Cymer 10-Q 2006
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2006
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934
For the Transition Period from to
Commission file number 0-21321
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report).
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ý Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). oYes ýNo
The number of shares of Common Stock, with $0.001 par value, outstanding on July 28, 2006 was 39,311,449.
For the Quarterly Period Ended June 30, 2006
(In thousands, except share data)
(In thousands, except per share data)
See Notes to Unaudited Consolidated Financial Statements.
See Notes to Unaudited Consolidated Financial Statements.
Three and Six Months Ended June 30, 2006
1. BASIS OF PRESENTATION
Unaudited Interim Financial Data The accompanying consolidated financial information has been prepared by Cymer, Inc., and its wholly-owned and majority-owned subsidiaries (collectively, Cymer), without audit, in accordance with the instructions to Form 10-Q. In the opinion of management, the unaudited consolidated financial statements for the interim periods presented reflect all material adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations as of and for such periods indicated. These unaudited consolidated financial statements and notes hereto should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005. Results for the interim periods presented herein are not necessarily indicative of results that may be reported for any other interim period or for the entire fiscal year.
Principles of Consolidation The accompanying consolidated financial statements include our accounts and the accounts of our wholly owned subsidiaries Cymer Japan, Inc. (Cymer Japan), Cymer Singapore Pte Ltd. (Cymer Singapore), Cymer B.V. in the Netherlands (Cymer B.V.), Cymer Southeast Asia, Ltd, in Taiwan (Cymer SEA), Cymer Semiconductor Equipment Shanghai Co., Ltd, in the Peoples Republic of China (Cymer PRC), Cymer Korea, Inc. (Cymer Korea), and our majority-owned subsidiary, TCZ GmbH, a Swiss limited liability company (TCZ). We formed TCZ in July 2005 in connection with a joint venture agreement we entered into with (i) Carl Zeiss SMT AG, a German corporation (SMT); (ii) Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH, a German limited liability company (LOB); and (iii) TCZ. LOB and SMT, together with their affiliated entities, are collectively referred to as Zeiss. We own 60% of TCZ and Zeiss owns 40%. On January 2, 2006, we acquired the remaining 19% minority interest in Cymer Korea. We paid a total of $7.0 million for this 19% interest. This transaction increased our total interest in Cymer Korea from 81% to 100%. Cymer Japan is currently our only subsidiary that sells excimer light source systems. Cymer Japan also provides field service to customers in Japan. Cymer Singapore, Cymer B.V., Cymer SEA, and Cymer PRC are field service offices for customers in their respective countries. Cymer Korea provides refurbishment manufacturing, field service, and administrative activities for Korea and the Asia-Pacific region. TCZ is currently developing, and will integrate, market and sell, and support tools employing an excimer laser beam to induce crystallization of low-temperature poly-silicon (LTPS) processing for the manufacture of flat panel displays. All significant intercompany balances and transactions have been eliminated in consolidation.
Accounting Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.
Accounting Pronouncements Adopted
In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151 (SFAS No. 151), Inventory Costs, an amendment of ARB 43 Chapter 4. This statement amends Accounting Research Bulletin No. 43 (ARB No. 43) Chapter 4, to clarify accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 requires that those items be recognized as current-period charges. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. We adopted SFAS No. 151 on January 1, 2006. The adoption of SFAS No. 151 did not have a significant impact on our consolidated financial statements.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (SFAS No. 154), Accounting Changes and Error Correctionsa replacement of APB Opinion No. 20 and FASB Statement No. 3. This Statement replaces APB Opinion No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We adopted SFAS No. 154 on January 1, 2006. The adoption of SFAS No. 154 did not have a significant impact on our consolidated financial statements.
Effective January 1, 2006, we adopted the provisions of FASB Statement of Financial Accounting Standards No. 123R (SFAS No. 123R) Share-Based Payment which replaces Statement of Financial Accounting Standards No. 123 (SFAS No.123), Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees. Under the fair value recognition provisions of SFAS No. 123R, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense over the requisite service period, or the vesting period. We elected the modified-prospective method in implementing SFAS No. 123R which does not require us to revise prior period financial statements for comparative purposes. We elected to use the Black-Scholes option pricing model to determine the fair value of our stock options under SFAS No. 123R. The valuation provisions of SFAS No. 123R apply to new options granted on or after January 1, 2006. We also elected to attribute the value of share-based compensation to expense using the straight-line method for awards granted on or after January 1, 2006. Estimated compensation expense for grants that were outstanding and unvested as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS No. 123 pro forma disclosures which uses an accelerated expense recognition method for those awards with a graded vesting schedule. The adoption of SFAS No. 123R had a material impact on our consolidated financial statements. See Footnote 2 for more detailed information on our adoption of SFAS No. 123R.
On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. We have elected to adopt the short-cut method provided in the FASB Staff Position for calculating the tax effects of share-based compensation pursuant to SFAS No. 123R. The short-cut method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of share-based compensation, and to determine the subsequent impact on the APIC pool, the consolidated statements of cash flows, and earnings per share of the tax effects of share-based compensation awards that were outstanding upon adoption of SFAS No. 123R.
In accordance with SFAS No. 123R, beginning in the first quarter of 2006, we have presented excess tax benefits for the exercise of share-based compensation awards as a financing activity in the consolidated statement of cash flows. Prior to the adoption of SFAS No. 123R, we presented the tax benefits for deductions resulting from the exercise of stock options as an operating cash flow activity.
Reclassifications Certain amounts in the prior year consolidated financial statements have been reclassified to conform to current period presentation.
2. STOCKHOLDERS EQUITY
Stock-Based Compensation Valuation Assumptions
We estimate the fair value of our stock options using a Black-Scholes option pricing model, consistent with the provisions of SFAS No. 123R. In addition, we used this same option pricing model to calculate the fair value of our stock options included in our prior period pro forma disclosures as required by SFAS No.123.
The fair value of stock options granted is recognized to expense over the requisite service period. For stock options granted after the SFAS No. 123R effective date of January 1, 2006, the straight-line attribution approach is used. For stock options granted prior to January 1, 2006, which are continuing to vest, we will continue to record expense using the Financial Accounting Standards Board Interpretation No. 28 (FIN 28) accelerated attribution approach.
Upon the adoption of SFAS No. 123R, we used a combination of historical and implied volatility (blended volatility) to value our stock options. Historical volatility is based on the five-year expected term of the options. Implied volatility was derived based on six-month traded options of our common stock. Prior to January 1, 2006, we used only historical stock price volatility in accordance with SFAS No. 123 for purposes of our pro forma stock compensation calculation. The expected term of our stock options represents the period of time options are expected to be outstanding and is based on observed historical exercise patterns for our company which we believe are indicative of future exercise behavior. For the risk free interest rate, we use the then currently available rate on zero coupon U.S. Government issues with a remaining life of five years for valuing options.
The following weighted average assumptions were used for grants issued in the three and six months ended June 30, 2005 under the SFAS No. 123 requirements and in the three and six months ended June 30, 2006 under the SFAS No. 123R requirements:
In our pro forma disclosures prior to the adoption of SFAS No. 123R, we accounted for forfeitures as they occurred. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeiture rates differ from those estimates. Forfeitures were estimated based on historical activity for our company. For the three and six months ended June 30, 2006, we estimated a 3% annual forfeiture rate. We amended our ESPP in May 2005, and as a result, our ESPP is treated as a noncompensatory plan.
Impact of SFAS No. 123R
The following table presents the impact to our consolidated financial statements as a result of our adoption of SFAS No. 123R for the three and six months ended June 30, 2006 (in thousands, except per share amounts):
As of June 30, 2006, the unamortized compensation expense related to outstanding unvested options was approximately $11.2 million with a weighted average remaining vesting period of 1.21 years. We expect to amortize this expense over the remaining vesting period of these stock options.
The amount of stock-based compensation costs capitalized into inventory during the six months ended June 30, 2006 was immaterial.
We account for options granted to non-employees under SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to other than Employees for Acquiring or in Conjunction with Selling Goods or Services. We measure the fair value of such options using the Black-Scholes option pricing model at each financial reporting date. We account for changes in fair values between reporting dates in accordance with FIN 28. Stock-based compensation expense for options granted to non-employees and for those employees who changed status during the six months ended June 30, 2005 and 2006 was $356,000 and $147,000, respectively.
Prior to the adoption of SFAS No. 123R, for options granted to employees, we applied the intrinsic value-based method of accounting required by Accounting Principles Board Opinion No. 25 and provided the pro forma disclosures of SFAS No. 123 as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. Since the exercise price equaled the market value of the underlying common stock on the date of grant, the stock options had no intrinsic value upon grant and no compensation expense was recorded prior to the adoption of SFAS No.123R.
Pro forma for 2005 Under SFAS No. 123
The following table compares the earnings per share that we reported to the pro forma amounts that we would have reported had we recognized compensation expense for our stock-based compensation plans in accordance with SFAS No. 123 (in thousands, except per share amounts):
In February 2005, our board of directors approved the acceleration of the vesting of stock options that had exercise prices of $30.50 per share or higher held by employees. This acceleration of stock options excluded directors, executive officers and certain vice presidents. The purpose of this acceleration of vesting was to enable us to eliminate the recognition in our statement of operations of the compensation expense associated with these out of the money stock options in future periods, upon our adoption of SFAS No. 123R on January 1, 2006. The acceleration of vesting of these stock options in the six months ended June 30, 2005 contributed approximately $10.4 million of pro forma stock-based compensation expense.
Stock Option Plans
Currently, we grant stock options from our 2005 Equity Incentive Plan (the 2005 Plan), which provides for the grant or award of various equity instruments to our employees, directors and consultants. Upon approval of the 2005 Plan by stockholders in May 2005, we discontinued the use of our 1996 Stock Option Plan and 2000 Equity Incentive Plan. Options issued under the 2005 Plan expire ten years after the options are granted. It is our practice to generally grant options that vest and become exercisable ratably over a four-year period following the date of grant. A total of 1,000,000 shares of common stock are reserved for issuance under the 2005 Plan and it provides for the issuance of incentive stock options, nonstatutory stock options, stock appreciation rights, stock bonus awards, stock purchase awards, stock unit awards and other stock awards. Options to purchase 560,548 shares are outstanding and 439,316 shares remain available for grant under the 2005 Plan as of June 30, 2006.
The following describes our other stock option plans from which we no longer issue awards although options to purchase shares are still outstanding under these plans and continue to vest and may be exercised:
1996 Stock Option Plan (the 1996 Plan) The 1996 Plan provided for the grant of incentive stock options to our employees and nonqualified stock options to our employees, directors and consultants. The exercise prices of stock options granted under the 1996 Plan were at least equal to the fair market value of our common stock on the dates of grant. Options issued under the 1996 Plan expire five to ten years after the options were granted and generally vest and become exercisable ratably over a four-year period following the date of grant. A total of 7,900,000 shares of common stock were reserved for issuance under the 1996 Plan. Of these shares, options to purchase 1,855,104 million shares are outstanding as of June 30, 2006.
2000 Equity Incentive Plan (the 2000 Plan) In August 2000, our board of directors adopted the 2000 Plan which provides for the grant of options to our employees or consultants who are neither directors nor officers. The exercise prices of the options granted under the 2000 Plan were equal to the quoted market value of our common stock at the date of grant. Options issued under the 2000 Plan expire ten years after the options were granted and generally vest and become exercisable ratably over a four year period following the date of grant. A total of 4,950,000 shares of common stock were reserved for issuance under the 2000 Plan. Of these shares, options to purchase 1,600,063 million shares are outstanding as of June 30, 2006.
The following is a summary of stock option activity under all stock option plans for the six months ended June 30, 2006 (in thousands, except per share data):
The following table summarizes information as of June 30, 2006 concerning currently outstanding and exercisable options:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value, based on a per share price of $46.46, the closing price of our common stock on June 30, 2006 as reported by the Nasdaq National Market, which would have been received by the option holders had all option holders
exercised their options as of that date. The total number of in-the-money stock options exercisable as of June 30, 2006 was 2.7 million.
The weighted average per share fair value of the options granted was $15.66 and $20.18 during the three months ended June 30, 2005 and 2006, respectively, and was $16.24 and $19.23 during the six months ended June 30, 2005 and 2006, respectively.
The total intrinsic value of options exercised was $268,000 and $22.9 million during the three months ended June 30, 2005 and 2006, respectively, and was $678,000 and $54.1 million during the six months ended June 30, 2005 and 2006, respectively.
The total cash received from employees as a result of employee stock option exercises during the six months ended June 30, 2006 was approximately $91.7 million. In connection with these exercises, the tax benefits recognized by us for the six months ended June 30, 2006 was $17.8 million.
We settle employee stock option exercises with newly issued shares of our common stock.
In January 2006, our board of directors approved the use of annual stock unit awards for non-employee directors pursuant to our 2005 Plan in lieu of quarterly stock options grants. The number of shares subject to each stock unit award is determined by dividing $100,000 by the closing price per share of our common stock as of the date of grant. During the six months ended June 30, 2006, 17,948 shares subject to such stock units awards were granted to non-employee directors with a grant date fair value of $39.00 per share. Each stock unit award shall vest 100% after one year from the date of grant. Stock based compensation expense for stock units for the three and six months ended June 30, 2006 was $175,000 and $321,000, respectively.
A summary of the change in stock unit awards outstanding during the six months ended June 30, 2006 is as follows (in thousands, except life data):
Weighted Average Remaining Recognition Period - 0.55 years
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value based on our closing stock price of $46.46 as of June 30, 2006.
Employee Stock Purchase Plan
1996 Employee Stock Purchase Plan (the ESPP) Our ESPP is intended to qualify for favorable income tax treatment associated with rights granted under an employee stock purchase plan which qualifies under Section 423 of the Internal Revenue Code. Under the ESPP, eligible employees may purchase shares of our common stock through payroll deductions of up to 15% of his or her compensation (as defined in the plan), at a price per share equal to 95% of the fair market value of our common stock at
the end of the purchase period. Our ESPP was amended in 2005. The amendment: a) changed the duration of offering periods under the plan from two years to six months b) reduced the discount to market price used to determine purchase price for shares of our common stock under the plan from 15% to 5%, and c) eliminated the lookback feature that allowed the purchase price to be determined as of the beginning of an offering period, or enrollment date, if the market price as of the enrollment date was lower than the market price at the end of the offering period. As a result of the amendment the plan became non-compensatory.
On February 7, 2006, our board of directors amended our ESPP to extend the expiration date of the plan until July 31, 2016. In addition, on May 18, 2006, our stockholders approved an amendment to increase the number of shares of common stock reserved for issuance under the plan by 300,000 shares from 1,200,000 shares to 1,500,000 shares.
The number of shares issuable under the ESPP as of June 30, 2006 was 380,235, and 1,119,765 shares have been previously issued. Because our ESPP is a non-compensatory plan as defined by SFAS No. 123R, no stock-based compensation expense is recorded for our ESPP.
The total cash received from employees as a result of ESPP shares issued during the six months ended June 30, 2006 was approximately $711,000.
Common Stock Warrants
During 2001, we issued warrants to purchase 200,000 shares of our common stock at a weighted average purchase price of $31.43 per share in conjunction with the acquisition of certain patents. In May 2006, these warrants were exercised with respect to all 200,000 shares for $6.3 million in cash.
3. EARNINGS PER SHARE
Earnings Per Share Basic earnings per share (EPS) excludes dilution and is computed by dividing net income or loss attributable to common stockholders by the weighted-average of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock (convertible subordinated notes using the if-converted method, warrants to purchase common stock and common stock options using the treasury stock method) were exercised or converted into common stock. Potential dilutive securities are excluded from the diluted EPS computation in loss periods as their effect would be anti-dilutive.
The following table sets forth the basic and diluted EPS for the three and six months ended June 30, 2005 and 2006 (in thousands, except per share information):
For the three months ended June 30, 2005 and 2006, weighted average options and warrants to purchase 5,706,000 and 354,000 shares of common stock, respectively, were outstanding but not included in the computation of diluted earnings per share as their effect was anti-dilutive. In addition, for the three months ended June 30, 2005, weighted average common shares attributable to convertible subordinated notes of 3,451,000 were not included in the computation of diluted earnings per share as their effect was also anti-dilutive.
For the six months ended June 30, 2005 and 2006, weighted average options and warrants to purchase 5,724,000 and 421,000 shares of common stock were outstanding but not included in the computation of diluted earnings per share as their effect was anti-dilutive. In addition, for the six months ended June 30, 2005, weighted average common shares attributable to convertible subordinated notes of 3,732,000 were not included in the computation of diluted earnings per share as their effect was also anti-dilutive.
Inventories consisted of the following as of December 31, 2005 and June 30, 2006 (in thousands):
5. REPORTING COMPREHENSIVE INCOME
Comprehensive income includes net income, effective unrealized gains and losses on forward contracts, foreign currency translation adjustments, and unrealized gains and losses on available-for-sale securities, which are recorded as short-term and long-term investments in the accompanying consolidated balance sheets.
The following table summarizes the change in each component of accumulated other comprehensive loss for the six months ended June 30, 2006 (in thousands):
Comprehensive income consisted of the following components (in thousands):
6. DEVELOPMENT AGREEMENT AND INTELLECTUAL PROPERTY LICENSE AGREEMENT
The research and development agreement we entered into effective as of January 23, 2004 with Intel Corporation (Intel) was amended effective on July 17, 2006 (Amended Development Agreement). Under the terms of the original agreement, Intel was to provide us with up to a total of $20.0 million over a three-year period to accelerate the development of production-worthy extreme ultraviolet (EUV) lithography light sources. The terms of the Amended Development Agreement are described more fully under Footnote 11 Subsequent Events.
The intellectual property license agreement we entered into effective as of January 28, 2004 with Intel was amended on June 28, 2006 (Amended Intellectual Property License Agreement). Under the original intellectual property license agreement, pursuant to which we licensed certain patents and trade secrets from Intel related to EUV lithography technology, our obligation to pay license fees to Intel did not commence until our first high volume manufacturing shipment of an EUV lithography light source. The Amended Intellectual Property License Agreement replaces the license fee payments tied to product shipments with an up-front license fee which we paid to Intel in full upon execution of the amendment. The Amended Intellectual Property License Agreement also changes a number of the EUV patents
covered by the license. All of the licensed patents under the Amended Intellectual Property License Agreement relate to EUV technology, and we intend to use them in connection with our continuing research and development efforts related to EUV.
We recorded the patent license rights acquired from Intel under this Amended Intellectual Property License Agreement as an intangible asset in our accompanying consolidated balance sheets. The total value of these patent license rights are being amortized over a period of 16.29 years which represents the average remaining life of all of the patents purchased under this amendment. The amortization of these patents is included in research and development expenses on the accompanying statement of operations since the field of use involves applications which are still in the research and development stages.
7. GOODWILL AND INTANGIBLE ASSETS
We account for our goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards No. 142 (SFAS No. 142), Goodwill and Other Intangible Assets. Under SFAS No. 142, our goodwill is subject to an annual impairment test. During the fourth quarter of 2005, we completed our annual impairment test of goodwill and intangible assets, and concluded that no impairment of goodwill existed.
The following table summarizes the activity in the carrying amount of goodwill as of December 31, 2005 and June 30, 2006 (in thousands):
Included in intangible assets net on the accompanying balance sheets are amounts associated with patents that were acquired in 2001, 2003, 2005 and 2006. As of December 31, 2005 and June 30, 2006, the net carrying amount of these patents was $10.5 million and $17.4 million, respectively. The accumulated amortization for these patents at December 31, 2005 and June 30, 2006 was $8.3 million and $9.6 million, respectively. Amortization expense for these patents was $593,000 and $636,000 for the three months ended June 30, 2005 and 2006, respectively, and $1.2 million and $1.3 million for the six months ended June 30, 2005 and 2006, respectively.
As of June 30, 2006, future estimated amortization expense for these patents is expected to be as follows for (in thousands):
In the ordinary course of business, we are not subject to potential obligations under guarantees that fall within the scope of Financial Accounting Standards Board Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, except for standard warranty provisions associated with product sales and
indemnification provisions related to intellectual property that are contained within many of our lithography tool manufacturer agreements. All of these provisions give rise only to the disclosure requirements prescribed by FIN 45.
(a) Product Warranties Warranty provisions contained within our lithography tool manufacturer agreements are generally consistent with those prevalent in the semiconductor equipment industry. The warranty period and terms for light source systems and spares and consumable parts varies by light source system model. We record a provision for warranty for all products, which is included in cost of product sales in the consolidated statements of operations and is recorded at the time that the related revenue is recognized. We review our warranty provision monthly, which is determined using a statistical financial model which calculates actual historical expenses, product failure rates, and potential risks associated with our different product models. We then use this financial model to calculate the future probable expenses related to warranty and the required level of the warranty provision. Throughout the year we review the risk levels, historical cost information and failure rates used within this model and update them as information changes over the products life cycle. If actual warranty expenditures differ substantially from our estimates, revisions to the warranty provision would be required. Actual warranty expenditures are recorded against the warranty provision as they are incurred.
The following table summarizes information related to our warranty provision for the six months ended June 30, 2006 (in thousands):
(b) Intellectual Property Indemnifications We include intellectual property indemnification clauses within our general terms and conditions with our customers and the general purchase agreements with our three lithography tool manufacturers, ASM Lithography, Canon, and Nikon. In general, these indemnification provisions provide that we will defend our customers against any infringement claims that arise related to our products. Under the indemnification clauses, we will pay all costs and damages, including attorneys fees, associated with such settlements or defenses, provided that the lithography tool manufacturer follows specific procedures for notifying us of such claims and allows us to manage the settlement proceedings. Due to the nature of these indemnification provisions, they are indefinite and extend beyond the term of the actual lithography tool manufacturer agreements.
An indemnification provision was also included in the contract manufacturing agreement with Seiko Instruments, Inc. (Seiko), which was terminated effective March 31, 2003. As with our indemnification provisions on intellectual property, we continue to honor this indemnification clause within the agreement even after its termination. Seiko and at least one Japanese lithography tool manufacturer have been notified that our light source systems in Japan may infringe certain Japanese patents. We believe, based upon the advice of counsel, that our products do not infringe any valid claim of the asserted patents or that we are entitled to prior use claims in Japan. Due to the nature of these indemnification provisions, they are indefinite and extend beyond the term of the actual lithography tool manufacturer agreements.
As part of the original research and development agreement signed with Intel in 2004, we also agreed to provide Intel with indemnity against any infringement of the intellectual property rights of any third party arising from Intels purchase and/or use of our EUV source systems. Although this agreement was recently amended, our obligations to indemnify Intel will be specifically negotiated in any purchase agreement related to such future products.
As part of the supply agreement signed with TCZ in September 2005, we agreed to indemnify TCZ against any infringement of the intellectual property rights of a third party arising from TCZs purchase of our products. We will defend such actions at our own expense and will pay the cost and damage awarded in any such action provided that TCZ grants us sole control of the defense and settlement of such action and also provides us with information required for the defense and settlement of such action. Due to the nature of these indemnification provisions, they are indefinite and extend beyond the term of the actual lithography tool manufacturer agreements.
9. RELATED PARTY TRANSACTIONS
As a result of the TCZ joint venture which was formed in July 2005, Zeiss is now a related party. In addition to transactions that occur among us, Zeiss and TCZ related to the joint venture, we also purchase certain optical parts directly from Zeiss and sell our light source system products to Zeiss periodically. We recorded revenue associated with this related party of $3.2 million and $5.4 million for the three and six months ended June 30, 2006, respectively. As of December 31, 2005 and June 30, 2006, we had accounts receivable balances of $588,000 and $3.5 million, respectively, and accounts payable balances of $5.0 million and $4.6 million, respectively, all of which were associated with these related party transactions with Zeiss.
10. CONTINGENCIES AND COMMITMENTS
We are party to legal actions in the normal course of business. Based in part on the advice of legal counsel, our management does not expect the outcome of legal action in the normal course of business to have a material impact on our financial position, liquidity, or results of operations.
Our former Japanese manufacturing partner, Seiko, and one of our Japanese customers were notified in July 1996 that our light source systems in Japan may infringe certain Japanese patents held by another Japanese company. We have agreed to indemnify our former Japanese manufacturing partner and our customers against patent infringement claims under certain circumstances, even after the termination date of the contract manufacturing agreement. We believe, based upon the advice of counsel, that our products do not infringe any valid claim of the asserted patents or that we are entitled to prior use claims in Japan.
11. SUBSEQUENT EVENTS
The research and development agreement we entered into effective as of January 23, 2004 with Intel was amended effective July 17, 2006. Under the terms of the Amended Development Agreement, most of the mutual obligations between us and Intel have been terminated, including Intels obligation to provide us with up to a total of $20.0 million over a three-year period to accelerate the development of production-worthy EUV lithography light sources. As of the date of the amendment, we had received a total of $8.5 million from Intel under the original agreement, which includes an advance payment of $1.3 million paid by Intel at the initiation of the agreement in 2004. Under the Amended Development Agreement, Intel has no obligation to provide us with further funding beyond that already received and we returned $347,222, which represents the unearned portion of the advance payment made by Intel. Although we will receive no additional funding from Intel under the Amended Development Agreement, we intend to continue to develop the EUV technology as part of our existing product roadmap. In addition, per the terms of the Amended Development Agreement, we will continue meeting with Intel on a regular basis to review our progress towards developing a production-worthy EUV source system.
On July 28, 2006, we announced that our board of directors had authorized us to repurchase up to $150 million of our common stock. The purchases will be made from time to time in the open market or in privately negotiated transactions. The program may be discontinued at any time. Total purchases through August 1, 2006 were $22.7 million or 589,515 shares under this program.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q.
Statements in this Quarterly Report on Form 10-Q that are not strictly historical in nature are forward-looking statements. These statements include, but are not limited to, references to the outlook for the semiconductor industry and us; expected domestic and international product sales and development; our research and development activities and expenditures; adequacy of our capital resources and investments; effects of business cycles in the semiconductor business; our competitive position; and our relationships with customers and third-party manufacturers of our products, and may contain words such as believes, anticipates, expects, plans, intends and words of similar meaning. These statements are predictions based on current information and our expectations and involve a number of risks and uncertainties. The underlying information and our expectations are likely to change over time. Actual events or results may differ materially from those projected in the forward-looking statements due to various factors, including, but not limited to, those contained under the caption Risk Factors and elsewhere in this Quarterly Report on Form 10-Q. Forward-looking statements herein speak only as of the date of this Quarterly Report on Form 10-Q. Unless required by law, we undertake no obligation to update or revise any forward-looking statements to reflect new information or future events or developments. Thus, you should not assume that our silence over time means that actual events are bearing out as expressed or implied in such forward-looking statements.
We are the worlds leading supplier of light source solutions for the semiconductor industry. Our products provide the essential light source for deep ultraviolet (DUV) photolithography systems. Almost all consumer electronic devices manufactured in the last several years contain a semiconductor manufactured using light sources such as ours. We currently supply light sources to all three lithography tool manufacturers, ASM Lithography, Canon, and Nikon, who in turn supply their wafer steppers and scanners to chipmakers. In addition, we sell replacement parts and services to the lithography tool manufacturers as well as directly to the chipmakers. Our light source systems currently constitute a substantial majority of all excimer light sources incorporated in lithography stepper and scanner tools. Our headquarters are located in San Diego, California where we develop and manufacture all of our light source systems. As a large portion of our revenue is derived from customers located outside of the U.S., we maintain a spare parts refurbishment facility and field service office in Korea and field service and support offices in Japan, the Netherlands, the Peoples Republic of China, Singapore and Taiwan. Japan is currently our only subsidiary office that sells excimer light source systems. We also maintain field service offices in the U.S. to service our installed base of light sources located in the U.S.
In July 2005, we entered into a joint venture agreement with (i) Carl Zeiss SMT AG, a German corporation (SMT); (ii) Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH, a German limited liability company (LOB); and (iii) the Swiss liability company that was formed as part of the JV Agreement and named TCZ GmbH (TCZ). LOB and SMT, together with their affiliated entities, are collectively referred to as Zeiss. TCZ is currently developing, and will integrate, market and sell, and support, production tools for the flat panel display manufacturing industry. The joint venture is currently headquartered in San Diego and is owned 60% by us and 40% by Zeiss. The joint venture is targeting the growing market for low-temperature poly-silicon (LTPS) processing used in the manufacture of liquid crystal displays that are brighter, have higher resolution, and consume less power than displays using todays predominant amorphous silicon films. We currently expect that TCZ will ship its first production tool, the TCZ 900X, in the first half of 2007, and we expect that TCZ will break even from a financial standpoint in the 2008 to 2009 timeframe.
Our products primarily consist of photolithography light source systems, replacement parts, and service.
Our excimer light sources for photolithography produce pulsed light of extremely short wavelengths within the DUV spectrum. The bandwidth of the light is further narrowed through a number of optical techniques. The DUV wavelengths are measured in nanometers (one nanometer is one billionth of a meter), and the light sources are referred to according to either the wavelength or the gases that are mixed to produce the light. Krypton Fluoride (KrF) gases produce light at a 248 nm wavelength, and Argon Fluoride (ArF) gases produce light at a 193 nm wavelength. The extremely short wavelengths and highly narrowed bandwidths of light produced by these light sources enable the very fine feature resolution required for patterning or printing the circuitry on silicon wafers. The pulse energy and repetition rate of the light source permit high throughput in wafer processing. We have designed our light sources to be reliable, easy to install and service and compatible with existing semiconductor manufacturing processes. Our light sources are used to pattern or print the integrated circuits, which are also called semiconductors or chips, that power many of todays advanced consumer and business electronics. In the second quarter of 2006, we sold 75 light source systems at an average selling price of $968,000.
Certain components and subassemblies included in our light sources require replacement or refurbishment following extended operation. We estimate that a light source used in a semiconductor production environment will require one to two replacement chambers per year, depending upon the level of usage. Similarly, certain optical components of the light source deteriorate with continued exposure to DUV light and require periodic replacement. We provide these and other spare and replacement parts for our photolithography light sources as needed by our customers.
As the life and usage of our installed base of light sources in production at chipmakers exceeds the original warranty periods, some chipmakers request service contracts from us. Additionally, we provide billable service or service contracts directly to the three semiconductor lithography tool manufacturers. These service agreements require us to maintain and/or service these light sources either on an on-call or regular interval basis or both. Included in some of the types of service contracts we provide to our customers are the replacement of consumable parts and non-consumable parts. The pricing for such contracts includes the replacement of these parts.
Included in some of our service contracts and sold separately is CymerOnLineTM, a diagnostic and performance software product which delivers critical laser diagnostics and performance information in near real-time directly to authorized users anywhere. The software simplifies reporting and allows users to efficiently manage consumables usage. CymerOnLine offers a user-friendly browser-based interface, which features a robust design and provides a secure data environment. Event-initiated messages sent to pagers, e-mail, mobile phones, or other handheld devices enable up-to-the-minute communication and proactive management.
Since we derive a substantial portion of our revenues from photolithography tool manufacturers, we are subject to the volatile and unpredictable nature of the semiconductor industry. The semiconductor industry is highly cyclical in nature and historically has experienced periodic ups and downs, and the activities of the last several years illustrate this cyclicality. In 2000, the semiconductor industry experienced strong growth, which was followed by a three year decline from 2001 through late 2003. Growth resumed in late 2003, but in late 2004, the industry again declined for several months, then leveled off early in 2005 and began to improve gradually thereafter.
In the final quarter of 2005, orders for our light sources increased substantially from the levels we had experienced earlier in the year. Our chipmaker customers began indicating that increasing demand for chips would require them to expand production capacity, and our lithography tool manufacturing
customers began placing orders for a growing number of light sources to meet increasing scanner demand. It began to appear that we were again entering an industry growth cycle and upturn.
There were many positive indicators in the first quarter of 2006 that reinforced our viewpoint that we were entering an upturn in the semiconductor industry. In addition to strong continuing demand for our ArF light sources in the first quarter of 2006, we also experienced substantial ongoing growth in our non-systems revenue which was driven by high light source utilization at chipmakers and high overall fab utilization. Additionally, there was stronger than anticipated demand for KrF light sources, as chipmakers ordered tools to expand capacity. Our bookings, revenue and profits grew substantially in the first quarter of 2006 compared to the fourth quarter of 2005.
This growth trend continued in the second quarter of 2006, and our revenue grew to a record $135.4 million, up seven percent from our revenue of $127.1 million in the first quarter of 2006. Utilization of our light sources at chipmakers continued to rise in the second quarter of 2006, and grew three percent over the previous quarters level. This drove our non-systems product revenue, which consists of consumables and spare parts, upgrades, and service, to a record $62.7 million for the second quarter of 2006. We shipped 31 of our XLA Series ArF light sources in the second quarter of 2006, the second highest volume since the XLA Series was introduced. Our direct customers are ramping up their ArF immersion scanner production to meet growing demand for immersion lithography tools from an expanding number of chipmakers. We anticipate that this will in turn drive increasing demand for the XLA 300, which is designed for use in high volume immersion production.
Industry trends stayed positive in the second quarter of 2006. Fab utilization continued in the low to mid 90 percent range, and fab managers remained cautious about buying too much equipment and building excess manufacturing capacity in the fab. NAND Flash memory manufacturers continued to expand their capacity, and 300mm fabs continued to be built and populated with equipment.
Looking at medium- and longer-term market conditions, demand for DUV lithography should continue to grow in all segments of the market. We believe we are well positioned as the leader in the most rapidly growing segment of the lithography market ArF light sources for both dry and immersion applications. Demand for ArF should extend well into the future through the use of both immersion and double patterning production techniques. Our most advanced, highest value-added products are experiencing growing demand, our ability to bring more advanced and highly innovative products to market strengthens our leadership, and our overall competitive position continues to be strong. However, macro-economic factors, such as high energy prices and rising interest rates, could have a negative impact on consumer spending, including spending on electronic devices. Additionally, geopolitical turmoil can create a heightened sense of uncertainty that can cause consumers to become more cautious about their spending. Either or both of these factors would have a negative effect on demand for our products.
We entered 2006 focusing our efforts on creating shareholder value through improved profitability, overall financial performance and execution. During the second quarter of 2006, our gross margin increased to 48 percent compared to 46 percent in the prior quarter. In the second quarter of 2006, we generated $16.4 million in cash from operations, which is a significant improvement from the $869,000 generated from operations in the first quarter of 2006. We expect to generate higher levels of cash from operations through the remainder of 2006 and we will continue to explore opportunities for the most effective use of our cash.
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and use judgment that may impact the reported amounts of assets,
liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. As a part of our ongoing internal processes, we regularly evaluate our estimates and judgments associated with revenue recognition, valuation of parts used in our refurbishment manufacturing process, inventory allowances, warranty provisions, stock-based compensation, income taxes, allowances for bad debts, long-lived assets valuation, intangible assets valuation, and contingencies and litigation. We base these estimates and judgments upon historical information and other facts and assumptions that we believe to be valid and/or reasonable under the circumstances. These assumptions and facts form the basis for making judgments and estimates and for determining the carrying values of our assets and liabilities that are not apparent from other sources. Actual results could vary from our estimates if we were to use different assumptions and conditions.
We believe that revenue recognition, valuation of parts used in our refurbishment manufacturing process, inventory allowances, warranty provisions, stock-based compensation, and income taxes require more significant judgments and estimates in the preparation of our consolidated financial statements than do other of our accounting estimates and judgments.
Our revenues consist of product sales, which include sales of light source systems, consumable and spare parts, upgrades, service, service contracts and training. Our revenues also consist of certain funded development activities performed for our customers and under government contracts and license agreements.
The sales of our light source systems generally include training and installation services. We determined these elements qualify as one unit of accounting under Emerging Issues Task Force (EITF) Bulletin No. 00-21, Revenue Arrangements with Multiple Deliverables as we do not have evidence of fair value for the undelivered training and installation elements. Furthermore, we determined that the undelivered training and installation elements are perfunctory performance obligations and are not essential to the functionality of our light source systems. Therefore, in accordance with the provisions of Staff Accounting Bulletin No. 104, we recognize revenue when the revenue recognition criteria are met for the light source system, and accrue the costs of providing the training and installation services. We recognize light source system revenue at one of following three points, depending on the terms of our arrangement with our customer 1) shipment of the light source system 2) delivery of the light source system or 3) receipt of an acceptance certificate. For the majority of our light source system sales, the shipping terms are F.O.B. shipping point and revenue is recognized upon shipment. For our arrangements which include F.O.B. destination shipping terms, revenue is recognized upon delivery of the light source system to our customer. Lastly, one of our arrangements includes an acceptance provision, which is satisfied by the issuance of an acceptance certificate by the customer. For these transactions, we recognize revenue upon receipt of the acceptance certificate. In addition, we test our light source systems in environments similar to those used by our customers prior to shipment to ensure that they meet published specifications.
Revenue from consumables and spare parts sales is recognized at the point that legal title passes to the customer, which is upon shipment from our facility. For a significant portion of our spare parts sales, our customers return the consumed assembly to us as part of the sale of the new part. We reuse some of the material within these core assemblies, mainly metal components, for the future build of core assemblies. As a result, our revenue consists of both cash and the value of the reusable parts received from our customers as consideration for these spare part sales. Revenue associated with our customers return of core assemblies is recognized upon receipt of the returned core assembly. The amount of the revenue is determined based upon the fair value of the reusable parts that we expect to yield from the returned core assembly based on historical experience. Service and training revenue is recognized as the services are rendered.
For funded development contracts, which are included in other revenue, funds received are accounted for on the percentage-of-completion method based on the relationship of costs incurred to total estimated costs. Revenues generated from these types of funded development contracts are derived from
cost sharing contracts between certain customers and us. If milestones on these funded development contracts require that specific results be achieved or reported by us, revenue is not recognized until that milestone is completed. For some of the funded development contracts that we enter into with customers and government agencies, we evaluate certain criteria to determine whether recording the funds received as revenue is appropriate. If certain conditions are met, these funds are not recorded as revenue but rather are offset against our own internal research and development expenses in the period that the milestone is achieved.
Valuation of Parts Used in Refurbishment Manufacturing Process and Corrected Accounting Method
Over the last several years as part of our regular business activities, we have conducted significant parts refurbishment and material reclaim activities related to some of our core assemblies, in particular our chamber assemblies. The volume of this activity significantly increased in 2004 and we expect volumes to increase over time as we become more efficient in these refurbishment activities and develop capabilities to reclaim material from and refurbish other core assemblies. These activities involve arrangements with our customers where we sell a new part to the customer at a reduced sales price if the customer returns the consumed assembly that the new part replaces. These returned core assemblies contain a certain amount of material, primarily metal components, that may be reused by us in future core assemblies. Upon receipt of these consumed assemblies from our customers, either we record an entry to recognize the estimated fair value of the reusable components as inventory and revenue or a reduction in cost of product sales sold depending on the reason for the part replacement. The value of the reusable parts contained within the consumed assembly is determined based upon historical data on the value of the reusable parts that we typically yield from a consumed assembly. As part of our normal excess and obsolete inventory analysis, these consumed assemblies are also reviewed on a quarterly basis and an inventory allowance is recorded as appropriate for these parts. The value that we assign to these core assemblies can be affected by the current demand for the reusable parts in our manufacturing operations and the actual yield rate achieved for parts within these consumed core assemblies. We believe that our methodology for valuing the reusable parts within these returned core assemblies is reasonable, but any changes in the demand for the parts or the yield of the parts included in these core assemblies could have a material adverse effect on our financial condition and results of operations.
Prior to the fourth quarter of 2004, we recorded the value of this material as a reduction of our cost of product sales in the period that the returned assembly was disassembled by our manufacturing operations and the value of the reusable parts could be determined. Upon further review of U.S. generally accepted accounting principles in the fourth quarter of 2004, we determined that we should instead estimate the value and record these consumed assemblies as inventory at the time that we receive the returned assembly from our customer and concurrently record this amount as either revenue or as a reduction to cost of product sales depending on the reason for the part replacement. During the fourth quarter of 2004, we corrected our accounting treatment for these refurbishment activities and recorded the financial impact for all of 2004 and prior years in our fourth quarter of 2004 financial statements.
We perform an analysis of our inventory allowances on at least a quarterly basis to determine the adequacy of this allowance on our financial statements. The amount of the inventory allowance is determined by taking into consideration certain assumptions related to market conditions and future demands for our products, including changes to product mix, new product introductions, and/or product discontinuances, which may result in excess or obsolete inventory. We determine the level of excess and obsolete inventory associated with our raw materials and production inventory, which includes all parts on hand from our refurbishment activities, by comparing the on hand inventory balances and inventory on order to the next 12 months of forecasted demand. We then adjust this calculation for inventory that has a high likelihood of use beyond one year or can be used in other products that may have lower demands. After this adjustment, we arrive at our total exposure for excess and obsolete inventory within our raw materials and production inventory. As part of this analysis, we also determine whether there are potential
amounts owed to vendors as a result of cancelled or modified raw material orders. We estimate and record a separate liability, which is included in accrued and other liabilities in the accompanying balance sheets for such amounts owed.
The inventory allowance totaled $10.4 million and $10.7 million at December 31, 2005 and June 30, 2006, respectively. The slight increase in the inventory allowance at June 30, 2006 as compared to December 31, 2005 is due to higher inventory levels from period to period and increased excess and obsolete allowances for both raw materials and parts contained in consumed assemblies which are received from our customers and are used in our material reclaim and refurbishment activities.
The methodologies used to analyze excess and obsolete inventory and determine the inventory allowance are significantly affected by future demand and usage of our products. There are many factors that could potentially affect the future demand or usage of our products, including the following:
Overall condition of the semiconductor industry, which is highly cyclical in nature;
Rate at which our lithography tool manufacturers and chipmaker customers take delivery of our light source systems and our consumable and spare parts;
Loss of any of our three major customers or a significant change in demand from any of these three customers;
Overall mix of light source system models or consumable and spare parts and any changes to that mix required by our customers; and
Utilization rates of our light sources at chipmakers.
Based upon our experience, we believe that the estimates we use in calculating the inventory allowance are reasonable and properly reflect the risk of excess and obsolete inventory. If actual demand or the usage periods for our inventory are substantially different from our estimates, adjustments to our inventory allowance may be required, which could have a material adverse effect on our financial condition and results of operations.
We maintain an accrual for the estimated cost of product warranties associated with our product sales. Warranty costs include the replacement parts and labor costs to repair our products during the warranty periods. At the time revenue is recognized, we record a warranty provision, which is included in cost of product sales in the accompanying consolidated statements of operations. The warranty coverage period and terms for light source systems and consumable and spare parts varies by light source system model. The warranty provision for our products is reviewed monthly and determined by using a statistical financial model, which takes into consideration actual historical expenses, product failure rates, and potential risks associated with our different products. This model is then used to estimate future expenses related to warranty and the required warranty provision. The risk levels and historical cost information and failure rates used within this model are reviewed throughout the year and updated as these inputs change over the products life cycle. Due to the highly technical nature of our light source system products, the newer model light sources and the modules contained within them have higher inherent warranty risks with their initial shipments and require higher warranty provisions until the technology becomes more mature.
The total balance in the warranty provision accrual as of December 31, 2005 and June 30, 2006 was $30.2 million and $31.4 million, respectively. This increase is primarily due to the higher level of consumables and spare parts sales in the first half of 2006 as compared to the second half of 2005 and the reserve amounts remaining in the warranty provision on June 30, 2006 related to those sales. The increase in the spares and consumables portion of the warranty provision as of the end of the second quarter of 2006 was partially offset by decreases in the warranty provision caused by a greater proportion of light source systems requiring lower warranty provisions as calculated by our financial model and an overall decrease in labor expenses that are expected in future periods to service the light source systems and spares and consumable parts under warranty as of June 30, 2006.
We actively engage in product improvement programs and processes to limit our warranty costs, but our warranty obligation is affected by the complexity of our product, product failure rates and costs incurred to correct those product failures at customer sites. The industry in which we operate is subject to rapid technological change, and as a result, we periodically introduce newer, more complex light sources. Although we classify these newly released light source models as having a higher risk in our warranty model resulting in higher warranty provisions, we are more likely to have differences between the estimated and actual warranty costs for these new products. This is due to limited or no historical product performance data on which to base our future warranty costs. Warranty provisions for our older and more established light source models are more predictable as we have more historical information available on these products. If actual product failure rates or estimated costs to repair those product failures were to differ from our estimates, revisions to our estimated warranty provision would be required, which could harm our financial condition and results of operations.
We grant options to purchase our common stock to our employees and grant stock unit awards to our non-employee directors under our current stock plan. The benefits provided under this plan are share-based payments subject to the provisions of SFAS No. 123R. Effective January 1, 2006, we adopted the requirements of SFAS No. 123R which address the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. As a result of this new accounting requirement, our consolidated financial statements for the six months ended June 30, 2006 include compensation expense as calculated per the provisions of SFAS No.123R. In adopting SFAS No. 123R, we elected to use the modified prospective transition method, thus our consolidated financial statements for periods prior to January 1, 2006 do not include any impact of SFAS No.123R. We also elected to attribute the value of share-based compensation to expense using the straight-line method for awards granted after December 31, 2005 upon our adoption of SFAS No. 123R. Compensation expense for awards outstanding as of December 31, 2005 are being recognized over the remaining service period using the compensation expense calculated according to the pro forma disclosure provisions under SFAS No. 123 which uses an accelerated expense recognition method for those awards with a graded vesting schedule. Share-based compensation expense related to stock options and stock units was $2.4 million and $4.8 million, before taxes for the three and six months ended June 30, 2006, respectively.
Upon adoption of SFAS No. 123R on January 1, 2006, we elected to value our share-based payment awards using the Black-Scholes option pricing model, as we had under the pro forma provisions of SFAS No. 123. The determination of fair value of stock-based payment awards on the date of grant is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These assumptions include our expected stock price volatility over the term of the awards and the expected term of stock options.
We determined our expected volatility by using a combination of historical and implied volatility, or blended volatility, to derive our expected volatility assumption as allowed under SFAS 123R and SAB 107. Implied volatility was based on our six-month traded options on our common stock. We determined that the volatility calculated using a blend of implied volatility and our historical volatility was more reflective of expected volatility than using only historical volatility. The expected term of stock options represents the weighted-average period the stock options are expected to remain outstanding. We determined the expected term of our stock options based on observed historical exercise patterns for our company, which we believe are indicative of future exercise behavior.
Other assumptions required for estimating fair value under the Black-Scholes option pricing model include the expected risk-free interest rate and expected dividend yield of our stock. Our risk-free interest rate assumption is based upon currently available rates on zero coupon U.S. Government issues for the expected term of our stock options. The expected dividend rate is not applicable to us as we have not historically declared or paid dividends nor do we anticipate paying cash dividends in the future.
SFAS No. 123R also requires forfeitures to be estimated at the time of grant and we have estimated our forfeitures based on historical experience. We will revise this estimate, if necessary, in subsequent periods if actual forfeiture rates differ from our estimates. In our pro forma information required under SFAS No. 123 for periods prior to January 1, 2006, we accounted for forfeitures as they occurred.
If we change any of the key assumptions that we use in the Black-Scholes option pricing model such as expected volatility or expected term or if we decide to use a different valuation model in the future, the compensation expense that we record under SFAS No. 123R may differ significantly in the future from what we have recorded in the current period. In addition, as the guidance by regulators for SFAS No. 123R is relatively new, the application of these principles may be subject to further interpretation and refinement over time.
We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (SFAS No. 109), Accounting for Income Taxes. Pursuant to SFAS No. 109, a deferred tax asset or liability is generally recognized for the estimated future tax effects attributable to temporary differences, net operating loss (NOL) carryforwards and tax credit carryforwards. Deferred tax assets are to be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized within the carryback or carryforward periods. Information about an enterprises current financial position and its results of operations for the current and preceding years, as well as all currently available information about future years should be considered.
We have considered our industrys outlook for the future, our historical performance and estimated future taxable income, and ongoing tax planning strategies in assessing the need for a valuation allowance. Using this information, we have prepared a model to forecast our expected taxable income in future years and to estimate when the benefits of our deferred tax assets are likely to be realized. Based upon the analysis, with the exception of TCZ GmbH, we believe that it is more likely than not that the results of future operations will generate sufficient taxable income to realize our deferred tax assets within the period covered by our model and, as such, no valuation allowance against deferred tax assets is provided. However, in the case of our joint venture, TCZ, we do not feel that there is sufficient evidence or operating history to conclude that the future operating profits of TCZ are likely to allow it to utilize its NOL carryforwards and, consequently, a full valuation allowance has been provided against those loss carryforwards.
A material adverse change in the outlook for worldwide lithography tool sales, the expected selling prices or profit margins for our products or our expected share of the global market for lithography light sources, could cause us to determine that additional valuation allowances are needed for some or all of our deferred tax assets, and would result in an increase to our income tax provision in the period in which such determination is made.
Our results reflect the impact of the American Jobs Creation Act of 2004, which repealed the Extraterritorial Income Exclusion (ETI) subject to certain transition rules. The ETI benefit is being replaced with a Manufacturing Activity deduction under Internal Revenue Code (IRC) Section 199, with a phase out of ETI benefits in 2005 and 2006. Our estimated ETI benefit for 2006 reflects the transition rules.
We have not provided for U.S. federal income and foreign withholding taxes on $57.6 million of undistributed earnings from non-U.S. operations as of June 30, 2006 as it is our intention to reinvest undistributed earnings of our foreign subsidiaries and thereby indefinitely postpone their remittance. Accordingly, no provision has been made for foreign withholding taxes or U.S. income taxes which may become payable if undistributed earnings of foreign subsidiaries were paid to us as dividends. Currently, we are not considering the repatriation of any foreign earnings and as such, no impact is reported in the
financial statements as of June 30, 2006. It is not practicable to estimate the amount of the deferred tax liability on such unremitted earnings.
RESULTS OF OPERATIONS
The following table sets forth certain items in our consolidated statements of operations as a percentage of total revenues for the periods indicated:
THREE MONTHS ENDED JUNE 30, 2005 AND 2006
Revenues. The types of revenue that we generate and how we recognize revenue for each is explained above under the heading Critical Accounting Policies and Estimates.
The following table summarizes the components of our revenue (in thousands, except units sold):