on Form 10-K. Basedon this evaluation, our President and Chief Executive Officer and our ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective to ensure that information we are required to disclose in reportsthat we file or submit under the Securities Exchange Act of 1934 is accumulatedand communicated to our management, including our President and Chief ExecutiveOfficer and our Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure and that such information is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

***Changesin Internal Controls***

There was no change in our internal control over financialreporting that occurred during our last fiscal quarter that has materiallyaffected or is reasonably likely to materially affect our internal control overfinancial reporting.

# ***Management’sReport on Internal Control Over Financial Reporting***

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting. There are inherent limitations in the effectiveness of anyinternal control, including the possibility of human error and thecircumvention or overriding of controls. Accordingly, even effective internalcontrols can provide only reasonable assurances with respect to financialstatement preparation. Further, because of changes in conditions, theeffectiveness of internal controls may vary over time.

Our managementassessed the effectiveness of our internal control over financial reporting asof December 31, 2006. In making this assessment, we used the criteria set forthin *Internal Control — Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on our assessment using those criteria, our management concluded that, asof December 31, 2006, our internal control over financial reporting waseffective.

Management’s assessment of theeffectiveness of our internal control over financial reporting as of December31, 2006 has been attested to by Deloitte & Touche LLP, an independentregistered public accounting firm, as stated in their report which is includedherein.

90

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

Tothe Board of Directors and Shareholders of

FEICompany

Hillsboro, Oregon

We have audited management’s assessment, included in the accompanying *Management’s Report on Internal Control Over Financial Reporting*,that FEI Company and subsidiaries (the “Company”) maintained effective internalcontrol over financial reporting as of December 31, 2006, based on criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the TreadwayCommission.  The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects.  Our audit included obtainingan understanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a processdesigned by, or under the supervision of, the company’s principal executive andprincipal financial officers, or persons performing similar functions, andeffected by the company’s board of directors, management, and other personnelto 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 internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2)provide reasonable assurance that transactions are recorded as necessary topermit preparation of financial statements in accordance with generallyaccepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors 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 the inherent limitations of internal control over financialreporting, including the possibility of collusion or improper managementoverride of controls, material misstatements due to error or fraud may not beprevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internalcontrol over financial reporting to future periods are subject to the risk thatthe controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effectiveinternal control over financial reporting as of December 31, 2006, is fairlystated, in all material respects, based on the criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission.  Also in our opinion, the Company maintained,in all material respects, effective internal control over financial reportingas of December 31, 2006, based on the criteria established in *Internal Control—Integrated Framework* issued by the Committeeof Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated financialstatements as of and for the year ended December 31, 2006 of the Company andour report dated March 1, 2007 expressed an unqualified opinion on thosefinancial statements, and included an explanatory paragraph regarding theCompany’s adoption of Statement of Financial Accounting Standard No. 123R “ShareBased Payment” on January 1, 2006.

DELOITTE& TOUCHE LLP

Portland,Oregon

# March1, 2007

91

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**Item 9B.  Other Information**

None.

**PART III**

**Item 10.  Directors, Executive Officers andCorporate Governance**

#### Information required by this item will be included under the captions *Election of Directors*, *Meetings and Committees ofthe Board of Directors*, *Audit Committee FinancialExpert*, *Code of Ethics*,Ex*ecutive Officers, Corporate Governance*and*Section 16(a) Beneficial Ownership ReportingCompliance*in our Proxy Statement for our 2007 Annual Meeting ofShareholders and is incorporated by reference herein.

On September 9, 2003, we adopted a code ofbusiness conduct and ethics that applies to all directors, officers andemployees. We posted our code of business conduct and ethics on our website atwww.fei.com. We intend to disclose any amendment to the provisions of the codeof business conduct and ethics that apply specifically to directors orexecutive officers by posting such information on our website. We intend todisclose any waiver to the provisions of the code of business conduct andethics that apply specifically to directors or executive officers by filingsuch information on a Current Report on Form 8-K with the SEC, to the extentsuch filing is required by The Nasdaq Stock Market’s listing requirements;otherwise, we will disclose such waiver by posting such information on ourwebsite.

**Item 11.  Executive Compensation**

Informationrequired by this item will be included under the captions *DirectorCompensation,**Executive Compensation,Employment Arrangements and Executive Severance Agreements*and*Compensation Committee Interlocks and Insider Participation*inour proxy statement for our 2007 Annual Meeting of Shareholders and isincorporated by reference herein.

**Item 12.  Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

Informationrequired by this item will be included under the captions *SecurityOwnership of Certain Beneficial Owners and Management* and *Securities Authorized for Issuance Under Equity Compensation Plans*inour proxy statement for our 2007 Annual Meeting of Shareholders and isincorporated by reference herein.

**Item 13.  Certain Relationships and RelatedTransactions, and Director Independence**

Informationrequired by this item will be included under the caption *CertainRelationships and Related Transactions*and*Director**Independence* in our Proxy Statement forour 2007 Annual Meeting of Shareholders and is incorporated by referenceherein.

**Item 14.  Principal Accountant Fees and Services**

Informationrequired by this item will be included under the caption *Ratificationof Appointment of Public Accounting Firm* in our proxy statement for our 2007 AnnualMeeting of Shareholders and is incorporated by reference herein.

92

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**PART IV**

**Item 15.  Exhibits and Financial Statement Schedules**

**FinancialStatements and Schedules**

The Consolidated Financial Statements,together with the report thereon of our independent registered publicaccounting firm, are included on the pages indicated below:
|                                                                                                              | ** ** | Page   | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|--------|------------|
| Report  of Independent Registered Public Accounting Firm                                                     |       | 52     |       |
|                                                                                                         |       |   |       |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                |       | 53     |       |
|                                                                                                         |       |   |       |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005 and 2004                  |       | 54     |       |
|                                                                                                         |       |   |       |
| Consolidated Statements of Comprehensive Income (Loss)  for the years ended December 31, 2006, 2005 and 2004 |       | 55     |       |
|                                                                                                         |       |   |       |
| Consolidated Statements of Shareholders’ Equity for  the years ended December 31, 2006, 2005 and 2004   |       | 56     |       |
|                                                                                                         |       |   |       |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                  |       | 57     |       |
|                                                                                                         |       |   |       |
| Notes to Consolidated Financial Statements                                                                   |       | 58     |       |

 

There are noschedules required to be filed herewith.

**Exhibits**

The following exhibits are filed herewithand this list is intended to constitute the exhibit index. A plus sign (+)beside the exhibit number indicates the exhibits containing a managementcontract, compensatory plan or arrangement, which are required to be identifiedin this report.
| Exhibit No.  | ** ** | **Description**                                                                                                                     |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(10)      |       | Third Amended and Restated Articles of Incorporation                                                                                |
|         |       |                                                                                                                                |
| 3.2(14)      |       | Articles of Amendment to the Third Amended and  Restated Articles of Incorporation                                                  |
|         |       |                                                                                                                                |
| 3.3(16)      |       | Amended and Restated Bylaws, as amended on August  17, 2006                                                                         |
|         |       |                                                                                                                                |
| 4.1(5)       |       | Indenture between FEI and BNY Western Trust Company  dated August 3, 2001                                                           |
|         |       |                                                                                                                                |
| 4.2(5)       |       | Form of Note for 5.5% Convertible Subordinated Notes  due 2008                                                                      |
|         |       |                                                                                                                                |
| 4.3(5)       |       | Registration Rights Agreement between FEI and Credit  Suisse First Boston dated August 3, 2001                                      |
|         |       |                                                                                                                                |
|  4.4(9) |       | Indenture, dated as of June 13, 2003, between FEI  and BNY Western Trust Company, a California state chartered banking  corporation |
|         |       |                                                                                                                                |
| 4.5(9)       |       | Form of Note for Zero Coupon Convertible  Subordinated Notes due 2008                                                               |
|         |       |                                                                                                                                |
| 4.6(9)       |       | Registration Rights Agreement, dated as of June 13,  2003, between FEI and the initial purchasers named therein                     |
|         |       |                                                                                                                                |
| 4.7(17)      |       | Indenture, dated as of May 19, 2006, between  the Company and The Bank of New York Trust Company, as trustee                   |
|         |       |                                                                                                                                |
| 4.8          |       | Form of 2.875% Convertible Subordinated Note  due 2013 (incorporated by reference to Annex A of Exhibit 4.7).                  |

 

93

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| 4.9(17)    |   | Registration Rights Agreement, dated as of  May 19, 2006, among FEI Company, Merrill Lynch, Pierce,  Fenner & Smith Incorporated, Needham & Company, LLC, Thomas  Weisel Partners LLC, D.A. Davidson & Co. and Merriman Curhan  Ford & Co. |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                |
| 4.10(14)   |   | Preferred Stock Rights Agreement dated July 21,  2005, between FEI and Mellon Investor Services, LLC                                                                                                                                                                                |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.1+(18)  |   | 1995 Stock Incentive Plan, as amended                                                                                                                                                                                                                                               |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.2+(2)   |   | 1995 Supplemental Stock Incentive Plan                                                                                                                                                                                                                                              |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.3+(1)   |   | Form of Incentive Stock Option Agreement                                                                                                                                                                                                                                            |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.4+(1)   |   | Form of Nonstatutory Stock Option Agreement                                                                                                                                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.5+(13)  |   | 1995 Employee Share Purchase Plan, as amended                                                                                                                                                                                                                                       |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.6(3)    |   | Lease Agreement, dated October 27, 1997, between  Philips Business Electronics International B.V., as lessor, and Philips  Electron Optics B.V., a wholly owned indirect subsidiary of FEI, as lessee,  including a guarantee by FEI of the lessee’s obligations thereunder    |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.7+(19)  |   | Executive Severance Agreement by and between Dr. Don  Kania and FEI Company                                                                                                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.8+(19)  |   | Stand-alone Non-statutory Stock Option Agreement  (for grant of 100,000 option shares outside of 1995 Stock Incentive Plan as a  material inducement for Dr. Kania to accept employment)                                                                                            |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.9+(19)  |   | Stand-alone Restricted Stock Unit Agreement (for  grant of 25,000 units outside the 1995 Stock Incentive Plan as a material  inducement for Dr. Kania to accept employment)                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.10+(19) |   | Stand-alone Restricted Stock Unit Agreement (for  grant of 50,000 units outside of 1995 Stock Incentive Plan as a material  inducement for Dr. Kania to accept employment)                                                                                                          |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.11+(19) |   | Form of Restricted Stock Unit grant (for grant of  75,000 units to Dr. Kania within the 1995 Stock Incentive Plan)                                                                                                                                                                  |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.12+(6)  |   | Form of Executive Severance Agreement between FEI  and Robert S. Gregg, Steven D. Berger and John A. Doherty                                                                                                                                                                        |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.13+(4)  |   | FEI Company Nonqualified Deferred Compensation Plan                                                                                                                                                                                                                                 |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.14(7)   |   | Purchase Agreement, effective as of November 1,  2002, between FEI and Philips Enabling Technologies Group Nederland B.V.                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.15(7)   |   | Lease Agreement, dated December 11, 2002, by and  among FEI, Technologicky Park Brno, a.s. and FEI Czech Republic, s.r.o.                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.16(8)   |   | Master Agreement for the Acht facility, dated  January 14, 2003                                                                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.17+(11) |   | Form of Indemnity Agreement for Directors and  Executive Officers of FEI                                                                                                                                                                                                            |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.18+     |   | Description of Compensation of Non-Employee  Directors                                                                                                                                                                                                                              |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.19+(22) |   | FEI Management Variable Compensation Plan Program  Summary Description                                                                                                                                                                                                              |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.20+(12) |   | Summary Description of Commission Compensation of  Senior Vice President of World-Wide Sales for FEI                                                                                                                                                                                |
|       |   |                                                                                                                                                                                                                                                                                |
| 10.21+(22) |   | Base Salary and Target Management Variable  Compensation Payment Plan for Certain Executive Officers                                                                                                                                                                                |

 

94

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| 10.22+(15) |   | Form of Lock-Up Agreement between FEI and Certain of  its Executive Officers and Other Members of Senior Management                                                                    |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                   |
| 10.23+(15) |   | Description of Accelerated Vesting of Certain Stock  Options Held by Employees                                                                                                         |
|       |   |                                                                                                                                                                                   |
| 10.24+(20) |   | Employment Agreement with Robert H. J. Fastenau,  dated November 28, 2006                                                                                                              |
|       |   |                                                                                                                                                                                   |
| 10.25(21)  |   | Description of Compensation for Executive Vice  President and Chief Financial Officer Raymond A. Link                                                                                  |
|       |   |                                                                                                                                                                                   |
| 14(11)     |   | Code of Ethics                                                                                                                                                                         |
|       |   |                                                                                                                                                                                   |
| 21         |   | Subsidiaries                                                                                                                                                                           |
|       |   |                                                                                                                                                                                   |
| 23         |   | Consent of Deloitte & Touche, LLP                                                                                                                                                  |
|       |   |                                                                                                                                                                                   |
| 31         |   | Certifications of Chief Executive Officer and Chief  Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934                            |
|       |   |                                                                                                                                                                                   |
| 32         |   | Certifications of Chief Executive Officer and Chief  Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the  Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |

----

(1)          Incorporated by reference to our RegistrationStatement of Form S-1, as amended, effective May 31, 1995 (CommissionRegistration No. 33-71146).

(2)          Incorporated by reference to our Annual Reporton Form 10-K for the year ended December 31, 1995.

(3)          Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended September 28, 1997.

(4)          Incorporated by reference to our RegistrationStatement on Form S-3, filed on April 23, 2001.

(5)          Incorporated by reference to our RegistrationStatement of Form S-3, as amended, effective November 7, 2001.

(6)          Incorporated by reference to our Annual Reporton Form 10-K for the year ended December 31, 2001.

(7)          Incorporated by reference to our Annual Reporton Form 10-K for the year ended December 31, 2002.

(8)          Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended March 30, 2003.

(9)          Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended June 29, 2003.

(10)    Incorporatedby reference to our Quarterly Report on Form 10-Q for the quarter endedSeptember 28, 2003.

(11)    Incorporatedby reference to our Annual Report on Form 10-K for the year ended December 31,2003.

(12)    Incorporatedby reference to our Annual Report on Form 10-K for the year ended December 31,2004.

(13)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on May 25, 2005.

(14)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on July 27, 2005.

(15)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on October 24, 2005.

(16)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on August 22, 2006.

(17)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on May 23, 2006.

(18)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on May 12, 2006.

(19)    Incorporatedby reference to our Quarterly Report on Form 10-Q for the quarter ended July 2,2006.

(20)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on December 4, 2006.

(21)    Incorporatedby reference to our Current Report on Form 8-K filed with the Securities andExchange Commission on May 27, 2005.

(22)    Incorporated by reference to our Current Report on Form 8-K filed withthe Securities and Exchange Commission on February 27, 2007.

 

95

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
| Date: February 26, 2007 |   | FEI COMPANY             |
|-------------------------|--------|-------------------------|
|                    |   |                    |
|                    |   | By /s/ DON R. KANIA     |   |
|                    |   | Don R. Kania            |
|                    |   | Director, President and |
|                    |   | Chief Executive Officer |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities indicated on February 26, 2007:
| Signature                | ** ** | **Title**                                            |
|--------------------------|------------|------------------------------------------------------|
|                     |       |                                                 |
| /s/ DON R. KANIA         |       |                                                 | Director, President and |
| Don R. Kania             |       | Chief Executive Officer                              |
|                     |       | (Principal Executive Officer)                        |
|                     |       |                                                 |
| /s/ RAYMOND A. LINK      |       |                                                 | Executive Vice President and Chief Financial |
| Raymond A. Link          |       | Officer (Principal Financial and Accounting Officer) |
|                     |       |                                                 |
| /s/ MICHAEL J. ATTARDO   |       |                                                 | Director |
| Michael J. Attardo       |       |                                                 |
|                     |       |                                                 |
| /s/ LAWRENCE A. BOCK     |       |                                                 | Director |
| Lawrence A. Bock         |       |                                                 |
|                     |       |                                                 |
| /s/ WILFRED J. CORRIGAN  |       |                                                 | Director |
| Wilfred J. Corrigan      |       |                                                 |
|                     |       |                                                 |
| /s/ THOMAS F. KELLY      |       |                                                 | Director |
| Thomas F. Kelly          |       |                                                 |
|                     |       |                                                 |
| /s/ WILLIAM W. LATTIN    |       |                                                 | Director |
| William W. Lattin        |       |                                                 |
|                     |       |                                                 |
| /s/JAN C. LOBBEZOO       |       |                                                 | Director |
| Jan C. Lobbezoo          |       |                                                 |
|                     |       |                                                 |
| /s/ GERHARD H. PARKER    |       |                                                 | Director |
| Gerhard H. Parker        |       |                                                 |
|                     |       |                                                 |
| /s/ JAMES T. RICHARDSON  |       |                                                 | Chairman of the Board |
| James T. Richardson      |       |                                                 |
|                     |       |                                                 |
| /s/ DONALD R. VANLUVANEE |       |                                                 | Director |
| Donald R. VanLuvanee     |       |                                                 |
|                          |            |                                                      |  |  |  |  |  |  |  |  |

 

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