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Varian Semiconductor Equipment Associates 10-K 2006 Documents found in this filing:
Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-K
OR
Commission File Number: 0-25395
Exact name of registrant as specified in its charter:
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
Address and telephone number of principal executive offices: 35 Dory Road, Gloucester, Massachusetts 01930-2297 (978) 282-2000
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES x NO ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES ¨ NO x
Indicate by checkmark 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. YES x NO ¨
Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
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):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by checkmark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ¨ No x
The aggregate market value of the registrant’s common stock held by non-affiliates as of March 31, 2006 was $1,602,242,000.
The number of shares of the registrants’ common stock outstanding as of December 1, 2006 was 55,326,158 shares of $0.01 par value common stock.
An index of exhibits filed with this Form 10-K is located on page 43.
DOCUMENTS INCORPORATED BY REFERENCE:
Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC
FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 29, 2006
TABLE OF CONTENTS
Table of Contents
Overview
Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) is the leading supplier of ion implantation systems used in the fabrication of semiconductor chips. Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment for virtually all of the major semiconductor manufacturers in the United States (“U.S.”), Europe and Asia Pacific. The VIISta™ ion implanter products are designed to leverage single wafer processing technology for the full range of semiconductor implant applications. Varian Semiconductor has shipped more than 3,600 systems worldwide.
Varian Semiconductor provides support, training, and after-market products and services that help its customers obtain high utilization and productivity, reduce operating costs, and extend capital productivity of investments throughout multiple product generations. In fiscal year 2006, Varian Semiconductor was ranked number one in customer satisfaction in VLSI Research Inc.’s customer survey for all large suppliers of wafer processing equipment, an honor received in nine of the past ten years.
Varian Semiconductor’s business is cyclical. The business depends upon semiconductor manufacturers’ expectations and resulting capacity investments for future integrated circuit demand. In fiscal year 2004 Varian Semiconductor experienced an increase in business activity owing to a generally strengthening economy and increased demand for semiconductor equipment. During calendar year 2005, there was an 11% decline in worldwide ion implanter sales. However, due to market share gains, Varian Semiconductor’s fiscal year 2005 revenue increased 13% over fiscal year 2004 as customers migrated to single wafer systems, which favor Varian Semiconductor’s product offerings. Single wafer systems are now preferred over batch systems as they process wafers in such a way that results in higher yields for advanced device manufacturers. During fiscal year 2006, Varian Semiconductor believes its 22% revenue increase over fiscal year 2005 was the result of both increases in worldwide ion implanter sales as well as Varian Semiconductor’s continued market share gains for the calendar year 2006.
Varian Semiconductor maintains a website at www.vsea.com. The information contained on the Varian Semiconductor website is not included in, or incorporated by reference into, this Annual Report on Form 10-K. Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, are made available through the Varian Semiconductor website, free of charge, as soon as reasonably practicable following the electronic filing or furnishing of such materials by Varian Semiconductor to the Securities and Exchange Commission (“SEC”) and are available at the SEC’s website at www.sec.gov.
The Industry
Historically, the semiconductor industry has experienced significant growth due to the continued demand for personal computers, the expansion of telecommunications, the emergence of new applications within consumer electronics, the escalation of wireless communication devices, infrastructure used to support the internet and the increased semiconductor content in many commercial products.
During the past five to ten years however, the semiconductor equipment market has experienced a slowdown in growth as compared to historical levels. This is the result of a maturing semiconductor market where overall demand has increasingly been driven by repackaging of available technology into new consumer products instead of business demands for productivity-improving information management technology.
Semiconductor manufacturing is highly competitive with each manufacturer seeking to provide the lowest cost, fastest processing, and lowest power-consuming devices. Integrated circuit manufacturers generally rely on
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Table of Contentsequipment suppliers for the timely development of equipment and processes to meet their rapidly changing and complex requirements. Today, a semiconductor manufacturing factory, or “fab,” can cost over $3 billion for a modern 65nm facility that can process 50,000 300mm wafers per month. As the industry transitions to 45nm devices, these costs are expected to increase.
The fabrication of integrated circuits requires a number of complex and repetitive processing steps, including deposition, photolithography, etch, metrology, anneal and ion implantation. Deposition is a process in which a film of either electrically insulating or electrically conductive material is deposited on the surface of a wafer. Photolithography is used to transfer a device or circuit pattern into a light-sensitive, resistant layer that, after development, can be used in turn to transfer the pattern onto the silicon surface. The etch process completes the transfer of the pattern into the various thin films used to make the integrated circuit. Metrology measures critical features and properties of the device to assure correct fabrication. Anneal is used to incorporate impurities into the silicon crystal matrix and make them electrically active. Ion implantation provides a means for introducing impurities into the silicon crystal, typically into selected areas defined by the photolithographic process. The selective implanting of ions into defined areas creates electrically conductive areas that form the transistors of the integrated circuits.
Semiconductor manufacturers have historically sought to increase the number of transistors per silicon substrate by “shrinking” device structures and by moving to larger silicon substrates, or “wafers.” The first is accomplished by utilizing finer lithography and reducing device geometries, commonly called “device nodes.” State-of-the-art production is now accomplished at 90nm nodes with production of 65nm in transition at more technologically advanced fabs. 45nm research and development is underway at multiple customer sites and semiconductor research labs. The use of larger silicon wafer substrates generally requires a great deal of infrastructure changes in equipment and factory automation systems, so it occurs less frequently, typically about every 10 years. The use of 200mm wafers in production began at the end of the 1980’s. The migration from 200mm to 300mm began at the end of the 1990’s and is now more than half of semiconductor expansions. Most advanced devices below 130nm are produced on 300mm wafers.
To achieve higher yields, implant systems must be capable of repeating the original process on a consistent basis for all devices on the wafer and for every wafer. These characteristics are known in the industry as “uniformity” and “repeatability.” In addition, implant systems must process wafers without damaging the device structures or introducing device damaging contamination, which is typically characterized by “cross contamination levels” and “particle defect adders.” In many cases implant performance is measured directly from the electrical performance of actual devices or device test structures. This is called “electrical parametrics.” In production fabs, there are typically multiple ion implantation systems performing the same processes in order to meet the production demands of the fab. In order to allow the greatest flexibility, semiconductor manufacturers require that each system perform equally well on each device step. This characteristic is known as “tool-to-tool” matching. In advanced device production, semiconductor manufacturers will often adjust the implant processes to compensate for variability in processes upstream from the implanter, making the implanter’s accuracy another important attribute. Uniformity, repeatability, accuracy, cross contamination, defect adders, parametrics and tool-to-tool matching are all critical in achieving commercially acceptable yields.
Semiconductor manufacturers generally measure the cost performance of their production equipment in terms of “cost of ownership,” which is determined by factoring in the fixed costs for acquisition and installation of the equipment, its variable operating costs and total wafer output. Equipment with higher wafer throughput increases total output and allows the semiconductor manufacturer to recover the purchase and installation costs of the equipment over a greater number of wafers and thereby reduces the cost of ownership of the equipment on a per wafer basis. Throughput is most accurately measured on a net or overall basis, which takes into account the processing speed of the equipment and any system setup and non-operational downtime for cleaning, maintenance or other repairs. The increased difficulty of achieving desired transistor performance at advanced nodes has made high yields important in selecting processing equipment. The most desired systems are those that can achieve process results within critical tolerance limits and still operate at desired throughput rates.
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Table of ContentsThe continuing evolution of semiconductor devices to smaller geometries and more complex multi-level circuitry has significantly increased the cost and performance requirements of the capital equipment used to manufacture these devices. As many of the advanced wafer manufacturing factories, especially those designed for 65nm device node processes on 300mm wafers, are projected to increase in cost substantially over previous generation facilities, yield losses and depreciation costs will become a much larger percentage of the aggregate production costs for semiconductor manufacturers relative to labor, materials and other variable manufacturing costs. As a result, there has been increasing focus by the semiconductor industry on obtaining increased capability and productivity to maintain returns from semiconductor manufacturing equipment, thereby increasing the revenue generated and reducing the effective cost of ownership of such systems.
Products
Varian Semiconductor designs, markets, manufactures and services ion implantation systems required to build the transistors that are the basis of integrated circuits. Ion implanters are used because of their ability to implant selected elements into the silicon wafers at precise locations and depths by bombarding the silicon surface with a precisely controlled beam of electrically charged ions of specific atomic mass and energy. These ions are embedded into the silicon crystal structure, changing the electrical properties of the silicon. The precision of ion implantation techniques permits customers to achieve the necessary control of this doping process to construct up to 500 billion transistors of uniform characteristics on a 300mm wafer using state-of-the-art processes. Since these transistors are the starting point of all subsequent process steps, repeatability, uniformity and yield are extremely important.
Varian Semiconductor offers a full range of ion implanters addressing each implant sector. The implant sectors are categorized within the industry as medium current, high current or high energy, based upon the energy ranges of the ion implantation system specified in electron-volts or “eV”: high current implanters are generally expected to operate at energy ranges between 200eV to 60keV; medium current at energy ranges between 20keV to 900keV; and high energy at energy ranges of 500keV to 3MeV. The relative sizes of each sector depends upon the growth of the number of applications in each sector, the productivity of the implant systems in performing that application and the migration of application requirements into the capability ranges of other sectors and device nodes.
Varian Semiconductor currently offers the following products:
Medium Current
Recognized as the industry benchmark for medium current performance and productivity, Varian Semiconductor’s single wafer VIISta 810XP series ion implanters provide superior overall throughput, precision doping capability and unmatched contamination control. These systems excel at threshold voltage (“Vt”), channel, retrograde well, pocket, and halo implants. Varian Semiconductor’s other medium current systems include the VIISta 810HP, VIISta 810XE and VIISta 900 XP ion implanters. In addition, Varian Semiconductor continues to provide support for its older generation VIISta and legacy medium current ion implanters still in use by its customers.
The number of medium current applications increases as more applications, such as some well applications, can be productively processed on medium current systems. To achieve higher device speeds, chip designers often increase manufacturing process complexity by utilizing multiple transistor designs in the same integrated circuit. An example of this is the use of multiple device Vt’s, which require separate medium current steps in the same integrated circuits for each Vt desired. This increase in the number of applications tends to be offset by the increasing productivity of medium current systems.
High Current
The high current VIISta HCP series single wafer ion implanter provides the highest productivity and best contamination performance. In addition, these systems feature implant angle accuracy, beam steering correction
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Table of Contentsand high-tilt angle capability – all of which are required for advanced device fabrication. The VIISta HCP has excellent process control capability for advanced ultra shallow junction applications, and can be used for source/drain, source/drain extension, gate doping, pre-amorphization, and materials modification applications. Varian Semiconductor’s other high current systems include the VIISta HC ion implanter. In addition, Varian Semiconductor continues to provide support for its older generation VIISta and legacy high current ion implanters still in use by its customers.
The high current sector is expected to grow relative to the overall implant market due to an increase in the number of implant steps needed to produce many advanced semiconductors. Due to the very low energies and high dose concentrations that are necessary for increased transistor speed and lower device power consumption, the productivity of high current systems tends to decline with advancing technology nodes, requiring more high current implanters. Most advanced devices require single wafer systems, and single wafer high current is expected to grow to nearly 75% of the high current market in calendar year 2006. Varian Semiconductor was the first to introduce single wafer systems to this market sector through its VIISta platform.
High Energy
The high energy VIISta 3000 series features true zero degree implant and low contamination. The VIISta 3000 series products are the only single wafer high energy implanters available on the market today, an advantage for semiconductor manufacturers that need increased device packing density in high-performance devices. The VIISta 3000HP has outstanding process accuracy, offers excellent productivity, uniformity, angle control and medium current back-up flexibility. The high energy products cover retrograde well, triple well, buried layers, and pocket applications. Varian Semiconductor’s high energy offerings are the VIISta 3000HP and the VIISta 3000 ion implanter. In addition, Varian Semiconductor continues to provide support for its legacy high energy ion implanters still in use by its customers.
VIISta PLAD
The VIISta PLAD is a multi-chamber tool built on a platform common with Varian Semiconductor’s VIISta family of implanters, the only truly complete platform available that covers all implant segments. The VIISta PLAD implants the entire wafer simultaneously by positioning the wafer directly in a chamber containing plasma of the desired species. A pulsed DC voltage applied to the wafer draws ions from the plasma at a precisely controlled energy, resulting in extremely fast high-dose implants. Pulsing the bias voltage allows the system to automatically neutralize any charge buildup on the wafer surface between pulses and measure the ion dose per pulse using a Faraday for closed-loop in-situ dose control. With throughput up to six times greater than beamline or modified-source beamline technologies, the VIISta PLAD has become an attractive solution for critical low-energy, high-dose applications, such as DRAM (dynamic random access memory) polysilicon gate doping.
VIISta Platform
The VIISta 900XP series, VIISta HCP series and VIISta 3000 series are based on the same platform, thereby providing a high degree of commonality in subsystems and overall architecture. The VIISta platform provides customers with a great deal of flexibility in managing overall bay productivity, resulting in a reduction in customers’ time to first silicon, greater productivity across all applications, and an increase on their return on investment. Varian Semiconductor has shipped more than 500 VIISta systems. The VIISta platform of ion implanters is the only single wafer platform solution for all production applications available. All of the VIISta products feature the Varian Control System (“VCS™”), the Varian Positioning Systems (“VPS™”), the VIISta IHC source, the VIISta single wafer endstation and dual magnet beamline architecture. This high degree of commonality across the VIISta platform facilitates process matching throughout the system set, and provides flexibility in managing capacity, product mix changes, spare parts and training. All of the VIISta systems are 200mm and 300mm compatible.
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Table of ContentsCustomer Support and Services
Varian Semiconductor provides customer support services designed to maximize the productivity of its customers’ equipment and to increase uptime through the effective management of machine maintenance, parts inventory and support services. All of these services provide a direct link to Varian Semiconductor’s manufacturing facility and research centers.
Varian Semiconductor provides a wide range of programs from a complete turnkey solution that supports the fab’s ion implant performance to economical service plans for those who require less support. These programs are customized to specific customer requirements, provide dedicated labor to maintain and troubleshoot the ion implanter, and make available on-call 24/7 service for around-the-clock support.
For parts management, Varian Semiconductor has strategically placed around the world approximately 30 parts banks that support more than 200 customer fabs. The use of a global enterprise resource planning system provides Varian Semiconductor with a distribution structure that efficiently manages inventory, delivery and logistics services. Varian Semiconductor also offers a comprehensive consumable and non-consumable parts program that can be tailored to individual fab needs to minimize its customers’ cost of ownership from the ordering of individual piece parts over its eCommerce site, vShop, to complete stocking and inventory management programs like Fab Specific Parts Programs.
Through VEDoc™, an electronic documentation system, customers can easily access information about their ion implanters. All assembly drawings, schematics, parts lists, maintenance and operation manuals, and video-illustrated maintenance procedures are available in a CD-ROM format. Varian Semiconductor’s commitment to customer service also includes training.
Marketing and Sales
Varian Semiconductor markets, sells, installs and services ion implantation systems directly to semiconductor industry manufacturers and has sold ion implantation products to most of the 20 largest semiconductor manufacturers in the world. Varian Semiconductor’s sales objective is to work closely with customers to secure purchases of multiple systems as customers expand capacity, update existing facilities, introduce new manufacturing processes or build new wafer manufacturing facilities. Varian Semiconductor seeks to build customer loyalty and to achieve a high level of repeat business by offering highly reliable products that give its customers a competitive edge, comprehensive field support and responsive parts replacement and service programs.
Varian Semiconductor has historically sold at least half of its systems in any particular period to a relatively small number of customers, some of which include Chartered Semiconductor Manufacturing, Limited (“Chartered”), Elpida Memory, Inc. (“Elpida”), Hynix Semiconductor, Inc. (“Hynix”), Hynix-ST Semiconductor Limited (“Hynix-ST”), Infineon Technologies AG (“Infineon”), Intel Corporation (“Intel”), Micron Technology, Inc. (“Micron”), Promos Technologies, Inc. (“Promos”), Samsung Electronics Company Limited (“Samsung”), Sony Corporation (“Sony”), STMicroelectronics, Taiwan Semiconductor Manufacturing Corporation, Limited (“TSMC”), Texas Instruments, Inc. (“Texas Instruments”), United Microelectronics Corporation (“UMC”), and Winbond Electronics Corporation (“Windbond”). Some of these customers have individually accounted for more than 10% of Varian Semiconductor’s total revenue in some periods. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future.
Revenue from Varian Semiconductor’s ten largest customers in fiscal years 2006, 2005 and 2004 accounted for approximately 63%, 66% and 60% of total revenue, respectively, including the non-recurring royalties in fiscal year 2005 of $18.9 million received from Applied Materials, Inc. (“Applied Materials”). In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10%, respectively, of Varian Semiconductor’s total
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Table of Contentsrevenue. In fiscal year 2005, revenue from two customers accounted for 20% and 14% of Varian Semiconductor’s total revenue. In fiscal year 2004, revenue from two customers accounted for 14% and 10% of Varian Semiconductor’s total revenue.
None of Varian Semiconductor’s customers has entered into a long-term agreement requiring it to purchase Varian Semiconductor’s products. Although Varian Semiconductor’s largest customers have varied from year to year, the loss of a significant customer or a reduction in orders from any significant customer, including reductions due to market, economic or competitive conditions in the semiconductor industry or in the industries that manufacture products utilizing integrated circuits, could adversely affect Varian Semiconductor’s business, financial condition and results of operations. In addition, sales of Varian Semiconductor’s systems depend, in significant part, upon the decision of a prospective customer to increase manufacturing capacity in an existing fab facility, to introduce a new manufacturing process or to transfer a manufacturing process to a new fab facility, all of which typically involve a significant capital commitment. Due to these and other factors, Varian Semiconductor’s products typically have a lengthy sales cycle during which Varian Semiconductor may expend substantial funds and management effort.
Varian Semiconductor’s ability to respond with prompt and effective field support is critical to Varian Semiconductor’s sales efforts. Due to substantial operational and financial commitments, customers who purchase ion implantation systems require assurance that the manufacturer can provide the necessary installation and operational support. Varian Semiconductor’s strategy of supporting its installed base through its customer support and research and development groups has served to encourage the use of Varian Semiconductor’s systems in production applications and has accelerated penetration of certain key accounts. Varian Semiconductor believes that its marketing efforts are enhanced by the technical expertise of its research and development personnel, who provide customer process support and participate in a number of industry forums.
Varian Semiconductor markets, sells, distributes and services its current products directly. Varian Semiconductor has five sales and service offices located in the U.S., five in Europe and 24 in Asia Pacific, for a total of 34 worldwide. Varian Semiconductor’s sales, marketing and service engineers are linked through Varian Semiconductor’s information technology systems, allowing Varian Semiconductor to review bookings and sales forecasts globally against detailed account management plans. By modeling parts usage by equipment type, installed base distribution, freight, routes, and specific customs regulations, Varian Semiconductor has developed an infrastructure of parts distribution and warehousing around the world.
International sales accounted for 78%, 78% and 80% of Varian Semiconductor’s total revenues in fiscal years 2006, 2005 and 2004, respectively, and more specifically, sales to the Asia Pacific region have accounted for 67%, 68% and 68% of total revenues in fiscal years 2006, 2005 and 2004, respectively. Please refer to the footnotes to the financial statements for additional information on the geographic distribution of revenues and long-lived assets.
Varian Semiconductor’s business is not seasonal in nature, but it is cyclical based on the capital equipment investment expenditures of major semiconductor manufacturers. These expenditure patterns are based on many factors, including anticipated market demand for integrated circuits, the development of new technologies and global economic conditions.
Backlog
Varian Semiconductor had backlog of $255.1 million and $166.6 million at the end of fiscal years 2006 and 2005, respectively. Varian Semiconductor includes in its backlog only those orders for which it has accepted purchase orders and assigned system shipment dates within the following twelve months. Orders are typically subject to cancellation or rescheduling by customers. Due to possible changes in system delivery schedules, cancellation of orders and delays in systems shipments, Varian Semiconductor’s backlog at any particular date is not necessarily an accurate predictor of revenue for any succeeding period.
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Table of ContentsManufacturing
Varian Semiconductor manufactures its products at its facility in Gloucester, Massachusetts. Varian Semiconductor benefits from the use of advanced manufacturing methods and technologies, including lean manufacturing, demand flow technology, statistical process control and solids modeling.
Varian Semiconductor purchases various unique raw materials from multiple suppliers worldwide. Varian Semiconductor closely monitors future markets and supply stream to ensure continuous availability. Additionally, some long lead agreements with suppliers are employed to provide a strategic safety stock at supplier locations.
Varian Semiconductor concentrates on product design characterization, high-level assembly and tests to reduce cycle time and improve its responsiveness in an inherently cyclical capital equipment market. Varian Semiconductor believes that outsourcing non-core competency assemblies enables it to minimize its fixed costs and capital expenditures while also providing the flexibility to increase or decrease production capacity. Varian Semiconductor purchases materials and components that are either standard products or built to Varian Semiconductor’s specifications. This strategy also allows Varian Semiconductor to focus on product differentiation through system design and quality control. Varian Semiconductor’s manufactured subsystems incorporate advanced technologies in robotics, vacuum and microcomputers. Varian Semiconductor works closely with its suppliers to achieve mutual cost reductions through joint design efforts. Varian Semiconductor manufactures most of its systems in clean-room environments that are similar to the clean-rooms used by semiconductor manufacturers for wafer fabrication. This procedure is intended to reduce installation and production qualification times and the amount of particulates and other contaminants in the assembled system, which in turn improves yield and reduces downtime for the customer.
Quality efforts at Varian Semiconductor begin with product development. Varian Semiconductor uses three dimensional computer-aided design, finite element analysis and other computer-based modeling methods to engineer and validate new designs. Product design is tested throughout all stages of development and validated through use of a “phase-gate” product introduction process before the first production system is built. Concurrent engineering programs help integrate new designs into manufacturing quickly and successfully.
Competition
The semiconductor capital equipment market is highly competitive and is characterized by a small number of large companies. The larger companies include Applied Materials, Tokyo Electron Limited (“Tokyo Electron”), KLA-Tencor Corporation (“KLA-Tencor”), Nikon Corporation, Canon, Inc., Novellus Systems, Inc. (“Novellus”), Lam Research Corporation, (“Lam”), and Hitachi High Technologies Corporation. Varian Semiconductor faces significant competition in the ion implantation market sector. Within this sector, multiple implant suppliers participate in one or more implant sectors. Generally, for each system selection, Varian Semiconductor is competing with one or more major competitors. As reported by Gartner Dataquest for calendar year 2005, the revenue market share for ion implantation equipment is Varian Semiconductor 39%, Axcelis Technologies, Inc. (“Axcelis”) 15%, Applied Materials 18%, Sumitomo Eaton Nova Corporation 17%, Nissin Electric Company, Limited 10%, and Ulvac Technologies, Inc. 1%.
Significant competitive factors in the ion implantation market include strategic relationships, cost of ownership, performance reliability, customer support, distribution and financial viability. In addition to these factors, significant competitive characteristics in the semiconductor capital equipment market include flexibility, size of manufacturer, installed customer base and breadth of product line. Products designed for one sector may compete against products offered by competitors’ systems in another sector. Due to the constant innovation that has characterized semiconductor manufacturers, competitors and potential new market entrants, it is possible that the application needs and manufacturing technologies used can change, disrupting historical trends in the market significantly. Varian Semiconductor believes it competes favorably in each of these categories, and in order to remain competitive, Varian Semiconductor recognizes it may require significant financial resources in order to
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Table of Contentsoffer a broad range of products, to maintain customer service and support centers worldwide and to invest in product and process research and development.
Research and Development
The semiconductor manufacturing industry is subject to rapid technological change requiring new product introductions and enhancements. Varian Semiconductor’s ability to remain competitive in this market will depend in part upon its ability to develop new and enhanced systems and to introduce these systems at competitive prices and on a timely and cost-effective basis. Accordingly, Varian Semiconductor devotes a significant portion of its personnel and financial resources to research and development programs and seeks to maintain close relationships with its customers to remain responsive to their product needs.
Varian Semiconductor’s current research and development efforts are directed at development of new systems and processes and improving existing system capabilities. Varian Semiconductor currently focuses its research and development efforts on the enhancement of its VIISta platform. The VIISta platform is designed to cover the complete range of implants required for the next several generations of integrated circuits. The VIISta single wafer platform allows customers to use a single platform for all implant applications including high current, medium current and high energy.
Expenditures by Varian Semiconductor for research and development during fiscal years 2006, 2005 and 2004 were $90.6 million, $77.7 million and $67.7 million, respectively. Varian Semiconductor expects in future years that research and development expenditures will continue to represent a substantial percentage of operating expenses. In addition to developing new high current and high energy products, Varian Semiconductor continues to focus on maintaining its leadership position in the market for medium current implanters.
Patent and Other Proprietary Rights
Varian Semiconductor pursues a policy of seeking patent, copyright and trade secret protection in the U.S. and other countries for developments, improvements and inventions originating within its organization that are incorporated in Varian Semiconductor’s products or that fall within its fields of interest. As of December 6, 2006, Varian Semiconductor owned approximately 141 patents in the U.S., 208 patents in other countries, and had 654 patent applications on file with various patent agencies worldwide. Varian Semiconductor intends to file additional patent applications as appropriate.
Varian Semiconductor relies on a combination of copyright, trade secret and other laws, and contractual restrictions on disclosure, copying and transferring title to protect its rights. Varian Semiconductor has trademarks, both registered and unregistered, that are maintained and enforced to provide customer recognition for its products in the marketplace. Varian Semiconductor also has agreements with third parties that provide for licensing of patented or proprietary technology. These agreements include royalty-bearing licenses and technology cross-licenses. The termination of certain of such licenses could have a material adverse effect on Varian Semiconductor’s business.
Varian Semiconductor’s competitors, like companies in many high-technology businesses, routinely review the products of others for possible conflict with their own patent rights. There has also been substantial litigation regarding patent and other intellectual property rights in semiconductor-related industries. Varian Semiconductor, its customers or suppliers could be subject to additional claims of patent infringement, and any such claim could require that Varian Semiconductor pay substantial damages or remove certain features from its products or both.
Pursuant to the dispute resolution provisions of an Agreement dated January 1, 1992 (“the Agreement”) between Varian Semiconductor and Applied Materials, Varian Semiconductor in September 2002 filed an arbitration demand with the American Arbitration Association asserting that Applied Materials breached the Agreement by
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Table of Contentsfailing to pay royalties on products Varian Semiconductor believed were covered by the Agreement’s patent license to Applied Materials. In its arbitration demand, Varian Semiconductor sought to recover back royalties, interest and attorneys’ fees. On May 2, 2003, the arbitration panel issued its decision that certain of Applied Materials’ products were subject to royalty obligations under the Agreement, and on September 1, 2004, the arbitration panel ruled that the patents at issue in the arbitration were valid and enforceable. Applied Materials made an initial payment of $22.0 million for back royalties and interest on October 4, 2004 and a final payment of $2.6 million for back interest and royalties on November 8, 2004. Applied Materials also is required to pay quarterly unit-based royalty payments to Varian Semiconductor on future sales of certain products found to be within the scope of the Agreement through expiration of the Agreement on March 20, 2007.
The royalty-bearing license agreements produced approximately $9.5 million in royalties in fiscal year 2006, $27.7 million in royalties in fiscal year 2005 and $7.9 million in royalties in fiscal year 2004. The last of the principal patents covered by these licenses will expire on July 9, 2007.
Environmental Matters
For a discussion of environmental matters, see “Risk Factors,” in Item 1A and “Environmental Liabilities” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Company History
On April 2, 1999, Varian Semiconductor was spun-off from Varian Associates, Inc. (“VAI”). Varian Semiconductor’s business was operated as the Semiconductor Equipment Business (“SEB”) of VAI.
On April 2, 1999, VAI contributed the SEB to Varian Semiconductor, then distributed to the holders of record of VAI common stock, one share of common stock of Varian Semiconductor for each share of VAI common stock owned.
Varian Semiconductor’s role in the semiconductor manufacturing market can be traced to VAI’s pioneering work in ultra-high vacuum technology. In the 1960’s, this technology was applied to many physics and space research projects requiring ultra-high vacuum environments. This technology proved critical in the semiconductor manufacturing process. SEB was successful in developing methods for controlling electron beams and ions in ultra-high vacuum environments and in depositing materials onto silicon wafers to create switching devices.
SEB entered the ion implantation business in fiscal year 1975 through the acquisition of Extrion Corporation, in Gloucester, Massachusetts. Since then, Varian Semiconductor has developed a complete line of medium and high current ion implanters and added the high energy product line in fiscal year 1998. These systems introduce precise quantities of dopant materials into silicon wafers, creating desired electrical characteristics. In June 1997, SEB sold its Thin Film Systems (“TFS”) business, which made physical vapor deposition equipment, also known as sputtering systems, to Novellus. In July 1998, SEB acquired the high energy ion implantation equipment product line of Genus, Inc.
Employees
As of November 24, 2006, Varian Semiconductor had 1,588 full-time employees worldwide—1,198 in North America, 309 in Asia Pacific and 81 in Europe. None of Varian Semiconductor’s employees based in the U.S. are subject to collective bargaining agreements and Varian Semiconductor has never experienced a work stoppage, slowdown or strike. None of Varian Semiconductor’s employees is represented by a labor union and Varian Semiconductor considers its employee relations to be good.
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Table of ContentsExecutive Officers
The current executive officers of Varian Semiconductor are listed below. Executive officers are elected on an annual basis and serve at the discretion of the Board of Directors.
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Table of Contents
The semiconductor industry is cyclical, and a slowdown in demand for Varian Semiconductor’s semiconductor manufacturing equipment may negatively affect financial results.
The semiconductor industry historically has been cyclical in nature and has experienced periodic downturns. The industry may experience volatility in product pricing and in product demand. Volatility may result in significant reductions and delays in the purchase of semiconductor manufacturing equipment and the construction of new fab facilities. If such significant reductions and delays in purchasing occur and Varian Semiconductor has procured materials prior to the receipt of the customer purchase order, significant inventory charges could be
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Table of Contentsincurred, thereby negatively impacting Varian Semiconductor’s financial results. In addition, even though Varian Semiconductor’s revenues may fluctuate significantly from period to period, in order to remain competitive, Varian Semiconductor continues to invest in research and development and to maintain its worldwide customer service and support capabilities. These investments in the business may adversely affect Varian Semiconductor’s financial results.
Varian Semiconductor faces intense competition in the semiconductor equipment industry.
Significant competitive factors in semiconductor equipment manufacturing include the strength of customer relationships, pricing, technological performance and timing, distribution capabilities and financial viability. Varian Semiconductor believes that in order to remain competitive in this industry, it will need to devote significant financial resources to research and development, to offer and market a broad range of products, and maintain and enhance customer service and support centers worldwide. The semiconductor equipment industry is increasingly dominated by large manufacturers who have resources to support customers worldwide, and some of Varian Semiconductor’s competitors have substantially greater financial resources and more extensive engineering, manufacturing, marketing, service and support than does Varian Semiconductor. With fewer resources, Varian Semiconductor may not be able to match the product offerings or customer service and technical support offered by its competitors. In addition, there are several smaller companies that provide innovative technology that may have performance advantages over Varian Semiconductor’s systems. If these manufacturers continue to improve their product performance and pricing, enter into strategic relationships, expand their current targeted geographic territory or consolidate with large equipment manufacturers, sales of Varian Semiconductor’s products may be adversely affected.
Varian Semiconductor derives a substantial portion of its revenues from a small number of customers, and its business may be harmed by the loss of any one significant customer.
From time to time within the same accounting period, Varian Semiconductor has sold significant percentages of its systems to its major customers, some of which include Chartered, Elpida, Hynix, Hynix-ST, Infineon, Intel, Micron, Promos, Samsung, Sony, STMicroelectronics, TSMC, Texas Instruments, UMC and Winbond. During some quarters, some of these customers have individually accounted for more than 10% of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. Furthermore, Varian Semiconductor may have difficulty attracting additional large customers because its sales depend, in large part, upon the decision of a prospective customer to increase manufacturing capacity in an existing fabrication facility or to transfer a manufacturing process to a new fabrication facility, both of which typically involve a significant capital commitment. Once a semiconductor manufacturer has selected a particular supplier’s capital equipment, the manufacturer generally relies upon that equipment for the specific production line application. Consequently, Varian Semiconductor may experience difficulty in selling to a prospective customer if that customer initially selects a competitor’s capital equipment.
Varian Semiconductor’s quarterly results of operations are likely to fluctuate, and as a result, Varian Semiconductor may fail to meet the expectations of its investors and securities analysts, which may cause the price of its common stock to decline.
Varian Semiconductor has experienced and expects to continue to experience significant fluctuations in its quarterly financial results. From time to time, customers may accelerate, postpone or cancel shipments, or production difficulties may delay shipments. A cancellation, delay in shipment or delay in customer acceptance of the product upon installation in any quarter may cause revenue in such quarter to fall significantly below expectations, which could cause the market price of Varian Semiconductor’s common stock to decline. Varian Semiconductor’s financial results also fluctuate based on gross profit realized on sales. Gross profit as a percentage of revenue may vary based on a variety of factors, including the mix and average selling prices of products sold, costs to manufacture and customize systems and inventory management. In addition, a number of
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Table of Contentsother factors may impact Varian Semiconductor’s quarterly financial results, including, but not limited to the following:
Because Varian Semiconductor’s operating expenses are based on anticipated capacity levels and a high percentage of Varian Semiconductor’s expenses are relatively fixed, a fluctuation in the timing of recognition of revenue and the level of gross profit from a single transaction could cause financial results to vary significantly from quarter to quarter.
It is difficult for Varian Semiconductor to predict the quarter in which it will be recognizing revenue from large product orders.
Varian Semiconductor customarily sells a relatively small number of systems within any period. Consequently, Varian Semiconductor’s revenue and financial results could be negatively impacted for a particular quarter if anticipated orders from even a few customers are not received in time to permit shipment and/or there are delays in customer acceptance of the product upon installation. Generally, Varian Semiconductor recognizes all or a portion of the revenue from a product upon shipment provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations, and there are no uncertainties regarding customer acceptance. [Please refer to the full revenue recognition policy in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Critical Accounting Policies and Significant Judgments and Accounting Estimates section.] As a result, it is often difficult to determine the timing of product revenue recognition. In addition, Varian Semiconductor’s product order backlog at the beginning of each quarter may not include all systems needed to achieve expected revenues for that quarter. Because Varian Semiconductor may build systems according to forecast, the absence of a significant backlog for an extended period of time could adversely affect financial results.
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Table of ContentsVarian Semiconductor’s future business depends, in part, on its ability to successfully introduce and manage the transition to new products, and Varian Semiconductor may not succeed in accomplishing these goals.
Varian Semiconductor believes that its future success will depend on its ability to develop, manufacture and successfully introduce new systems and product lines with improved capabilities and to continue enhancing existing products; in particular, products that respond to the trend toward single wafer processing and 300mm wafer processing at more advanced nodes. Varian Semiconductor derives virtually all of its revenue from sales and servicing of systems and related products and services. Varian Semiconductor must accurately forecast the demand for new products while managing the transition from older products. In addition, Varian Semiconductor may be unable to complete the development or meet the technical specifications of new systems or enhancements or to manufacture and ship these systems or enhancements in volume and on time, which may harm its reputation and business. If any of Varian Semiconductor’s new products have reliability or quality problems, Varian Semiconductor may incur additional warranty and service expenses, experience a decline in product orders or incur higher manufacturing costs to correct such problems, all of which could adversely affect financial results.
Varian Semiconductor is subject to the risks of operating internationally and it derives a substantial portion of its revenues from outside the U.S.
International revenue accounts for a substantial portion of Varian Semiconductor’s revenue. Because Varian Semiconductor relies on sales to customers in Asia Pacific for a significant portion of its revenue, its business is very likely to be adversely impacted by economic downturns and instability in that region. Varian Semiconductor’s business in Asia Pacific is affected by demand in each country. In addition, international sales are subject to risks, including, but not limited to:
If Varian Semiconductor is unable to protect its proprietary rights adequately, it may lose its ability to compete effectively in the semiconductor equipment industry.
Varian Semiconductor relies on obtaining and maintaining patent, copyright and trade secret protection for significant new technologies, products and processes and obtaining key licenses because of the length of time and expense associated with bringing new products through the development process to market. Varian Semiconductor intends to continue to file applications as appropriate for patents covering new products and manufacturing processes. However, Varian Semiconductor cannot provide assurance of the following:
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Table of ContentsVarian Semiconductor also has agreements with third parties for licensing of patented or proprietary technology. These agreements include royalty-bearing licenses and technology cross-licenses.
In addition, Varian Semiconductor maintains and enforces its trademarks to increase customer recognition of its products. If its trademarks are used by unauthorized third parties, Varian Semiconductor’s business may be harmed. Varian Semiconductor also relies on contractual restrictions on disclosure, copying and transferring title, including confidentiality agreements with vendors, strategic partners, co-developers, employees, consultants and other third parties to protect its proprietary rights. If these contractual agreements are breached, Varian Semiconductor may not have adequate remedies for any such breaches. Varian Semiconductor also cannot provide assurance that its trade secrets will not otherwise become known to or be independently developed by others.
Patent claims may be expensive to pursue, defend or settle and may substantially divert Varian Semiconductor’s resources and the attention of management.
Varian Semiconductor could incur substantial costs and diversion of management resources in defending patent suits brought against it or in asserting its patent rights against others. If the outcome of any such litigation is unfavorable to Varian Semiconductor, its business may be harmed. Varian Semiconductor may not be aware of pending or issued patents held by third parties that relate to its products or technologies. In the event that a claim is asserted against Varian Semiconductor, it may need to acquire a license to or contest the validity of a competitor’s patent. Varian Semiconductor cannot be certain that it could acquire such a license on commercially acceptable terms, if at all, or that it would prevail in such a proceeding. From time to time Varian Semiconductor has received notices from and has issued notices to such third parties alleging infringement of patent and other intellectual property rights relating to its products. If Varian Semiconductor is subject to future claims of patent infringement, it may be required to make substantial settlement or damage payments and may have to devote substantial resources to reengineering its products.
Varian Semiconductor depends on limited groups of suppliers or single source suppliers, the loss of which could impair its ability to manufacture products and systems.
Varian Semiconductor obtains some of the components and subassemblies included in its products from a limited group of suppliers, or in some cases a single source supplier. The loss of any supplier (or the temporary inability of any supplier to meet Varian Semiconductor’s production requirements, including any single source supplier) would require obtaining one or more replacement suppliers and may also require devoting significant resources to product development to incorporate new parts from other sources into Varian Semiconductor’s products. The need to change suppliers or to alternate between suppliers might cause delays in delivery or significantly increase Varian Semiconductor’s costs. Although Varian Semiconductor has insurance to protect against loss due to business interruption from some sources as necessary, Varian Semiconductor cannot provide assurance that such coverage will be adequate or that it will remain available on commercially acceptable terms. Although Varian Semiconductor seeks to reduce its dependence on these limited source suppliers, disruption or loss of these sources could negatively impact its business and damage customer relationships.
Varian Semiconductor’s outsource providers may fail to perform as it expects
Outsource providers have an increasing role in Varian Semiconductor’s manufacturing operations, research and development initiatives and in transactional and administrative functions. Although Varian Semiconductor aims at selecting reputable providers and securing their performance on terms documented in written contracts, it is possible that one or more of these providers could fail to perform as Varian Semiconductor expects and such failure could have an adverse impact on Varian Semiconductor’s business. In addition, the expansive role of outsource providers has required and will continue to require Varian Semiconductor to implement changes to its existing operations and to adopt new procedures to deal with and manage the performance of these outsource providers. Any delay or failure in the implementation of our operational changes and new procedures could adversely affect Varian Semiconductor’s customer relationships and /or have a negative effect on Varian Semiconductor’s operating results.
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Table of ContentsVarian Semiconductor’s indemnification obligations under the Distribution Related Agreements could be substantial, and Varian Semiconductor may not be fully indemnified in accordance with the Distribution Related Agreements for the expenses it incurs.
Under the terms of the Distribution Related Agreements, each of Varian Medical Systems, Inc. (“VMS”) (formerly VAI), Varian, Inc. (“VI”) and Varian Semiconductor has agreed to indemnify the other parties, and certain related persons, from and after the spin-off with respect to certain indebtedness, liabilities and obligations, which could be significant. The availability of such indemnities will depend upon the future financial strength of the companies. There is a risk that one or more of these companies will not be able to satisfy their indemnification obligations. In addition, the Distribution Related Agreements generally provide that if a court prohibits a company from satisfying its indemnification obligations, then such obligations will be shared equally by the other companies.
Failure to comply with present or future environmental regulations could subject Varian Semiconductor to penalties and environmental remediation costs.
Varian Semiconductor is subject to a variety of foreign, federal, state and local laws regulating the discharge of materials into the environment and the protection of the environment. These regulations include discharges into the soil, water and air and the generation, handling, storage, and transportation and disposal of waste and hazardous substances. These laws increase the costs and potential liabilities associated with the conduct of Varian Semiconductor’s operations.
VAI has been named by the U.S. Environmental Protection Agency and third parties as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended (“CERCLA”), at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also in various stages of environmental investigation and/or remediation under the direction of, or in consultation with foreign, federal, state and local agencies at certain current or former VAI facilities. The Distribution Related Agreements provide that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.
For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued estimated environmental investigation and remediation costs for these sites and facilities. As to other sites and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has sufficient accruals to cover Varian Semiconductor’s portion of these costs.
Accrued amounts are only estimates of anticipated future environmental-related costs, and the amounts actually spent may be greater than such estimates. Accordingly, Varian Semiconductor may need to make additional accruals and subsequent payments to cover its indemnification obligations that would exceed current estimates. In addition, Varian Semiconductor’s present and past facilities have been in operation for many years, and over that time in the course of those operations, such facilities have used substances which are or might be considered hazardous. Varian Semiconductor also may have generated and disposed of wastes which are or might be considered hazardous. Therefore, it is possible that additional environmental issues may arise in the future that Varian Semiconductor cannot now predict.
Varian Semiconductor’s ability to manage potential growth or decline, integration of potential acquisitions, and potential disposition of product lines and technologies creates risks.
The cyclical nature of the semiconductor industry may cause Varian Semiconductor to experience rapid growth or decline in demand for products and services. As a result, Varian Semiconductor may face significant
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Table of Contentschallenges in maintaining adequate financial and business controls, materials management, management processes, information systems and procedures on a timely basis, training, managing and appropriately sizing the work force. There can be no assurance that Varian Semiconductor will be able to perform such actions successfully.
An important element of Varian Semiconductor’s management strategy is to review acquisition prospects that would complement existing products, augment market coverage and distribution ability, or enhance technological capabilities. In the future, Varian Semiconductor may make acquisitions of complementary companies, products or technologies, or may reduce or dispose of certain product lines or technologies that no longer fit Varian Semiconductor’s long-term strategies. Managing an acquired business, disposing of product technologies or reducing personnel entails numerous operational and financial risks, including difficulties in assimilating acquired operations and new personnel or separating existing business or product groups, diversion of management’s attention to other business concerns, amortization of acquired intangible assets, the incurrence of debt and contingent liabilities and potential loss of key employees or customers of acquired or disposed operations, among others. Varian Semiconductor’s success will depend, to a significant extent, on the ability of its executive officers and other members of its senior management to identify and respond to these challenges effectively. In addition, any acquisitions could result in dilutive issuances of equity securities. There can be no assurance that Varian Semiconductor will be able to achieve and manage successfully any such growth, decline, integration of potential acquisitions, disposition of product lines or technologies, or reduction in personnel, or that management, personnel or systems will be adequate to support continued operations. Any such inabilities or inadequacies may have a material adverse effect on Varian Semiconductor’s business, operating results, financial condition, cash flows and/or the price of Varian Semiconductor common stock.
Varian Semiconductor manufactures its products at one primary manufacturing facility and is thus subject to risk of disruption.
Varian Semiconductor has one primary manufacturing facility, located in Gloucester, Massachusetts, and its operations are subject to disruption for a variety of reasons, including, but not limited to natural disasters, work stoppages, operational facility constraints and terrorism. Such disruption may cause delays in shipments of products to Varian Semiconductor’s customers and may result in cancellation of orders or loss of customers and could seriously harm Varian Semiconductor’s business.
If Varian Semiconductor loses key employees or is unable to attract and retain key employees, it may be unable to pursue business opportunities.
Varian Semiconductor’s future success depends to a significant extent on the continued service of key managerial, technical and engineering personnel. Competition for such personnel is intense, particularly in the labor markets around Varian Semiconductor’s facilities in Massachusetts. The available pool of qualified candidates is limited, and Varian Semiconductor may not be able to retain its key personnel or to attract, train, assimilate or retain other highly qualified engineers and technical and managerial personnel in the future. The loss of these persons or Varian Semiconductor’s inability to hire, train or retrain qualified personnel could harm Varian Semiconductor’s business and results of operations.
Varian Semiconductor has anti-takeover defenses that could delay or prevent an acquisition and could adversely affect the price of its common stock.
Provisions of Varian Semiconductor’s certificate of incorporation and by-laws and of Delaware law could delay, defer or prevent an acquisition or change in control of Varian Semiconductor or otherwise adversely affect the price of its common stock. For example, Varian Semiconductor’s Board of Directors is classified into three classes, and stockholders do not have the right to call special meetings of stockholders. Varian Semiconductor’s certificate of incorporation also permits its Board of Directors to issue shares of preferred stock without stockholder approval. In addition to delaying or preventing an acquisition, the issuance of a substantial number of
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Table of Contentspreferred shares could adversely affect the price of the common stock. Varian Semiconductor has also adopted a stockholders’ rights plan which could significantly dilute the equity interests of a person seeking to acquire control of Varian Semiconductor without the approval of the Board of Directors.
Varian Semiconductor does not anticipate paying dividends on its common stock in the future.
Varian Semiconductor has not paid and does not anticipate paying dividends on its common stock. Varian Semiconductor’s Board of Directors has discretion to make decisions to pay dividends to common stockholders in the future. The decision will depend on a number of factors, including results of operations, financial conditions and contractual restrictions that the Board, in its opinion, deems relevant.
Varian Semiconductor’s financial results may be adversely impacted by higher than expected tax rates or exposure to additional income tax liabilities.
As a global company, Varian Semiconductor’s effective tax rate is highly dependent upon the geographic composition of worldwide earnings and tax regulations governing each region. Varian Semiconductor is subject to income taxes in both the U.S. and various foreign jurisdictions, and significant judgment is required to determine worldwide tax liabilities. Varian Semiconductor’s effective tax rate could be adversely affected by changes in the distribution of earnings between countries with differing statutory tax rates, in the valuation of deferred tax assets, in tax laws or by material audit assessments, which could affect profitability. For example, recent U.S. legislation governing taxation of extraterritorial income repealed certain export subsidies that were prohibited by the World Trade Organization and enacted different tax provisions. These new tax provisions are not expected to fully offset the loss of the repealed tax provisions and, as a result, Varian Semiconductor’s U.S. tax liability may increase. In addition, Varian Semiconductor’s effective tax rate has benefited from the research and development (“R & D”) tax credit which expired on December 31, 2005. If the R & D credit is not extended, Varian Semiconductor’s tax liability may increase. Further, the carrying value of deferred tax assets, which are predominantly in the U.S., is dependent on Varian Semiconductor’s ability to generate future taxable income in the U.S. In addition, the amount of income taxes paid is subject to ongoing audits in various jurisdictions, and a material assessment by a governing tax authority could affect profitability.
Varian Semiconductor’s headquarters and manufacturing facility is located in Gloucester, Massachusetts. In addition, Varian Semiconductor has five sales and service offices located in the U.S. and 29 located outside of the U.S., including offices in France, Germany (three), the Netherlands, Japan (eight), Korea (four), Taiwan (four), China (five), Singapore and Malaysia (two). These offices and facilities aggregate approximately 638 thousand square feet, of which 197 thousand square feet is leased. Since fiscal year 1994, the manufacturing facilities have been registered to the internationally recognized ISO 9001 standard. ISO 2000 certification was obtained in fiscal year 2002, and recertification was obtained in 2005. Field support operations in Europe and Korea have been registered to the ISO 9001:2002 standard since 2003 and 2002, respectively, with Europe operations obtaining recertification in 2006.
Varian Semiconductor’s management does not believe there is any material, long-term, excess capacity in Varian Semiconductor’s facilities, although utilization is subject to change based on customer demand. Furthermore, Varian Semiconductor’s management believes that Varian Semiconductor’s facilities and equipment generally are well maintained, in good operating condition, suitable for Varian Semiconductor’s purposes, and adequate for its present operations.
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Table of ContentsThe following table reflects Varian Semiconductor’s locations by geographic segment.
Varian Semiconductor’s operations are subject to various foreign, federal, state and/or local laws relating to the protection of the environment. These include laws regarding discharges into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. In addition, several countries are reviewing proposed regulations that would require manufacturers to dispose of their products at the end of a product’s useful life. These laws have the effect of increasing costs and potential liabilities associated with the conduct of certain operations.
Varian Semiconductor is currently the plaintiff in several legal disputes related to employment and contract matters. While Varian Semiconductor believes favorable judgments will be rendered with respect to such claims, the timing and amount, if any, of these judgments is uncertain.
From time to time, Varian Semiconductor may become involved in a number of legal actions and could incur an uninsured liability in one or more of them. Accordingly, while the ultimate outcome of these legal matters is not determinable, management believes the resolution of these matters will not have a material adverse effect on the financial condition or results of operations of Varian Semiconductor.
No matters were submitted to a vote of security holders of Varian Semiconductor, through solicitation of proxies or otherwise, during the last quarter of fiscal year 2006.
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Table of ContentsPART II
Since April 5, 1999, Varian Semiconductor’s common stock has traded on The Nasdaq Global Select Market under the symbol “VSEA.”
The following table sets forth the high and low sale prices per share of Varian Semiconductor’s common stock during each quarter for the two most recent fiscal years. The share prices have been retroactively adjusted to reflect the three-for-two stock split in February 2006.
The reported closing price of Varian Semiconductor’s common stock on The Nasdaq Global Select Market on September 29, 2006 was $36.70 per share. The number of stockholders of record on December 1, 2006 was 2,618.
Varian Semiconductor has never declared or paid cash dividends on its common stock and does not expect to pay any cash dividends on its common stock in the foreseeable future.
On October 22, 2004, Varian Semiconductor’s Board of Directors authorized the repurchase, from time to time, of up to $100 million of Varian Semiconductor’s common stock on the open market. The first purchases under this plan were made during the first quarter of fiscal year 2006. On August 1, 2006, the Board of Directors of Varian Semiconductor amended the share repurchase program to increase the amount of funds that may be expended in repurchasing Varian Semiconductor’s common stock from $100 million to $200 million. The program does not have a fixed expiration date. During fiscal year 2006, Varian Semiconductor spent $108.9 million on the repurchase of 3,747,555 shares at a weighted-average price per share of $29.03.
See Item 12 of Part III of this Annual Report on Form 10-K for information required by Item 201(d) of Regulation S-K.
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Table of ContentsThe following table provides information about purchases by Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) during the quarter ended September 29, 2006 of equity securities that are registered by Varian Semiconductor pursuant to Section 12 of the Securities Exchange Act of 1934:
ISSUER PURCHASES OF EQUITY SECURITIES
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Table of Contents
The information included in the following table reflects selected consolidated summary financial data for each of the last five fiscal years. This data should be read in conjunction with the consolidated financial statements and notes thereto, and with “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” below.
This selected financial data should be read in conjunction with the consolidated financial statements and notes thereto included in “Item 15—Exhibits and Financial Statement Schedules.”
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Table of ContentsQUARTERLY FINANCIAL DATA (Unaudited)
Selected Quarterly Results of Operations
The following tables set forth unaudited quarterly consolidated statements of income data for each of the eight fiscal quarters in the period ended September 29, 2006. The quarterly data should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K.
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This Annual Report on Form 10-K contains certain forward-looking statements. For purposes of the safe harbor provisions under The Private Securities Litigation Reform Act of 1995, any statements using the terms “believes,” “anticipates,” “expects,” “plans” or similar expressions, are forward-looking statements. The forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected. There are a number of important factors that could cause Varian Semiconductor’s actual results to differ materially from those indicated by forward-looking statements made in this report and presented by management from time to time. Some of the important risks and uncertainties that may cause Varian Semiconductor’s financial results to differ are described in Item 1A. “Risk Factors.”
Overview
Varian Semiconductor is the leading supplier of ion implantation equipment used in the fabrication of semiconductor chips. Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment for virtually all of the major semiconductor manufacturers in the world. The VIISta ion implanter products are designed to leverage single wafer processing technology for the full range of semiconductor implant applications. Varian Semiconductor has shipped more than 3,600 systems worldwide.
Varian Semiconductor provides support, training, and after-market products and services that help its customers obtain high utilization and productivity, reduce operating costs, and extend capital productivity of investments through multiple product generations. In fiscal year 2006, Varian Semiconductor was ranked number one in customer satisfaction in VLSI Research Inc.’s customer survey for all large suppliers of wafer processing equipment, an honor received in nine of the past ten years.
Varian Semiconductor’s business is cyclical. The business depends upon semiconductor manufacturers’ expectations and resulting capacity investments for future integrated circuit demand. In fiscal year 2004 Varian Semiconductor experienced an increase in business activity owing to a generally strengthening economy and increased demand for semiconductor equipment. During calendar year 2005, there was an 11% decline in worldwide ion implanter sales. However, due to market share gains, Varian Semiconductor’s fiscal year 2005 revenue increased 13% over fiscal year 2004 as customers migrated to single wafer systems, which favor Varian Semiconductor’s product offerings. Single wafer systems are now preferred over batch systems as they process wafers in such a way that results in higher yields for advanced device manufacturers. During fiscal year 2006, Varian Semiconductor believes its 22% revenue increase over fiscal year 2005 was the result of both increases in worldwide ion implanter sales as well as Varian Semiconductor’s continued market share gains for the calendar year 2006.
Wafer size and market. The migration from 200mm to 300mm began at the end of the 1990s and 300mm fabs now represent more than half of semiconductor expansions. Most advanced devices below 130nm are produced on 300mm wafers. Varian Semiconductor believes the increase in shipments from 200mm to 300mm will continue and is evidence that Varian Semiconductor’s tools meet the newest technology requirements. Memory manufacturers typically produce integrated circuits used for DRAM, flash, etc. which store and retrieve information, while logic manufacturers typically produce integrated circuits used to process data. Significant purchasing fluctuations from memory, logic and foundry fabs could lead to significant fluctuations in Varian Semiconductor’s revenues, even if the total ion implant market remains flat.
The first table below shows Varian Semiconductor’s calendar year 2005, 2004 and 2003 market share, as reported by Gartner Dataquest in April 2006, April 2005 and April 2004. Market share estimates are calculated on a subset of revenue, and information reported by Gartner Dataquest may not be consistent on a company by company basis. The second table below shows the total available market for ion implanter sales in calendar years 2005, 2004 and 2003, also reported by Gartner Dataquest in April 2006, April 2005 and April 2004. The total available market represents an estimated worldwide total revenue for ion implanters sold by all companies which sell ion implanters during each of the calendar years.
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Table of ContentsMarket Share
Total Available Market
Market Share and Total Available Market. Market share and total available market research data is also published by VLSI Research Inc. In April 2006, VLSI Research Inc. reported that Varian Semiconductor’s overall market share was 41% and that the total available market was $1,070 million for calendar year 2005. Varian Semiconductor’s increase in high current and medium current market share has led to increased revenues, as the total available market for ion implanter sales decreased by 11% during calendar year 2005, compared to calendar year 2004. Varian Semiconductor’s increase in high current market share is a result of the industry shift to single wafer implanters at advanced technology nodes (65nm and below). Varian Semiconductor began developing single wafer high current tools during 1994 and believes it is currently the industry leader. In addition, Varian Semiconductor continues to invest in research and development to maintain its medium current market share lead. High energy implanters are the smallest component of the total available market for ion implanter sales and Varian Semiconductor maintained its market share. Please refer to Item 1. “Business” of this document for additional information on the technology and markets for ion implantation equipment.
Critical Accounting Policies and Significant Accounting Estimates
Varian Semiconductor’s discussion and analysis of its financial condition and results of operations are based upon Varian Semiconductor’s consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the U.S. The preparation of these consolidated financial statements requires Varian Semiconductor to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On a continual basis, Varian Semiconductor evaluates its estimates, including those related to revenues, inventories, accounts receivable, long-lived assets, income taxes, warranty obligations, deferred revenue, post-retirement benefits, contingencies, stock-based compensation and foreign currencies. Varian Semiconductor operates in a highly cyclical and competitive industry that is influenced by a variety of diverse factors including, but not limited to, technological advances, product life cycles, customer and supplier lead times, and geographic and macroeconomic trends. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor bases its estimates on historical experience and on various other assumptions that are believed to
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Table of Contentsbe reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. See also the factors discussed in Item 1A. “Risk Factors.”
Varian Semiconductor believes that the following sets forth the critical accounting policies used by Varian Semiconductor in the preparation of its consolidated financial statements.
Revenue Recognition
Product revenue includes established products, new products, upgrades and spare parts.
Varian Semiconductor recognizes revenue from product sales upon shipment, provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations, and there are no uncertainties regarding customer acceptance.
For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance. For new products, revenue allocated to the equipment is recognized upon customer acceptance. Revenue related to spare parts and upgrade sales is recognized upon the later of delivery or when the title and risk of loss passes to the customer.
Products are classified as established products if post-delivery acceptance provisions and the installation process have been determined to be routine, due to the fact that the acceptance provisions are generally a replication of pre-shipment procedures, and there is a demonstrated history of achieving predetermined installation cost targets. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions cannot be replicated in Varian Semiconductor’s facilities, or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes. Varian Semiconductor has predetermined criteria for changing the classification of a new product to an established product. A new product must achieve a set number of acceptances and a set target for installation cost. Once the criteria have been achieved for a new product, the product is considered established.
Service revenue includes revenue from maintenance and service contracts, extended warranties, paid service and system installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Extended warranty revenue is deferred and recognized ratably over the applicable warranty term. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation and customer acceptance. It takes approximately three to six weeks for Varian Semiconductor technicians to complete the installation of Varian Semiconductor products and perform tests agreed to with customers. Certain customers formally document their acceptance of Varian Semiconductor’s products at this time. Other customers elect to perform additional internal testing prior to formal acceptance, and this process generally takes eight to twelve weeks.
Royalty and license revenue is recognized when contractual obligations are met, and in the case of royalties, upon receipt of a royalty report from the customer, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured. When fees are not fixed or determinable, revenue is recorded when payments become due.
Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair
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Table of Contentsvalue of those elements. The amount allocated to installation is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue.
Inventory and Purchase Order Commitments
Varian Semiconductor values its inventory at the lower of cost or market. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor also provides for losses on those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under the commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. Once inventory is written down and a new cost basis has been established, it is not written back up if demand increases. If market conditions are less favorable than those projected by management, additional inventory provisions may be required. If market conditions are more favorable than those projected by management, and specific inventory previously written down is subsequently sold, gross profit would improve by the amount of the specific write-down reversed in the period the inventory is sold. In the case of purchase order commitments, more favorable market conditions or successful negotiations with suppliers will result in a reduction of provisions in the period the excess purchase order commitments are reduced.
Valuation Allowance on Deferred Tax Assets and Income Tax Provision
Varian Semiconductor records a valuation allowance against deferred tax assets if it is more likely than not that a portion of the deferred tax asset will not be realized. On a quarterly basis, Varian Semiconductor evaluates both the positive and negative evidence bearing upon the realizability of its deferred tax assets. Varian Semiconductor considers future taxable income, ongoing prudent and feasible tax planning strategies, and the ability to utilize tax losses and credits in assessing the need for a valuation allowance. A valuation allowance related to certain state tax credit carryforwards has been recorded. Management has concluded that it is more likely than not that these credits will not be utilized since historically the annual amount of state credits generated exceeds the amount of credits that can be used. Should Varian Semiconductor determine that it is not able to realize all or part of its other deferred tax assets in the future, a valuation allowance would be required resulting in an expense recorded within the provision for income taxes in the statement of income in the period in which such determination was made. It is possible that the amount of the deferred tax asset considered realizable could be reduced in the near term if future taxable income is reduced. Varian Semiconductor’s effective tax rate is affected by levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, U.S. foreign income exclusion, investment tax credits and other tax incentives specific to domestic and foreign operations. In the normal course of business, Varian Semiconductor and its subsidiaries are examined by various tax authorities, including the U.S. Internal Revenue Service (“IRS”). The IRS conducted an examination for the tax years 1999 through 2003 as part of its routine examinations of Varian Semiconductor’s income tax returns. Fieldwork for the examination was completed in the fourth quarter of fiscal year 2005 and submitted to the Congressional Joint Committee on Taxation (“Joint Committee”) for final approval. Varian Semiconductor was notified of Joint Committee approval in the first quarter of fiscal year 2006. In the first quarter of fiscal year 2006, Varian Semiconductor recognized a discrete income tax benefit of $9.0 million related to the favorable conclusion of this multi-year examination by the IRS. In addition, Varian Semiconductor recorded $1.6 million of interest income related to various income tax refunds that were released by the IRS at the conclusion of this examination.
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Table of ContentsProduct Warranties
Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes including actively monitoring and evaluating the quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.
Results of Operations
Fiscal Year
Varian Semiconductor’s fiscal year is a 52- or 53-week period that ends on the Friday nearest September 30. Fiscal year 2006 was comprised of a 52-week period ended on September 29, 2006. Fiscal year 2005 was comprised of a 52-week period ended on September 30, 2005. Fiscal year 2004 was comprised of a 52-week period ended on October 1, 2004.
Fiscal Year 2006 Compared to Fiscal Year 2005 and Fiscal Year 2005 Compared to Fiscal Year 2004
Revenue
The following table sets forth revenue by revenue stream and territory for fiscal years 2006, 2005 and 2004:
Product
Varian Semiconductor’s product sales increased by 31% during fiscal year 2006 after a 7% increase during fiscal year 2005. The fiscal year 2006 increases were mainly due to a unit increase in system sales of 33%, primarily related to high current system sales, and an increase in sales of parts. Varian Semiconductor believes that market share gains, particularly in the high current sector, and an overall increase in industry spending, were the primary
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Table of Contentsreasons for Varian Semiconductor’s increase in sales in fiscal year 2006. In fiscal year 2005, Varian Semiconductor’s product sales increased by 7% due to a unit increase in system sales of 3%, a shift towards VIISta systems, which typically have higher selling prices than legacy systems, and an increase in sales of parts and upgrades.
Service
Service revenue decreased by 6% in fiscal year 2006 as compared to fiscal year 2005, primarily as a result of the reduction in fair value of system installations. Generally, installation revenue is influenced by shipment volume of systems, product mix, customer mix, timing of customer acceptance and the fair value of installations. As products mature and the installation requires less effort to complete, the fair value of installation revenue per system is reduced, which contributes to the reduction in service revenue. Service contract revenues partially offset this decrease by increasing 8% from fiscal year 2005 to fiscal year 2006, primarily as a result of sales of service contracts with new systems. System installation revenues increased by 92% in fiscal year 2005 compared to fiscal year 2004. The increase in service revenue from fiscal year 2004 to fiscal year 2005 was primarily the result of an increase in the number of system installations as the fair value of the installations decreased only slightly. Service contract revenues also increased from fiscal year 2004 to fiscal year 2005 by 12%, primarily as a result of sales of service contracts with new systems.
Royalty and License
In fiscal year 2005, Varian Semiconductor received payments from Applied Materials of $18.9 million for past due royalties. Applied Materials is also required to make quarterly unit-based royalties payments to Varian Semiconductor on future sales of certain products found to be within the scope of the Agreement through the expiration of the Agreement in March 2007. Varian Semiconductor recognized an additional $6.4 million during fiscal year 2006 as royalty revenue related to this agreement.
Pursuant to the terms of a Settlement and License Agreement between Lam and Varian Semiconductor, Lam was required to make quarterly cash payments of $1.25 million through the first quarter of fiscal year 2005 for future use of the patents. These quarterly cash payments were recognized as revenue in fiscal years 2005 and 2004.
Customers
Revenue from Varian Semiconductor’s ten largest customers in fiscal years 2006, 2005 and 2004 accounted for approximately 63%, 66% and 60% of revenue, respectively. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10%, respectively, of Varian Semiconductor’s total revenue. In fiscal year 2005, revenue from two customers accounted for 20% and 14% of Varian Semiconductor’s total revenue. In fiscal year 2004, revenue from two customers accounted for 14% and 10% of Varian Semiconductor’s total revenue.
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Table of ContentsShipment Mix
Varian Semiconductor’s tools are used primarily for 200mm and 300mm wafer size implants. In addition, Varian Semiconductor’s tools are used in both major markets – memory and logic – for integrated circuits. Shipments to foundry manufacturers are allocated based upon Varian Semiconductor’s estimate of usage for either memory or logic. The following table sets forth tool shipments by wafer size and market, as a percent of total tool shipments, for fiscal years 2006, 2005 and 2004. Percentages are based on the number of tools shipped during the respective period.
Cost of Product Revenue
Cost of product revenue was $371.1 million and gross margin was 42% for fiscal year 2006, compared to the cost of product revenue of $280.4 million and gross margin of 43% for fiscal year 2005. For fiscal year 2004, cost of product revenue was $249.1 million and gross margin was 45%. The slight decrease in gross margin from fiscal year 2005 to fiscal year 2006 was primarily due to the fact that parts and upgrades sales, which have higher margins than systems, were a lower percentage of product sales in fiscal year 2006 than in fiscal year 2005. In addition, during fiscal year 2006 there were increased product transition costs and market share penetrations, where the initial costs to support the first system in the fab are higher than for follow-on business. Gross margin decreased from fiscal year 2004 to fiscal year 2005 due to higher levels of field support and distribution costs associated with the larger installed base of systems in new fabs. Cost of product revenue in fiscal years 2006, 2005 and 2004 was favorably impacted by $1.7 million, $1.7 million and $0.9 million, respectively, from the sale of certain inventory for which the carrying value had been reduced in previous periods. Cost of product revenue for fiscal year 2006 included $1.1 million of equity-based compensation costs recorded upon the adoption of SFAS No. 123(R), “Share-Based Payment” (“SFAS No. 123 (R)”) as of October 1, 2005.
Cost of Service Revenue
Cost of service revenue was $50.1 million and gross margin was 37% for fiscal year 2006, compared to $51.4 million and gross margin of 39% for fiscal year 2005 and $41.2 million and gross margin of 38% for fiscal year 2004. The decrease in cost of service revenue for fiscal year 2006 was primarily due to a decrease in installation costs. The decrease in service margins in fiscal year 2006 was related to decreased margins on installations and the mix of customers for both contracts and paid service. The increase in cost of service revenue and gross margin from fiscal year 2004 to fiscal year 2005 was related to the increased number of installations. The fair value of installations is assessed periodically and is largely based upon the historical experience of the effort and cost to complete installations. The fair value of tool installation is determined at the time of tool shipment. As products have matured and the installation requires less effort to complete, the fair value of installation revenue per installation is reduced. Based upon the results of the first quarter 2006, the fair value was reduced for certain products shipped in the remaining quarters of fiscal year 2006 thus reducing the gross margin. Generally, installation revenue is influenced by shipment volume of systems, product mix, customer mix, timing of
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Table of Contentscustomer acceptances and the fair value of installations. Cost of service revenue for fiscal year 2006 included $1.0 million of equity-based compensation costs recorded upon the adoption of SFAS No. 123(R) as of October 1, 2005.
Research and Development
Research and development expenses were $90.6 million for fiscal year 2006, compared to $77.7 million for fiscal year 2005 and $67.7 million for fiscal year 2004, an increase of $12.9 million, or 17% from fiscal year 2005 to fiscal year 2006, and an increase of $10.0 million, or 15% from fiscal year 2004 to fiscal year 2005. The increases in research and development spending are attributable to Varian Semiconductor’s rapid development cycle and continuing efforts to improve productivity and technical development of its products. The year-over-year increase was a result of increased labor and material spending associated with the development of new products, particularly for new generation high current implanters. In addition to developing new high current products, Varian Semiconductor continues to focus on maintaining its leadership position in the market for medium current implanters. Research and development expense for fiscal year 2006 included $3.7 million of equity-based compensation costs recorded upon the adoption of SFAS No. 123(R) as of October 1, 2005.
Marketing, General and Administrative
Marketing, general and administrative expenses were $116.1 million for fiscal year 2006, compared to $104.9 million for fiscal year 2005 and $85.6 million for fiscal year 2004, an increase of $11.2 million, or 11% from fiscal year 2005 to fiscal year 2006, and an increase of $19.3 million, or 23% from fiscal year 2004 to fiscal year 2005. The increase in expense from fiscal year 2005 to fiscal year 2006 was primarily the result of the expensing of stock based compensation. Increased product marketing expenses, service expenses, and IT expenses also contributed to the increase. These increases were partially offset by decreases in marketing expenses related to the customer evaluations and demonstration of new generation products, and decreases in legal expenses. The increase in expense from fiscal year 2004 to fiscal year 2005 was the result of increased marketing expenses related to the customer evaluations and demonstration of new generation products and increases in the cost of variable compensation programs that partially fluctuate with profitability, as well as increased legal expenses associated with patent enforcement actions. Marketing, general and administrative expenses for fiscal year 2006 included $13.2 million of equity-based compensation costs recorded upon the adoption of SFAS No. 123(R) as of October 1, 2005. Additionally, the first quarter of fiscal year 2005 included a $3.5 million charge, largely non-cash, associated with the retirement of the President and Chief Operating Officer of Varian Semiconductor.
Restructuring Costs
During fiscal year 2005, Varian Semiconductor recognized $0.9 million in restructuring costs. The restructuring costs related to reductions in headcount and facilities in Europe. There were no restructuring costs recognized during fiscal year 2004. The restructuring reserve balance of $0.2 million as of September 30, 2005, was paid during fiscal year 2006, and there were no additional charges in fiscal year 2006.
Interest Income and Interest Expense
During fiscal year 2006, Varian Semiconductor earned $21.5 million in net interest income, compared to $16.3 million for fiscal year 2005 and $4.3 million for fiscal year 2004. Interest income in fiscal year 2006 included $1.6 million related to the release of tax refunds by the IRS upon the conclusion of a multi-year tax examination. Interest income in fiscal year 2005 included $5.7 million in interest on the past due royalties received from Applied Materials. In addition, interest income, during both fiscal years 2006 and 2005, increased due to higher cash balances and rates, along with an increased portfolio of investments. At September 29, 2006, Varian Semiconductor had $98.2 million in cash equivalents whose interest was exempt from taxation by the IRS. The rates of return on these cash equivalents were approximately 33% lower than rates earned on comparable fully-taxable cash equivalents.
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Table of ContentsOther Income (Expense), Net.
During fiscal year 2006, Varian Semiconductor recorded other income of $0.9 million, primarily related to a gain on the sale of certain non-operating real estate owned by Varian Semiconductor. During fiscal year 2005, Varian Semiconductor recorded other income of $2.8 million, primarily related to the reduction of an estimated loss contingency of $2.7 million associated with patent infringement and antitrust litigation. During fiscal year 2004, Varian Semiconductor recorded other expense of $0.9 million, primarily related to the cancellation of capital projects. Other income, net also includes foreign currency exchange gains and losses.
Provision for Income Taxes
Varian Semiconductor’s effective income tax rate was 24% in fiscal year 2006, 31% in fiscal year 2005 and 32% in fiscal year 2004. Exclusive of the effects of the discrete tax benefit received in the first quarter of fiscal year 2006, as discussed in the following paragraph, and other one time items, the effective tax would have been 32% for the fiscal year 2006. The rate is lower than the U.S. federal statutory rate in fiscal years 2006, 2005 and 2004, principally due to credits and lower-taxed foreign income. Future tax rates may vary from these historic rates depending on the worldwide composition of earnings and the continuing availability of income tax credits, as well as the potential resolution of tax contingencies. On October 22, 2004, the American Jobs Creation Act of 2004 (“AJCA”) was signed into law. The AJCA phases out the benefits from the extraterritorial exclusion in fiscal years 2005 and 2006, and provides a new deduction for income from domestic production activities. This deduction became effective for Varian Semiconductor in fiscal year 2006. The AJCA also creates a temporary incentive for U.S. companies to repatriate accumulated foreign earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. Varian Semiconductor completed its evaluation of the foreign repatriation provisions and decided not to repatriate foreign earnings under these provisions as it would not be beneficial to Varian Semiconductor.
In the normal course of business, Varian Semiconductor and its subsidiaries are examined by various tax authorities, including the IRS. The IRS conducted an examination for the tax years 1999 through 2003 as part of its routine examinations of Varian Semiconductor’s income tax returns. The IRS completed fieldwork for this examination of Varian Semiconductor in the fourth quarter of fiscal year 2005 and submitted its report to the Joint Committee for final approval. Varian Semiconductor was notified of Joint Committee approval in the first quarter of fiscal year 2006. Related to the conclusion of this examination, Varian Semiconductor recorded a discrete tax benefit of $9.0 million in the first quarter of fiscal year 2006.
Net Income
As a result of the foregoing factors, for fiscal year 2006 Varian Semiconductor recorded net income of $94.7 million, compared to net income of $72.0 million for fiscal year 2005 and $61.1 million for fiscal year 2004. The net income per diluted share was $1.66 for fiscal year 2006, compared to net income per diluted share of $1.28 for fiscal year 2005 and $1.10 for fiscal year 2004.
Liquidity and Capital Resources
Varian Semiconductor generated $140.6 million of cash from operations during fiscal year 2006, compared to $73.0 million during fiscal year 2005. Cash provided by operations in fiscal year 2006 was derived primarily from net income of $94.7 million, less non-cash expenses such as stock based compensation of $18.9 million, depreciation and amortization of $13.0 million, and the tax benefit from stock options exercised and employee stock purchase plan issuances of $10.8 million. Also contributing to cash from operations were a decrease in other current assets of $14.7 million and an increase in accounts payable of $12.6 million. The cash flow effects of net income, non-cash items and the changes in other current assets and accounts payable were partially offset by increases in inventory of $11.8 million and decreases in accrued expenses of $5.9 million. The decrease in other current assets is primarily related to the receipt of refunds from the IRS associated with the conclusion of a
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Table of Contentsmulti-year tax examination. The increase in accounts payable and inventory is related to a higher manufacturing build schedule for the first quarter of fiscal year 2007 as opposed to the schedule for the first quarter of fiscal year 2006. Additionally, increases in inventory are also due to increased field inventory primarily for new customers. In fiscal year 2005, cash provided by operations was derived primarily from net income of $72.0 million, depreciation and amortization of $12.8 million, the tax benefit from stock options exercised and employee stock purchase plan issuances of $9.9 million, an increase in accrued expenses of $6.9 million and a decrease in other current assets of $5.7 million. The cash flow effects of net income, non-cash items and the changes in accrued expenses and other current assets were partially offset by increases in inventory of $34.6 million. Increases in inventory were due to increased customer evaluation systems and field inventory primarily for new customers. In fiscal year 2004, cash provided by operations was derived primarily from net income of $61.1 million, and increases in deferred revenue of $30.8 million, depreciation and amortization of $13.0 million and accounts payable of $11.6 million. The cash flow effects of net income and the increases in deferred revenue, depreciation and amortization and accounts payable were partially offset by increases in accounts receivable of $59.8 million and inventory of $48.4 million.
During fiscal year 2006, Varian Semiconductor used $9.1 million for the net purchase of investments and $12.0 million for the purchase of property, plant and equipment. In fiscal year 2005, Varian Semiconductor used $109.6 million for the net purchase of investments and $12.4 million for the purchase of property, plant and equipment. In fiscal year 2006, Varian Semiconductor’s net purchase of investments was lower than in fiscal year 2005 due to the repurchase of $108.9 million of its stock and the relative attractiveness of rates of return on cash equivalents. In fiscal year 2004, Varian Semiconductor used $134.9 million for the net purchase of short-term investments and $11.6 million of cash for the purchase of property, plant and equipment.
During fiscal year 2006, Varian Semiconductor used $54.5 million of cash for financing activities. Varian Semiconductor repurchased $108.9 million of its stock during the fiscal year as part of its authorized share repurchase program. This was partially offset by the issuance of stock upon the exercise of stock options and under the employee stock purchase plan of $50.3 million and the excess tax benefit from stock based compensation of $4.5 million. During fiscal year 2006, Varian Semiconductor’s Board of Directors amended the share repurchase program by increasing the amount of funds that may be expended in repurchasing common stock from $100 million to $200 million. The program does not have a fixed expiration date. During fiscal year 2006, Varian Semiconductor repurchased 3.7 million shares at a weighted-average price per share of $29.03. During fiscal year 2005, Varian Semiconductor generated $23.4 million of cash from financing activities, primarily due to the issuance of stock upon the exercise of stock options and under the employee stock purchase plan of $27.7 million, partially offset by repayments of short- and long-term borrowings. During fiscal year 2004, $24.1 million of cash was generated by financing activities, primarily due to $26.2 million from the issuance of stock upon the exercise of stock options, partially offset by repayments of short- and long-term borrowings.
Varian Semiconductor’s liquidity is affected by many factors, some based on the normal operations of the business and others related to the uncertainties of the industry and global economies. Varian Semiconductor believes that cash, cash equivalents and investments of $549.5 million at September 29, 2006 will be sufficient to satisfy working capital requirements, commitments for capital expenditures, any future common stock repurchases and other purchase commitments, environmental contingencies and cash requirements for the foreseeable future.
Off-Balance Sheet Arrangements
Varian Semiconductor does not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, Varian Semiconductor is not exposed to any financing, liquidity, market or credit risk that could arise if Varian Semiconductor had engaged in such relationships.
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Table of ContentsContractual Obligations
Under GAAP, some obligations and commitments are not required to be included in the consolidated balance sheets and statements of income. These obligations and commitments, while entered into in the normal course of business, may have a material impact on liquidity. Other than the principal portion of the loan payments, which is included in the balance sheet, the following commitments as of September 29, 2006 have not been included in the consolidated balance sheets and statements of income included under Item 8. “Financial Statements and Supplementary Data”.
As of September 29, 2006 and September 30, 2005, Varian Semiconductor’s subsidiary in Japan had two credit facilities available with two different financial institutions. At September 29, 2006, maximum available borrowings under each of the two facilities were as follows: Yen 1,000,000,000 ($8.5 million) and Yen 500,000,000 ($4.3 million). The loans are unsecured and contain no restrictive covenants, although each loan is guaranteed by Varian Semiconductor. The interest rate for the Yen 1,000,000,000 credit facility is based on the short-term prime rate and was approximately 1.675% at September 29, 2006 and 1.375% at September 30, 2005. The interest rate for the Yen 500,000,000 facility is the 3-month Tokyo interbank offered rate (TIBOR) + 1.00% and was approximately 1.44% at September 29, 2006. There were no outstanding borrowings under either facility at September 29, 2006 or September 30, 2005.
Varian Semiconductor also has borrowing capacity in Europe and Taiwan. Varian Semiconductor’s subsidiary in Europe maintains a credit facility that includes overdraft protection of Euro 2.5 million which at September 29, 2006 translated to $3.2 million. Interest accrues at the Euro base rate + 1.5% and was approximately 5.25% at September 29, 2006. Varian Semiconductor’s subsidiary in Taiwan maintains a credit facility of $1.0 million. Any outstanding borrowings under the Taiwan facility accrue interest at the local base rate + 2.0% plus taxes, which was approximately 7.7% at September 29, 2006, and are payable on demand. Both credit facilities are unsecured and contain no restrictive covenants, although each facility is guaranteed by Varian Semiconductor. There were no outstanding borrowings as of September 29, 2006 or September 30, 2005 under either facility.
In February 2003, Varian Semiconductor purchased its previously leased facility located in Newburyport, Massachusetts. The purchase price consisted of cash payments totaling $3.4 million, the assumption of the seller’s outstanding loan of $5.1 million and the transfer of other prepaid assets of $0.8 million. The loan has a fixed interest rate of 9.05% with monthly payments of principal and interest until the loan matures in January 2013. The loan may be prepaid in full, but not in part, at any time after November 5, 2006. Prepayment would require Varian Semiconductor to pay a prepayment penalty equal to the greater of two percent of the outstanding principal balance or the excess of the present value of all future loan payments over the outstanding principal balance of the loan. The loan is secured by the property. The $3.7 million carrying amount of the loan had an estimated fair value of $3.9 million at September 29, 2006. The fair value of the loan was estimated using a discounted cash flow analysis. The interest rate was estimated based on current market conditions and Varian Semiconductor’s financial condition at September 29, 2006. As of September 29, 2006, Varian Semiconductor also has a standby letter of credit outstanding for $1.9 million as a guarantee for the debt on this facility.
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Table of ContentsTransactions with Affiliates and Related Parties
Operations prior to April 2, 1999 had been part of the former VAI, now known as VMS. On April 2, 1999, VAI contributed its SEB to Varian Semiconductor, then distributed to the holders of record of VAI common stock one share of common stock of Varian Semiconductor for each share of VAI common stock owned on March 24, 1999. At the same time, VAI contributed its Instruments Business (“IB”) to VI and distributed to the holders of record of VAI common stock one share of common stock of IB for each share of VAI common stock owned on March 24, 1999. VAI retained its Health Care Systems business and changed its name to VMS effective as of April 2, 1999. These transactions were accomplished under the terms of a Distribution Agreement by and among Varian Semiconductor, VAI, hereafter referred to as VMS for periods following the spin-off and VI (the “Distribution Agreement”). For purposes of providing an orderly transition and to define certain ongoing relationships between and among Varian Semiconductor, VMS and VI after the spin-off, Varian Semiconductor, VMS and VI also entered into the Distribution Related Agreements.
The Distribution Related Agreements provide that from and after the spin-off, VMS, VI, and Varian Semiconductor will indemnify each and their respective subsidiaries, directors, officers, employees and agents against all losses arising in connection with shared liabilities (including certain environmental and legal liabilities). All shared liabilities will be managed and administered by VMS and expenses and losses, net of proceeds and other receivables, will be borne one-third each by VMS, VI, and Varian Semiconductor. The Distribution Related Agreements also provide that Varian Semiconductor shall assume all of its liabilities, other than shared liabilities (including accounts payable, accrued payroll and pension liabilities) in accordance with their terms. During fiscal years 2006, 2005 and 2004, Varian Semiconductor was charged $1.4 million, $1.2 million and $1.6 million, respectively, by VMS in settlement of these obligations.
Recent Accounting Pronouncements
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” This statement replaces APB Opinion No. 20, “Accounting Changes”, and SFAS 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. This statement applies to all voluntary changes in accounting principles. 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 requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principles. SFAS No. 154 is effective for accounting changes and corrections of errors made during Varian Semiconductor’s fiscal year 2007, beginning on September 30, 2006. Varian Semiconductor does not believe the adoption of SFAS No. 154 will have a material impact on its financial statements.
In June 2006, the FASB ratified the consensus reached by the EITF on Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). EITF 06-3 states that a company should disclose its accounting policy regarding the gross or net presentation of certain taxes. If taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction, such as sales tax or value-added tax. Taxes assessed on an entity’s activities over a period of time, such as gross receipts taxes, are not within the scope of the issue. EITF 06-3 will be effective for Varian Semiconductor’s second quarter of fiscal year 2007. The disclosures required under EITF 06-3, which may be presented on an aggregate basis, are effective retrospectively for all periods presented. Varian Semiconductor is in the process of evaluating whether the adoption of EITF 06-3 will have a material impact on its financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” This interpretation clarifies the accounting for uncertainty in income
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Table of Contentstaxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation will be effective for Varian Semiconductor for its fiscal year 2008. Varian Semiconductor is in the process of evaluating whether the adoption of this interpretation will have a material impact on its financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), which expresses the staff’s views regarding the process of quantifying financial statement misstatements. SAB 108 requires companies to consider current and prior year errors and effects on all financial statements when evaluating the materiality of any misstatement. It will be effective for Varian Semiconductor’s fiscal year 2007. Varian Semiconductor does not believe the adoption of SAB 108 will have a material impact on its financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this statement does not require any new fair value measurements. However, for some entities, the application of this statement will change current practice. This statement will be effective for Varian Semiconductor’s fiscal year 2009. Varian Semiconductor is still in the process of evaluating the impact of this statement on its financial statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R).” This statement requires employers that sponsor defined benefit plans to recognize the funded status of a benefit plan on its balance sheet; recognize gains, losses and prior service costs or credits that arise during the period that are not recognized as components of net periodic benefit cost as a component of other comprehensive income, net of tax; measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end balance sheet; and disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Most provisions of statement will be effective for Varian Semiconductor for its fiscal year 2007, except for the requirement to measure benefits and obligations as of the employers fiscal year end, which will be effective for Varian Semiconductor’s fiscal year 2009. Varian Semiconductor is in the process of evaluating whether the adoption of this statement will have a material impact on its financial statements.
Foreign Currency Exchange Risk
As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could impact Varian Semiconductor’s financial results. However, a 10% change in the exchange rate of the U.S. dollar against other major currencies would not have a material effect on Varian Semiconductor’s results of operations. Historically, Varian Semiconductor’s primary exposures have resulted from non-U.S. dollar-denominated sales and purchases in Asia Pacific and Europe. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to nine months in original maturity. No forward exchange contract exceeds one year in original maturity.
Varian Semiconductor hedges currency exposures that are associated with certain of its assets and liabilities denominated in various non-U.S. dollar currencies. The aggregate exchange losses for the fiscal years ended 2006, 2005 and 2004 were $146,000, $46,000 and $126,000, respectively.
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Table of ContentsForward exchange contracts outstanding are summarized as follows (dollars in thousands):
Varian Semiconductor uses derivative instruments to protect its foreign operations from fluctuations in earnings and cash flows caused by volatility in currency exchange rates. Varian Semiconductor hedges its current exposures and a portion of its anticipated foreign currency exposures with hedging instruments having terms of up to twelve months.
Varian Semiconductor’s international sales, except for those in Japan, are primarily denominated in the U.S. dollar. For foreign currency-denominated sales, however, the volatility of the foreign currency markets represents risk to Varian Semiconductor. Upon forecasting the exposure, Varian Semiconductor enters into hedges with forward sales contracts whose critical terms are designed to match those of the underlying exposure. These hedges are evaluated for effectiveness at least quarterly using the change in value of the forward contracts to the change in value of the underlying transaction, with the effective portion of the hedge accumulated in other comprehensive income. Any measured ineffectiveness is included immediately in other income and expense in the consolidated statements of operations. There was an immaterial amount of ineffectiveness recognized during the fiscal years ended September 29, 2006 and September 30, 2005. There were seven forward foreign exchange sell contracts designated as hedges of anticipated product sales in Japanese Yen outstanding at September 29, 2006 totaling an equivalent of $35.5 million. In addition, there were three forward foreign exchange purchase contracts totaling an equivalent of $11.7 million offsetting three of the forward sell contracts. At September 30, 2005, there were four forward foreign exchange sell contracts outstanding designated as hedges of anticipated product sales in Japanese Yen totaling an equivalent of $30.4 million. In addition, there were four forward foreign exchange purchase contracts totaling an equivalent of $9.3 million offsetting the four forward sell contracts.
There were approximately $0.7 million net unrealized gains on these forward Yen contracts as of September 29, 2006. There were approximately $1.2 million in net unrealized gains on these forward Yen contracts as of September 30, 2005. The fair value of forward exchange contracts generally reflects the estimated amounts that Varian Semiconductor would receive or pay to terminate the contracts at the reporting date. The notional amounts of forward exchange contracts are not a measure of Varian Semiconductor’s exposure.
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Table of ContentsInterest Rate Risk
Although payments under certain of Varian Semiconductor’s overseas borrowing facilities are tied to market indices, Varian Semiconductor is not exposed to material interest rate risk from these borrowing facilities. Varian Semiconductor has no material cash flow exposure due to rate changes for cash equivalents and short-term investments. Varian Semiconductor maintains cash investments primarily in U.S. Treasury, government agency and investment-grade corporate and municipal securities, as well as short-term time deposits with investment grade financial institutions. Cash equivalents at September 29, 2006 and September 30, 2005 were $234.1 million and $182.1 million, respectively. At September 29, 2006, Varian Semiconductor’s short-term investments were $154.8 million and consisted primarily of U.S. Treasury, government agency and corporate bonds and certificates of deposit with ratings of AA or better. At September 30, 2005, Varian Semiconductor’s short-term investments were $280.6 million and consisted primarily of U.S. Treasury, government agency and corporate bonds and certificates of deposit with ratings of AA or better. At September 29, 2006, Varian Semiconductor’s long-term investments were $135.8 million and consisted of the same types of securities as its short-term portfolio. Varian Semiconductor reported no long-term investments at September 30, 2005.
In February 2003, Varian Semiconductor purchased its facility located in Newburyport, Massachusetts. As part of the purchase price, Varian Semiconductor assumed the seller’s outstanding loan of $5.1 million. The loan has a fixed interest rate of 9.05% with monthly payments of principal and interest until the loan matures in January 2013. The loan may be prepaid in full, but not in part, at any time after November 5, 2006. The loan is secured by the property. The $3.7 million remaining principal amount of the loan had an estimated fair value of $3.9 million at September 29, 2006. The fair value of the loan was estimated using a discounted cash flow analysis. The interest rate was estimated based on current market conditions and Varian Semiconductor’s financial condition at September 29, 2006.
Commodity Price Risk
Varian Semiconductor is not exposed to material commodity price risk.
The response to this item is submitted as a separate section to this report. See “Item 15. Exhibits and Financial Statement Schedules.”
Not applicable.
Disclosure Controls and Procedures
The management of Varian Semiconductor, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the disclosure controls and procedures of Varian Semiconductor as of September 29, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to Varian Semiconductor’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls
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Table of Contentsand procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of Varian Semiconductor’s disclosure controls and procedures as of September 29, 2006, Varian Semiconductor’s Chief Executive Officer and Chief Financial Officer concluded that, as of such date, Varian Semiconductor’s disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control over Financial Reporting
No change in Varian Semiconductor’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 29, 2006 that has materially affected, or is reasonably likely to materially affect, Varian Semiconductor’s internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Management of Varian Semiconductor is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Management, with the participation of the Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of Varian Semiconductor’s internal control over financial reporting as of September 29, 2006. In their evaluation, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework.
Based on management’s evaluation using the COSO criteria, management concludes that Varian Semiconductor maintained effective internal control over financial reporting as of September 29, 2006. This evaluation has been audited by PricewaterhouseCoopers LLP, an independent registered accounting firm, as stated in their report which appears herein.
None.
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Table of ContentsPART III
The response to this item is contained in part under the caption “Executive Officers” in Part I of this Annual Report on Form 10-K and in part in Varian Semiconductor’s Proxy Statement for the Annual Meeting of Stockholders to be held on February 5, 2007 (the “2007 Proxy Statement”) under the caption “Election of Directors,” which section is incorporated herein by this reference.
The response to this item is contained in the 2007 Proxy Statement under the caption “Executive Compensation,” which section is incorporated herein by this reference.
The response to this item is contained in the 2007 Proxy Statement under the caption “Principal Stockholders” and “Equity Compensation Plan Information,” which sections are incorporated herein by this reference.
The response to this item is contained in the 2007 Proxy Statement under the caption “Transactions with Related Parties,” which section is incorporated herein by this reference.
The response to this item is contained in the 2007 Proxy Statement under the caption “Independent Accountants’ Fees,” which section is incorporated herein by this reference.
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Table of ContentsPART IV
The following documents are filed as part of this Annual Report on Form 10-K:
(1) Consolidated Financial Statements: (see index on page F-1 of this report)
(2) Consolidated Financial Statement Schedule: (see index on page F-1 of this report)
The following financial statement schedule of Varian Semiconductor and its subsidiaries for fiscal years 2006, 2005 and 2004 is filed as a part of this Annual Report on Form 10-K and should be read in conjunction with the consolidated financial statements of Varian Semiconductor and its subsidiaries.
All other required schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.
(3) The list of Exhibits filed as a part of this Annual Report on Form 10-K are set forth in the Exhibit Index immediately preceding such Exhibits, and is incorporated herein by this reference.
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Table of ContentsSIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: December 7, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
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Table of ContentsEXHIBIT INDEX
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
The following financial statements of the Registrant and its subsidiaries are required to be included in Item 8:
All other required schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.
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Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Varian Semiconductor Equipment Associates, Inc.:
We have completed integrated audits of Varian Semiconductor Equipment Associates, Inc.’s 2006 and 2005 consolidated financial statements and of its internal control over financial reporting as of September 29, 2006 and an audit of its 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedule
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(1) present fairly, in all material respects, the financial position of Varian Semiconductor Equipment Associates, Inc. and its subsidiaries at September 29, 2006 and September 30, 2005, and the results of their operations and their cash flows for each of the three years in the period ended September 29, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 4 to the consolidated financial statements, the Company changed the manner in which it accounts for stock-based compensation in fiscal 2006.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of September 29, 2006 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 29, 2006, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider 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 process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in
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Table of Contentsaccordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PRICEWATERHOUSECOOPERS LLP
Boston, Massachusetts December 6, 2006
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes to the consolidated financial statements are an integral part of these statements.
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes to the consolidated financial statements are an integral part of these statements.
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes to the consolidated financial statements are an integral part of these statements.
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
The accompanying notes to the consolidated financial statements are an integral part of these statements.
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Company
Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits to customers located both in the United States (“U.S.”) and in international markets. Varian Semiconductor faces risk factors similar to all companies in the semiconductor manufacturing equipment market including, but not limited to, competition, market downturn, technological change, international operations and related foreign currency risks and the ability to recruit and retain key employees.
Note 2. Summary of Significant Accounting Policies
Fiscal Year
Varian Semiconductor’s fiscal year is a 52- to 53-week period that ends on the Friday nearest September 30. Fiscal year 2006 is comprised of a 52-week period ended on September 29, 2006. Fiscal year 2005 is comprised of a 52-week period ended on September 30, 2005. Fiscal year 2004 is comprised of a 52-week period ended on October 1, 2004.
Principles of Consolidation
The consolidated financial statements include the accounts of Varian Semiconductor and its wholly owned subsidiaries. All material intercompany accounts and transactions are eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, Varian Semiconductor evaluates its estimates and assumptions including, but not limited to, deferred revenue, loss contingencies, warranty accruals, the reserve for excess and obsolete inventory, income taxes payable, deferred tax assets and allowance for doubtful accounts. Actual results may differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current period presentation for comparative purposes. These include a reclassification of certain items from current liabilities into long term related to product warranty and deferred revenue.
Revenue Recognition
Product revenue includes established products, new products, upgrades and spare parts.
Varian Semiconductor recognizes revenue from product sales upon shipment, provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations, and there are no uncertainties regarding customer acceptance.
For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance. For new products, revenue allocated to the
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
equipment is recognized upon customer acceptance. Revenue related to spare parts and upgrade sales is recognized upon the later of delivery or when the title and risk of loss passes to the customer.
Products are classified as established products if post-delivery acceptance provisions and the installation process have been determined to be routine, due to the fact that the acceptance provisions are generally a replication of pre-shipment procedures, and there is a demonstrated history of achieving predetermined installation cost targets. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions cannot be replicated in Varian Semiconductor’s facilities or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes. Varian Semiconductor has predetermined criteria for changing the classification of a new product to an established product. A new product must achieve a set number of acceptances and a set target for installation cost. Once the criteria have been achieved for a new product, the product is considered established.
Service revenue includes revenue from maintenance and service contracts, extended warranties, paid service and system installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Extended warranty revenue is deferred and recognized ratably over the applicable warranty term. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation and customer acceptance. It takes approximately three to six weeks for Varian Semiconductor technicians to complete the installation of Varian Semiconductor products and perform tests agreed to with customers. Certain customers formally document their acceptance of Varian Semiconductor’s products at this time. Other customers elect to perform additional internal testing prior to formal acceptance, and this process generally takes eight to twelve weeks.
Royalty and license revenue is recognized when contractual obligations are met, and in the case of royalties, upon receipt of a royalty report from the customer, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured. When fees are not fixed or determinable, revenue is recorded when payments become due.
Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair value of those elements. The amount allocated to installation is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue.
Deferred Revenue
Deferred revenue includes customer advances and amounts that have been billed per the contractual terms but have not been recognized as revenue. Varian Semiconductor also defers the fair value of extended warranties bundled with equipment sales as deferred revenue. Deferred revenue for extended warranties is recognized ratably over the applicable warranty term, which generally is from 13 to 24 months from the date the customer accepts the products.
Evaluation Tools
Varian Semiconductor occasionally supplies evaluation tools to potential new customers, usually for a period of three months to one year. While the tool is at the customer’s semiconductor manufacturing factory (“fab”),
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Varian Semiconductor and the customer work closely together through complex processes to qualify the tool for that particular customer’s requirements. These qualification costs are included in marketing, general and administrative expenses in the period incurred. In addition, during the evaluation period, Varian Semiconductor generally reduces the carrying value of the evaluation tool ratably over a period of four years. This cost is recorded as a component of marketing, general and administrative expenses and the carrying value of the evaluation tool is included in inventory. Customer evaluations are often successful and upon fulfillment of all four revenue recognition criteria. Varian Semiconductor recognizes the revenue from the evaluation tool and remaining tool cost through revenue and cost of product revenue, respectively.
Stock-based Compensation
Effective October 1, 2005, Varian Semiconductor adopted the provisions of the Financial Accounting Standard Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment” (“SFAS No. 123(R)”). (See Note 4 of Notes to Consolidated Financial Statements). Under SFAS No. 123(R), Varian Semiconductor is required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value, estimated in accordance with the provisions of SFAS 123(R), and for the unvested portion of all share-based payments previously granted that remain outstanding based on the grant date fair value, estimated in accordance with the original provisions of SFAS 123. The estimated fair value of Varian Semiconductor’s stock-based awards is expensed on a straight-line basis.
The choice of a valuation technique, and the approach utilized to develop the underlying assumptions for that technique, involve significant judgments. These judgments reflect management’s assessment of the most accurate method of valuing the stock options Varian Semiconductor issues, based on our historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. Varian Semiconductor’s judgments could change over time as additional information becomes available, or the facts underlying the assumptions change over time. Any change in judgments could have a material impact on Varian Semiconductor’s financial statements. Varian Semiconductor believes that these estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.
Cash, Cash Equivalents and Investments
Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments.
Short-term investments consist primarily of certificates of deposit and corporate bonds with ratings AA or better. All short-term investments have been classified as available-for-sale and are carried at fair market value, which approximates cost, due to the short period of time to maturity and the relative risk of the investments. As of September 30, 2005, Varian Semiconductor had the intent and ability to liquidate any of its investments in order to meet its liquidity needs. Accordingly, those investments with contractual maturities greater than one year from the date of acquisition were classified as short-term. As of September 29, 2006, Varian Semiconductor had the ability but no longer the intent to liquidate certain investments in order to meet its liquidity needs for the next 12 months. Accordingly, those investments with contractual maturities greater than one year from the date of acquisition have been classified as long-term.
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Accounts Receivable and Allowance for Doubtful Accounts
Substantially all of Varian Semiconductor’s accounts receivable balance relate to trade receivables. Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is Varian Semiconductor’s best estimate of the amount of probable credit losses in its existing accounts receivable. Varian Semiconductor maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments for products and services. Accounts with known financial issues are first reviewed and specific estimates are recorded. The remaining accounts receivable balances are then grouped in categories by the amount of days the balance is past due, and the estimated loss is calculated as a percentage of the total category based upon past history. Account balances are charged off against the allowance when it is probable the receivable will not be recovered.
Inventory and Purchase Order Commitments
Varian Semiconductor values its inventory at the lower of cost or market using the first-in, first-out method. On a quarterly basis, Varian Semiconductor assesses the realizability of all inventories to determine whether adjustments for impairment are required. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor also provides for losses on those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under the commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. Once inventory is written down and a new cost basis has been established, it is not written back up if demand increases.
Property, Plant, and Equipment
Property, plant, and equipment are stated at cost. Major improvements are capitalized, while maintenance and repairs are expensed in the period the cost is incurred. Plant and equipment are depreciated over their estimated useful lives using the straight-line method. Leasehold improvements are amortized using the straight-line method over their estimated useful lives, or the remaining term of the lease, whichever is less. When assets are retired or otherwise disposed of, the assets and related accumulated depreciation are relieved from the accounts, and resulting gains or losses are included in other income (expense) in the consolidated statements of income.
Goodwill and Other Long-Lived Assets
At September 29, 2006 and September 30, 2005, goodwill was $12.3 million. In accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized. Varian Semiconductor tests for the impairment of goodwill on an annual basis or whenever events or changes in circumstances suggest that the carrying amount may not be recoverable. Varian Semiconductor tests for goodwill impairment at the entity level, as its subsidiaries do not constitute separate businesses and all possess similar economic characteristics. The test is performed by deducting the fair value of all assets and liabilities from the total estimated fair value to determine residual goodwill. As of September 29, 2006, Varian Semiconductor completed its annual goodwill impairment test and determined that no impairments existed.
Whenever events or changes in circumstances indicate that the carrying amounts of a long-lived asset may not be recoverable, Varian Semiconductor reviews these assets for impairment. If the future undiscounted cash flows are less than the carrying amount of that asset, an impairment exists. Varian Semiconductor recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets. Fair value is normally assessed using a discounted cash flow model.
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Table of ContentsVARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Product Warranties
Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes including actively monitoring and evaluating the quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.
Environmental Liabilities
Liabilities are recorded when environmental assessments and/or remedial efforts are probable and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or Varian Semiconductor’s commitment to a formal plan of action. In situations where the various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate then future costs, the lower limit of an estimated range is accrued on a non-discounted basis. All other liabilities, where Varian Semiconductor has generally sufficient knowledge to estimate the scope of costs and future activities, are accrued on a discounted basis. Should new information become available and/or different assumptions are applied in the estimation of environmental liabilities, revisions to the accrued environmental liability would be required.
Income Taxes
Varian Semiconductor uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statement and tax bases of assets and liabilities. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on Varian Semiconductor’s income tax provision and net income in the period in which the determination is made.
Derivative Financial Instruments
Varian Semiconductor’s foreign subsidiaries operate and sell Varian Semiconductor’s products in various global markets. As a result, Varian Semiconductor is exposed to changes in foreign currency exchange rates. Varian Semiconductor utilizes foreign currency forward exchange contracts to hedge against currency exposures that are associated with certain of its assets and liabilities denominated in various non-U.S. dollar currencies. The effect of exchange rate changes on forward exchange contracts is expected to offset the effect of exchange rate changes on the underlying hedged items. Varian Semiconductor believes these financial instruments do not subject it to speculative risk that would otherwise result from changes in currency exchange rates. Varian Semiconductor does not use derivative financial instruments for speculative or trading purposes.
All of Varian Semiconductor’s derivative financial instruments are recorded at fair value based upon quoted market prices for comparable instruments. For derivative instruments designated and qualifying as cash flow hedges of anticipated foreign currency denominated transactions, the effective portion of the gain or loss on these
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hedges is reported as a component of accumulated other comprehensive income in stockholders’ equity, and is reclassified into earnings when the hedged transaction affects earnings. If the transaction being hedged fails to occur, or if a portion of any derivative is ineffective, the gain or loss on the associated financial instrument is recorded immediately in earnings. For derivative instruments used to hedge existing foreign currency denominated assets or liabilities, the gain or loss on these hedges is recorded immediately in earnings to offset the changes in the fair value of the assets or liabilities being hedged. There were seven forward foreign exchange sell contracts designated as hedges of anticipated product sales in Japanese Yen outstanding at September 29, 2006 totaling an equivalent notional value of $35.5 million. In addition, there were three forward foreign exchange purchase contracts in the amount of an equivalent notional value of $11.7 million offsetting three of the seven forward sell contracts.
Foreign Currency Translation
For international operations, the U.S. dollar is the functional currency. Monetary assets and liabilities of foreign subsidiaries are translated into U.S. dollars at current exchange rates. Nonmonetary assets such as inventories and property, plant, and equipment are translated at historical rates. Income and expense items are translated at effective rates of exchange prevailing during each year, except that inventories and depreciation charged to operations are translated at historical rates. Foreign exchange gains and losses are recorded in the Statement of Income in other income (expense), net.
Concentration of Risk
Financial instruments that potentially expose Varian Semiconductor to concentrations of credit risk consist principally of trade accounts receivable, cash investments and forward foreign exchange contracts. In recent fiscal years, Varian Semiconductor has sold over half of its systems to its ten largest customers, and its trade accounts receivable is primarily comprised of these respective customers. However, the concentration of credit risk is limited as the customer base is dispersed among many geographic regions and is comprised primarily of large multi-national companies. Varian Semiconductor performs ongoing credit evaluations and generally does not require collateral from its customers. As of September 29, 2006, two customers accounted for 15% and 11% of the total accounts receivable balance. As of September 30, 2005, two customers accounted for 16% and 9% of the total accounts receivable balance
In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10% of Varian Semiconductor’s total revenue. In fiscal year 2005, revenue from two customers accounted for 20% and 14% of Varian Semiconductor’s total revenue. In fiscal year 2004, revenue from two customers accounted for 14% and 10% of Varian Semiconductor’s total revenue.
Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments. Cash equivalents at September 29, 2006 and September 30, 2005 were $234.1 million and $182.1 million, respectively. Cash and cash equivalents are invested with multiple financial institutions. Investments consist primarily of U.S. Treasury, government agency and corporate bonds and certificates of deposit with ratings AA or better. All investments have been classified as available-for-sale and are carried at fair market value due to the short period of time to maturity and the relative risk of the investments. Varian Semiconductor manages its cash equivalents and investments as a single portfolio of highly marketable securities that is intended to be available to meet Varian Semiconductor’s current cash requirements. Varian Semiconductor also places forward foreign exchange contracts with investment grade financial institutions in order to minimize currency risk exposure.
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Varian Semiconductor obtains some of the components and subassemblies that are included in its products from a limited group of suppliers, or in some cases a single source supplier. The loss of any supplier, including any single source supplier, would require obtaining one or more replacement suppliers and may also require devoting significant resources to product development to incorporate new parts from other sources into Varian Semiconductor’s products. The need to change suppliers or to alternate between suppliers might cause delays in delivery or significantly increase Varian Semiconductor’s costs. Although Varian Semiconductor has insurance to protect against loss due to business interruption from these and other sources, Varian Semiconductor cannot provide assurance that such coverage will be adequate or that it will remain available on commercially acceptable terms. Although Varian Semiconductor seeks to reduce its dependence on these limited source suppliers, disruption or loss of these sources could negatively impact its business and damage customer relationships.
Recent Accounting Pronouncements
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” This statement replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes”, and SFAS 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. This statement applies to all voluntary changes in accounting principles. 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 requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principles. SFAS No. 154 is effective for accounting changes and corrections of errors made during Varian Semiconductor’s fiscal year 2007, beginning on September 30, 2006. Varian Semiconductor does not believe the adoption of SFAS No. 154 will have a material impact on its financial statements.
In June 2006, the FASB ratified the consensus reached by the EITF on Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). EITF 06-3 states that a company should disclose its accounting policy regarding the gross or net presentation of certain taxes. If taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction, such as sales tax or value-added tax. Taxes assessed on an entity’s activities over a period of time, such as gross receipts taxes, are not within the scope of the issue. EITF 06-3 will be effective for Varian Semiconductor’s second quarter of fiscal year 2007. The disclosures required under this Issue, which may be presented on an aggregate basis, are effective retrospectively for all periods presented. Varian Semiconductor is in the process of evaluating whether the adoption of EITF 06-3 will have a material impact on its financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation will be effective for Varian Semiconductor for its fiscal year 2008. Varian Semiconductor is in the process of evaluating whether the adoption of this interpretation will have a material impact on its financial statements.
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In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), which expresses the staff’s views regarding the process of quantifying financial statement misstatements. This SAB requires companies to consider current and prior year errors and effects on all financial statements when evaluating the materiality of any misstatement. It will be effective for Varian Semiconductor’s fiscal year 2007. Varian Semiconductor does not believe the adoption of SAB 108 will have a material impact on its financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this statement does not require any new fair value measurements. However, for some entities, the application of this statement will change current practice. This statement will be effective for Varian Semiconductor’s fiscal year 2009. Varian Semiconductor is in the process of evaluating the impact of this statement on its financial statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R).” This statement requires employers that sponsor defined benefit plans to recognize the funded status of a benefit plan on its balance sheet; recognize gains, losses and prior service costs or credits that arise during the period that are not recognized as components of net periodic benefit cost as a component of other comprehensive income, net of tax; measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end balance sheet; and disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Most provisions of statement will be effective for Varian Semiconductor for its fiscal year 2007, except for the requirement to measure benefits and obligations as of the employers fiscal year end, which will be effective for Varian Semiconductor’s fiscal year 2009. Varian Semiconductor is in the process of evaluating whether the adoption of this statement will have a material impact on its financial statements.
Note 3. Stock Split
On February 1, 2006, the Board of Directors declared a three-for-two stock split, effected in the form of a stock dividend, payable on February 28, 2006 to stockholders of record at the close of business on February 13, 2006. Varian Semiconductor has retained the current par value of $0.01 per share for all common shares. All references in the financial statements and notes to the number of shares outstanding, per share amounts, stock option, restricted stock and ESPP data of Varian Semiconductor’s common shares have been restated to reflect the effect of the stock split for all periods presented.
Stockholders’ equity as of October 3, 2003, October 1, 2004, September 30, 2005 and September 29, 2006 reflects the stock split by reclassifying from “Capital in excess of par value” to “Common stock” an amount equal to the par value of the additional shares arising from the stock split.
Note 4. Stock-Based Compensation
Effective October 1, 2005, Varian Semiconductor adopted on a modified prospective basis the provisions of SFAS No. 123(R), and related guidance, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options, restricted stock awards and employee stock purchases related to Varian Semiconductor’s Employee Stock Purchase Plan (“ESPP”) based on estimated fair values. Accordingly, stock-based compensation cost is measured
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at grant date, based on the fair value of the award, and is recognized as expense on a straight-line basis over the employee’s requisite service period.
Varian Semiconductor adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of October 1, 2005, the first day of Varian Semiconductor’s fiscal year 2006. Under this transition method, stock-based compensation expense recognized during the fiscal year ended September 29, 2006 includes: (a) ESPP awards with the offering period commencing on July 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, (b) stock options and restricted stock awards granted prior to, but not yet vested as of September 30, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and (c) stock options, restricted stock and ESPP awards granted, subsequent to September 30, 2005, based on the grant-date fair value, in accordance with the provisions of SFAS No. 123(R). Under the modified prospective transition method, results for prior periods are not restated.
The estimated fair value of Varian Semiconductor’s stock-based awards, less expected forfeitures, is amortized over the awards’ vesting period on a straight-line basis. The effect of recording stock-based compensation for the fiscal year ended September 29, 2006 was as follows:
Varian Semiconductor estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the risk-free interest rate over the option’s expected term, the expected annual dividend yield and the expected stock price volatility. Varian Semiconductor has determined that a blended volatility, using Varian Semiconductor’s historical and implied volatility measures and a peer group implied volatility, will best reflect expected volatility over the expected term of the option. Varian Semiconductor believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in
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calculating the fair values of Varian Semiconductor’s stock options granted during fiscal year 2006. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards.
The fair value of Varian Semiconductor’s stock-based awards granted during the fiscal year ended September 29, 2006 was estimated on the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Prior to the adoption of SFAS No. 123(R)
Prior to October 1, 2005, Varian Semiconductor accounted for its stock plans under the provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB No. 25”) and FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25” and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”. Stock-based compensation expense related to restricted stock granted at no cost to the employees were reflected in net income.
The pro-forma information for the fiscal years ended September 30, 2005 and October 1, 2004 was as follows:
The $14.0 million in pro-forma stock-based compensation for the fiscal year ended September 30, 2005 included $2.1 million resulting from the amendment to the definition of retirement in the Omnibus Stock Plan by Varian Semiconductor’s Board of Directors on October 5, 2004 and the Retirement Agreement entered into on December 8, 2004 (see Note 20. Retirement Plans).
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The fair value of Varian Semiconductor’s stock-based awards granted during the fiscal years ended September 30, 2005 and October 1, 2004 was estimated using the following weighted-average assumptions:
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