UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

ANNUAL REPORT PURSUANT

TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

 

Commission File number 0-23621

 

 

 

 

MKS Instruments, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s Telephone Number, including area code
(978) 284-4000

 

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

 

 

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

None

 

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

 

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 o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

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

 

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  þ     Accelerated filer  o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

Aggregate market value of the voting and non-voting common equity held by nonaffiliates of the registrant as of June 30, 2006 based on the closing price of the registrant’s Common Stock on such date as reported by the Nasdaq Global Market: $834,878,092.

 

Number of shares outstanding of the issuer’s Common Stock, no par value, as of February 16, 2007: 57,087,671.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement for MKS’ Annual Meeting of Stockholders to be held on May 7, 2007 are incorporated by reference into Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

MKS’ management believes that this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act and Section 27E of the Securities Exchange Act. When used herein, the words “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “may,” “see,” “will,” “would” and similar expressions are intended to identify forward-looking statements. These forward-looking statements reflect management’s current opinions and are subject to certain risks and uncertainties that could cause actual results to differ materially from those stated or implied. MKS assumes no obligation to update this information. Risks and uncertainties include, but are not limited to, those discussed in the section entitled “Risk Factors.”

 

MKS Instruments, Inc. (the “Company” or “MKS”) was founded in 1961 as a Massachusetts corporation. We are a leading worldwide provider of instruments, components, subsystems and process control solutions that measure, control, power and monitor critical parameters of semiconductor and other advanced manufacturing processes.

 

We are managed as one operating segment which is organized around three product groups: Instruments and Control Systems, Power and Reactive Gas Products and Vacuum Products. Our products are derived from our core competencies in pressure measurement and control, materials delivery, gas and thin-film composition analysis, electrostatic charge control, control and information management, power and reactive gas generation and vacuum technology.

 

Our products are used in diverse markets, applications and processes including:

 

 

For over 45 years, we have focused on satisfying the needs of our customers by establishing long-term, collaborative relationships. We have a diverse base of customers that includes manufacturers of semiconductor capital equipment, semiconductor devices, capital equipment manufacturers of thin-film coatings used in flat panel displays, optical and magnetic data storage equipment, architectural glass, solar panels and electro-optical products, industrial and manufacturing companies, as well as medical equipment manufacturers, and university, government and industrial research laboratories. Our top 10 customers for the year ended December 31, 2006 were Applied Materials, Hitachi, Lam Research, Novellus Systems, Oviso Manufacturing, Phillips, PSK Tech, Samsung, Tokyo Electron and Ultra Clean Technology.

 

We file reports, proxy statements and other documents with the Securities and Exchange Commission. You may read and copy any document we file at the SEC Headquarters at Office of Investor Education and Assistance, 100 F Street, NE, Washington, D.C. 20549. You should call 1-800-SEC-0330 for more information on the public reference room. Our SEC filings are also available to you on the SEC’s Internet site at http://www.sec.gov.

 

Our internet address is www.mksinstruments.com. We are not including the information contained in our website as part of, or incorporating it by reference into, this annual report on Form 10-K. We make available free of charge through our web site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on

Form 8-K and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as soon as reasonably practicable after we electronically file such materials with the Securities and Exchange Commission.

 

Markets and Applications

 

We are focused on improving process performance and productivity by controlling advanced manufacturing processes in semiconductor, thin-film and other non-semiconductor market sectors. We estimate that approximately 70%, 71% and 74% of our net sales for the years ended December 31, 2006, 2005 and 2004, respectively, were to semiconductor capital equipment manufacturers and semiconductor device manufacturers. Approximately 8%, 8% and 8% of our net sales in the years ended December 31, 2006, 2005 and 2004, respectively, were for thin-film processing equipment applications, including compact discs, digital video discs (DVDs) and other digital storage media; flat panel displays for computer and television screens; and thin-film coatings for architectural glass and optics. Approximately 22%, 21% and 18% of our net sales in the years ended December 31, 2006, 2005 and 2004, respectively, were for other non-semiconductor manufacturing applications. These include, but are not limited to, industrial manufacturing, magnetic resonance imaging (MRI) medical equipment, energy generation and conservation processes, and university, government and industrial research laboratories.

 

We estimate that approximately 34%, 37% and 34% of our net sales for the years ended December 31, 2006, 2005 and 2004, respectively, were to customers located in international markets. International sales include sales by our foreign subsidiaries, but exclude direct export sales. Please refer to Note 11 in the Notes to Consolidated Financial Statements for further information about geographical information.

 

Semiconductor Manufacturing Applications

 

The majority of our sales are derived from products sold to semiconductor capital equipment manufacturers and semiconductor device manufacturers. Our products are used in the major semiconductor processing steps such as depositing materials onto substrates and etching and cleaning circuit patterns.

 

Our products are also used for process facility applications such as gas distribution, pressure control and vacuum distribution, and electrostatic charge control in clean rooms where semiconductor manufacturing takes place. In addition, we provide specialized instruments that monitor the performance of manufacturing equipment and products that distribute, manage, and classify process control information. We anticipate that the semiconductor manufacturing market will continue to account for a substantial portion of our sales. While the semiconductor device manufacturing market is global, major semiconductor capital equipment manufacturers are concentrated in Europe, Japan and the United States.

 

Thin-Film Manufacturing Applications

 

Flat Panel Display Manufacturing.

 

Our products are used in the manufacture of flat panel displays, which require the same or similar fabrication processes as semiconductor manufacturing. Flat panel displays are used in electronic hand-held devices, laptop computers, desktop computer monitors, and television sets. Flat panel display technology is designed to replace bulkier cathode ray tube (CRT) technology in computer monitors and television sets. We sell products to flat panel display equipment manufacturers and to end-users in the flat panel display market. The major manufacturers of flat panel displays are concentrated in Japan, Korea and Taiwan, and the major manufacturers of flat panel display equipment are concentrated in Japan and the United States. The transition to larger panel sizes and higher display resolution is driving the need for improved process controls to reduce defects.

 

Magnetic and Optical Storage Media.

 

Our products are used to manufacture:

 

 

 

The transition to higher density storage capacity requires manufacturing processes incorporating tighter process controls. The major manufacturers of storage media are concentrated in Japan and the Asia Pacific region, and the major manufacturers of storage media capital equipment are concentrated in Europe, Japan and the United States.

 

Optical Filters, Optical Fibers and Other Coating Processes.

 

Our products are used in optical filter, optical fiber and other optical thin-film coating processes. Our products are sold both to coating equipment manufacturers and to manufacturers of products made using optical thin-film coating processes. Optical filters and fibers used for data transmission are manufactured using processes to deposit chemical vapors that are similar to those used in semiconductor manufacturing. The requirement for higher data transmission rates is driving the need for improved control of optical filters and fiber coating processes. Optical thin film coating for eyeglasses, solar panels and architectural glass are deposited using processes similar to those used in semiconductor manufacturing. Optical filter, optical fiber and other optical thin-film processing manufacturers are concentrated in Europe, Japan and the United States.

 

Other Non-Semiconductor Manufacturing Applications

 

Our products are used in energy generation and conservation processes such as nuclear fuel processing, combustion and emissions control, solar cells and fuel cell research. Other advanced applications include chemical agent detection, medical instrument sterilization, consumable medical supply manufacturing and vacuum freeze drying of pharmaceuticals, foods and beverages. Our power delivery products are also incorporated into other end-market products such as MRI medical equipment. In addition, our products are sold to government, university and industrial laboratories for vacuum applications involving research and development in materials science, physical chemistry and electronics materials. The major equipment and process providers and research laboratories are concentrated in Europe, Japan and the United States.

 

Acquisitions

 

We completed three acquisitions in 2006. On January 3, 2006, we completed our acquisition of Ion Systems, Inc. (“Ion”), a leading provider of electrostatic management solutions located in Alameda, California. Ion’s ionization technology monitors electrostatic charges to reduce process contamination and improve yields, which complements our process monitoring and control technologies. Additionally, on January 3, 2006, we completed our acquisition of Umetrics, AB (“Umetrics”), a leader in multivariate data analysis and modeling software located in Umea, Sweden. Umetrics’ multivariate data analysis and modeling software converts process data into useable information for yield improvement, when linked with our open and modular platform of process sensors and data collection, integration, data storage, and visualization capabilities. On October 11, 2006, we completed our acquisition of Novx Corp. (“Novx”), a provider of electrostatic charge monitoring technology for semiconductor, data storage, telecommunication, medical device and other markets. Novx’s technology expands our capability to monitor, detect and control electrostatic charge in advanced process environments, such as semiconductor and hard disk drive manufacturing.

 

Product Groups

 

We group our products into three product groups: Instruments and Control Systems, Power and Reactive Gas Products and Vacuum Products. Also, please refer to Note 11 in the Notes to Consolidated Financial Statements for further information.

 

 

This product group includes pressure measurement and control products, materials delivery products, gas and thin film composition analysis products, electrostatic charge control products, and control and information technology products.

 

Pressure Measurement and Control Products.  Each of our pressure measurement and control product lines consists of products that are designed for a variety of pressure ranges and accuracies.

 

Baratron Pressure Measurement Products.  These products are typically used to measure the pressure of the gases being distributed upstream of the process chambers, to measure process chamber pressures and to measure pressures between process chambers, vacuum pumps and exhaust lines. We believe we offer the widest range of gas pressure measurement instruments in the semiconductor and advanced thin-film materials processing industries.

 

Automatic Pressure and Vacuum Control Products.  These products enable precise control of process pressure by electronically actuating valves that control the flow of gases in and out of the process chamber to minimize the difference between desired and actual pressure in the chamber.

 

In most cases, Baratron pressure measurement instruments provide the pressure input to the automatic pressure control device. Together, these components create an integrated automatic pressure control subsystem. Our pressure control products can also accept inputs from other measurement instruments, enabling the automatic control of gas input or exhaust based on parameters other than pressure.

 

Materials Delivery Products.  Each of our materials delivery product lines consists of products that are designed for a variety of flow ranges and accuracies.

 

Flow Measurement and Control Products.  Flow measurement products include gas, vapor and liquid flow measurement products based upon thermal conductivity, pressure and direct liquid injection technologies. The flow control products combine the flow measurement device with valve control elements based upon solenoid, piezo-electric and piston pump technologies. These products measure and automatically control the mass flow rate of gases and vapors into the process chamber. Our thermal-based mass flow controllers control gas flow based on the molecular weight of gases and our pressure-based mass flow controllers, based on Baratron pressure instrument measurement and control technology, restrict flow in the gas line to transform pressure control into mass flow control.

 

Our flow measurement products also include a calibration system that independently measures mass flow and compares this measurement to that of the process chamber mass flow controller. The demand for our calibration system is driven by the increasingly stringent process control needs of the semiconductor industry and the need to reduce costly downtime resulting from stopping operations to address mass flow controller problems.

 

Gas and Thin-Film Composition Analysis Products.  Gas and thin-film composition analysis instruments are sold to a variety of industries including the semiconductor industry.

 

Mass Spectrometry-Based Gas Composition Analysis Instruments.  These products are based on quadruple mass spectrometer sensors that separate gases based on molecular weight. These sensors include built-in electronics and are provided with software that analyzes the composition of background and process gases in the process chamber. These instruments are provided both as portable laboratory systems and as process gas monitoring systems used in the diagnosis of semiconductor manufacturing process systems.

 

Fourier Transform Infra-Red (FTIR) Based Gas and Thin-Film Composition Analysis Products.  FTIR-based products provide information about the composition of gases and thin-films by measuring the absorption of infra-red light as it passes through the sample being measured. Gas analysis applications include measuring the compositions of mixtures of reactant gases; measuring the purity of individual process gases; measuring the composition of process exhaust gas streams to determine process health; monitoring gases to ensure environmental health and safety; and monitoring combustion exhausts. These instruments are provided as portable laboratory systems and as process gas monitoring systems used in the diagnosis of manufacturing processes.

 

Mass spectrometry-based and FTIR-based gas monitoring systems can indicate out-of-bounds conditions, such as the presence of undesirable contaminant gases and water vapor or out-of-tolerance amounts of specific gases in the process, which alert operators to diagnose and repair faulty equipment.

 

Leak Detection Products.  Helium leak detection is used in a variety of industries including semiconductor, HVAC, automotive and aerospace to ensure the leak integrity of both manufactured products and manufacturing equipment. We believe that our products are the smallest mass spectrometer-based helium leak detectors currently available.

 

Optical Monitoring Instruments.  We manufacture a range of optical monitoring instruments that are sold primarily for thin-film coating applications such as the manufacture of optical filters. The optical monitors measure the thickness and optical properties of a film being deposited, allowing the user to better control the process.

 

Electrostatic Charge Control Products.  Industries that rely on high technology manufacturing, such as the semiconductor, flat panel display, and data storage industries, are vulnerable to electrostatic charge-related contamination and yield problems. We design and manufacture products to control electrostatic attraction, electrostatic discharge, and electromagnetic interference.

 

Control and Information Technology Products.  We design and manufacture a suite of products that allow semiconductor manufacturing customers to better control their processes through computer-controlled automation. These products include digital control network products, process chamber and system controllers, data analysis products and connectivity products. Digital control network products are used to connect sensors, actuators and subsystems to the chamber and system control computers. They support a variety of industry-standard connection methods including DeviceNet, Profibus, ethernet and conventional discrete digital and analog signals. Chamber and system control computers process these signals in real time and allow customers to precisely manage the process conditions. Connectivity products allow information to flow from the process sensors and subsystems and from the process tool control computer to the factory network. By enabling this information flow, we believe that we help customers optimize their processes through Advanced Process Control (APC), and diagnose equipment problems from a remote location (e-diagnostics).

 

 

This product group includes power delivery products and reactive gas generation products.

 

Power Delivery Products.  Our power delivery products are used in the semiconductor, flat panel display, data storage and medical markets. In the semiconductor, flat panel and data storage markets, our microwave, RF and DC power supplies are used to provide energy to various etching, stripping and deposition processes. A range of impedance matching units transfer power from the power supplies to the customer’s process. We also provide sensors to measure delivered voltage and current along with plasma impedance. This information is used both to better control the generator output and as a process chamber diagnostic. Our power amplifiers are also used in MRI medical equipment including the most advanced 3T (three Tesla) machines.

 

Reactive Gas Generation Products.  Reactive gases are used to etch, strip and deposit films on wafers, to clean wafers during processing, and to clean process chambers to reduce particle contamination. A reactive gas is created when energy is added to a stable gas to break apart its molecules. The resulting dissociated gas produces rapid chemical reactions when it comes into contact with other matter. Our reactive gas products include ozone generators and subsystems used for deposition of insulators onto semiconductor devices, ozonated water delivery systems for advanced semiconductor wafer and flat panel display cleaning, atomic fluorine generators for process chamber cleaning, microwave plasma based products for photo resist removal and a new line of generators based on the fluorine cleaning architecture which provide reactive gases for a wide range of semiconductor, flat panel and thin film applications.

 

 

This product group consists of vacuum technology products, including vacuum gauges, valves and components.

 

Vacuum Gauging Products.  We offer a wide range of vacuum instruments consisting of vacuum measurement sensors and associated power supply and readout units. These vacuum gauges measure phenomena that are related to the level of pressure in the process chamber and downstream of the process chamber between the chamber and the pump. These gauges are used to measure vacuum at pressures lower than those measurable with a Baratron instrument or to measure vacuum in the Baratron instrument range where less accuracy is required. Our indirect pressure gauges use thermal conductivity and ionization gauge technologies to measure pressure from atmospheric pressure to one trillionth of atmospheric pressure.

 

Vacuum Valves and Components.  Our vacuum valves are used on the gas lines between the process chamber and the pump downstream of the process chamber. Our vacuum components consist of flanges, fittings, traps and heated lines that are used downstream from the process chamber to provide leak free connections and to prevent condensable materials from depositing particles near or back into the chamber. The manufacture of devices with small circuit patterns cannot tolerate contamination from atmospheric leaks or particles. Our vacuum components are designed to minimize such contamination and thus increase yields and reduce downtime.

 

Application-Specific Integrated Subsystems

 

We also combine these products and technologies into application-specific integrated subsystems. Integrated subsystems are made by each product group, and typically provide higher functionality in a smaller footprint, depending upon the application.

 

For example, we have a line of integrated flow and pressure control subsystems that combine two or more of our products and technologies into products for specific process applications. We have developed a range of Back-Side Wafer Cooling Subsystems which are needed to control the flow and pressure of the helium used to effect the cooling of wafers in semiconductor manufacturing. By combining the functions of our Baratron pressure measurement instruments, flow measurement instruments, control electronics and valves into a range of compact subsystems, this product line addresses the need for smaller components that save valuable clean room space.

 

Sales for integrated subsystems were $206.4 million or approximately 26% of total net sales for the year ended December 31, 2006 compared to $139.2 million or approximately 27% of total net sales and to $140.2 million or 25% of total net sales for the years ended December 31, 2005 and 2004, respectively.

 

Customers

 

Our largest customers include leading semiconductor capital equipment manufacturers such as Applied Materials, Lam Research, Novellus Systems and Tokyo Electron. Sales to our top ten customers accounted for approximately 49%, 48% and 49% of net sales for the years ended December 31, 2006, 2005 and 2004, respectively. Applied Materials accounted for approximately 21%, 18% and 20% of our net sales for the years ended December 31, 2006, 2005 and 2004, respectively.

 

Sales, Marketing and Support

 

Our worldwide sales, marketing and support organization is critical to our strategy of maintaining close relationships with semiconductor capital equipment manufacturers and semiconductor device manufacturers. We sell our products primarily through our direct sales force. As of December 31, 2006, we had 208 sales employees worldwide, located in China, France, Germany, Japan, Korea, the Netherlands, Singapore, Sweden, Taiwan, the United Kingdom and the United States. We also maintain sales representatives and agents in a number of countries, which supplement this direct sales force. We maintain a marketing staff that identifies customer requirements, assists in product planning and specifications, and focuses on future trends in semiconductor and other markets.

 

As semiconductor device manufacturers have become increasingly sensitive to the significant costs of system downtime, they have required that suppliers offer comprehensive local repair service and close customer support. Manufacturers require close support to enable them to repair, modify, upgrade and retrofit their equipment to improve yields and adapt new materials or processes. To meet these market requirements, we maintain a worldwide sales and support organization in 14 countries. Technical support is provided by applications engineers located at offices in China, France, Germany, Japan, Korea, the Netherlands, Singapore, Taiwan, the United Kingdom and the

United States. Repair and calibration services are provided at 27 service depots located worldwide. We typically provide warranties from one to three years, depending upon the type of product.

 

Research and Development

 

Our products incorporate sophisticated technologies to power, measure, control and monitor increasingly complex gas-related semiconductor manufacturing processes, thereby enhancing uptime, yield and throughput for our semiconductor device manufacturing customers. Our products have continuously advanced as we strive to meet our customers’ evolving needs. We have developed, and continue to develop, new products to address industry trends, such as the shrinking of integrated circuit critical dimensions from 90 nanometers to 65 nanometers and below. In addition, we have developed, and continue to develop, products that support the migration to new classes of materials and ultra-thin layers, such as copper for low resistance conductors, high-k dielectric materials for capacitors and gates and low-k dielectric materials for low loss insulators that are used in small geometry manufacturing. We have undertaken an initiative to involve our marketing, engineering, manufacturing and sales personnel in the concurrent development of new products in order to reduce the time to market for new products. Our employees also work closely with our customers’ development personnel helping us to identify and define future technical needs on which to focus research and development efforts. We support research at academic institutions targeted at advances in materials science and semiconductor process development. At December 31, 2006, we had 456 research and development employees, primarily located in the United States. Our research and development expenses were $69.7 million, $55.9 million and $57.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. Our research and development efforts include numerous projects, none of which are individually material, and generally have a duration of 12 to 30 months.

 

Manufacturing

 

Our manufacturing facilities are located in China, Germany, Israel, Japan, Mexico, the United Kingdom and the United States. Manufacturing activities include the assembly and testing of components and subassemblies, which are integrated into products. We outsource some of our subassembly work. We purchase a wide range of electronic, mechanical and electrical components, some of which are designed to our specifications. We consider our responsiveness to our customers’ significantly fluctuating product demands, by using lean manufacturing techniques, to be a distinct competitive advantage.

 

Competition

 

The market for our products is highly competitive. Principal competitive factors include:

 

 

Although we believe that we compete favorably with respect to these factors, there can be no assurance that we will continue to do so.

 

We encounter substantial competition in most of our product lines, although no single competitor competes with us across all product lines. Certain of our competitors may have greater financial and other resources than us. In some cases, competitors are smaller than we are, but well established in specific product niches. Celerity offers products that compete with our pressure and materials delivery products. Advanced Energy and Horiba each offer materials delivery products that compete with our product line of mass flow controllers. Nor-Cal Products, Inc. and VAT, Inc., each offer products that compete with our vacuum components. Inficon offers products that compete with our vacuum measurement and gas analysis products. Brooks Automation and Inficon each offer products that compete with our vacuum gauging products. Advanced Energy offers products that compete with our power delivery and reactive gas generator products.

 

Patents and Other Intellectual Property Rights

 

We rely on a combination of patent, copyright, trademark and trade secret laws and license agreements to establish and protect our proprietary rights. As of December 31, 2006, we owned 308 U.S. patents, 225 foreign patents and had 110 pending U.S. patent applications. Foreign counterparts of certain of these applications have been filed or may be filed at the appropriate time.

 

We require each of our employees, including our executive officers, to enter into standard agreements pursuant to which the employee agrees to keep confidential all of our proprietary information and to assign to us all inventions while they are employed by us.

 

For a discussion of litigation relating to our intellectual property, see “Item 3. Legal Proceedings.”

 

Employees

 

As of December 31, 2006, we employed 2,960 persons. We believe that our ongoing success depends upon our continued ability to attract and retain highly skilled employees for whom competition is intense. None of our employees are represented by a labor union or are party to a collective bargaining agreement. We believe that our employee relations are good.

 

Our business depends substantially on capital spending in the semiconductor industry which is characterized by periodic fluctuations that may cause a reduction in demand for our products.

 

We estimate that approximately 70%, 71% and 74% of our net sales for the years ended December 31, 2006, 2005 and 2004, were to semiconductor capital equipment manufacturers and semiconductor device manufacturers, and we expect that sales to such customers will continue to account for a substantial majority of our sales. Our business depends upon the capital expenditures of semiconductor device manufacturers, which in turn depend upon the demand for semiconductors. Periodic reductions in demand for the products manufactured by semiconductor capital equipment manufacturers and semiconductor device manufacturers may adversely affect our business, financial condition and results of operations.

 

Historically, the semiconductor market has been highly cyclical and has experienced periods of overcapacity, resulting in significantly reduced demand for capital equipment. For example, in 2001 through the first half of 2003, we experienced a significant reduction in demand from OEM customers, and lower gross margins due to reduced absorption of manufacturing overhead. In addition, many semiconductor manufacturers have operations and customers in Asia, a region that in past years has experienced serious economic problems including currency devaluations, debt defaults, lack of liquidity and recessions. We cannot be certain of the timing or magnitude of future semiconductor industry downturns. A decline in the level of orders as a result of any downturn or slowdown in the semiconductor capital equipment industry could have a material adverse effect on our business, financial condition and results of operations.

 

Our quarterly operating results have fluctuated, and are likely to continue to vary significantly, which may result in volatility in the market price of our common stock.

 

A substantial portion of our shipments occurs shortly after an order is received and therefore we operate with a low level of backlog. As a result, a decrease in demand for our products from one or more customers could occur with limited advance notice and could have a material adverse effect on our results of operations in any particular period. A significant percentage of our expenses is relatively fixed and based in part on expectations of future net sales. The inability to adjust spending quickly enough to compensate for any shortfall would magnify the adverse impact of a shortfall in net sales on our results of operations. Factors that could cause fluctuations in our net sales include:

 

 

 

In addition, our quarterly operating results may be adversely affected due to charges incurred in a particular quarter, for example, relating to inventory obsolescence, warranty or asset impairments.

 

As a result of the factors discussed above, it is likely that we may in the future experience quarterly or annual fluctuations and that, in one or more future quarters, our operating results may fall below the expectations of public market analysts or investors. In any such event, the price of our common stock could decline significantly.

 

The loss of net sales to any one of our major customers would likely have a material adverse effect on us.

 

Our top ten customers accounted for approximately 49%, 48% and 49% of our net sales for the years ended December 31, 2006, 2005 and 2004, respectively. The loss of a major customer or any reduction in orders by these customers, including reductions due to market or competitive conditions, would likely have a material adverse effect on our business, financial condition and results of operations. During the years ended December 31, 2006, 2005 and 2004, one customer, Applied Materials, accounted for approximately 21%, 18% and 20%, respectively, of our net sales. None of our significant customers, including Applied Materials, has entered into an agreement requiring it to purchase any minimum quantity of our products. The demand for our products from our semiconductor capital equipment customers depends in part on orders received by them from their semiconductor device manufacturer customers.

 

Attempts to lessen the adverse effect of any loss or reduction of net sales through the rapid addition of new customers could be difficult because prospective customers typically require lengthy qualification periods prior to placing volume orders with a new supplier. Our future success will continue to depend upon:

 

 

As part of our business strategy, we have entered into and may enter into or seek to enter into business combinations and acquisitions that may be difficult and costly to integrate, may be disruptive to our business, may dilute stockholder value or may divert management attention.

 

We made several acquisitions in the years 2000 through 2002 and, more recently in 2006. As a part of our business strategy, we may enter into additional business combinations and acquisitions. Acquisitions are typically accompanied by a number of risks, including the difficulty of integrating the operations, technology and personnel of the acquired companies, the potential disruption of our ongoing business and distraction of management, possible internal control weaknesses of the acquired companies, expenses related to the acquisition and potential unknown liabilities associated with acquired businesses. If we are not successful in completing acquisitions that we may pursue in the future, we may be required to reevaluate our growth strategy, and we may incur substantial expenses and devote significant management time and resources in seeking to complete proposed acquisitions that will not generate benefits for us.

 

In addition, with future acquisitions, we could use substantial portions of our available cash as all or a portion of the purchase price. We could also issue additional securities as consideration for these acquisitions, which could cause significant stockholder dilution. Further, our prior acquisitions and any future acquisitions may not ultimately help us achieve our strategic goals and may pose other risks to us.

 

As a result of our previous acquisitions, we have added several different decentralized operating and accounting systems, resulting in a complex reporting environment. We will need to continue to modify our accounting policies, internal controls, procedures and compliance programs to provide consistency across all our operations. In order to increase efficiency and operating effectiveness and improve corporate visibility into our decentralized operations, we are currently implementing a new worldwide Enterprise Resource Planning (“ERP”) system. We completed our first site implementation in October 2005 and we expect to continue to implement the ERP system by converting our remaining operations in phases over the next few years. Although we have a plan to accomplish the ERP implementation, we may risk potential disruption of our operations during the conversion periods and the implementation could require significantly more management time and higher implementation costs than currently estimated.

 

An inability to convince semiconductor device manufacturers to specify the use of our products to our customers that are semiconductor capital equipment manufacturers would weaken our competitive position.

 

The markets for our products are highly competitive. Our competitive success often depends upon factors outside of our control. For example, in some cases, particularly with respect to mass flow controllers, semiconductor device manufacturers may direct semiconductor capital equipment manufacturers to use a specified supplier’s product in their equipment. Accordingly, for such products, our success will depend in part on our ability to have semiconductor device manufacturers specify that our products be used at their semiconductor fabrication facilities. In addition, we may encounter difficulties in changing established relationships of competitors that already have a large installed base of products within such semiconductor fabrication facilities.

 

If our products are not designed into successive generations of our customers’ products, we will lose significant net sales during the lifespan of those products.

 

New products designed by semiconductor capital equipment manufacturers typically have a lifespan of five to ten years. Our success depends on our products being designed into new generations of equipment for the semiconductor industry. We must develop products that are technologically advanced so that they are positioned to be chosen for use in each successive generation of semiconductor capital equipment. If customers do not choose our products, our net sales may be reduced during the lifespan of our customers’ products. In addition, we must make a significant capital investment to develop products for our customers well before our products are introduced and before we can be sure that we will recover our capital investment through sales to the customers in significant volume. We are thus also at risk during the development phase that our products may fail to meet our customers’ technical or cost requirements and may be replaced by a competitive product or alternative technology solution. If that happens, we may be unable to recover our development costs.

 

The semiconductor industry is subject to rapid demand shifts which are difficult to predict. As a result, our inability to expand our manufacturing capacity in response to these rapid shifts may cause a reduction in our market share.

 

Our ability to increase sales of certain products depends in part upon our ability to expand our manufacturing capacity for such products in a timely manner. If we are unable to expand our manufacturing capacity on a timely basis or to manage such expansion effectively, our customers could implement our competitors’ products and, as a result, our market share could be reduced. Because the semiconductor industry is subject to rapid demand shifts which are difficult to foresee, we may not be able to increase capacity quickly enough to respond to a rapid increase in demand. Additionally, capacity expansion could increase our fixed operating expenses and if sales levels do not increase to offset the additional expense levels associated with any such expansion, our business, financial condition and results of operations could be materially adversely affected.

 

We operate in a highly competitive industry.

 

The market for our products is highly competitive. Principal competitive factors include:

 

 

 

Although we believe that we compete favorably with respect to these factors, we may not be able to continue to do so. We encounter substantial competition in most of our product lines. Certain of our competitors may have greater financial and other resources than we have. In some cases, competitors are smaller than we are, but well established in specific product niches. We may encounter difficulties in changing established relationships of competitors with a large installed base of products at such customers’ fabrication facilities. In addition, our competitors can be expected to continue to improve the design and performance of their products. Competitors may develop products that offer price or performance features superior to those of our products. If our competitors develop superior products, we may lose existing customer and market share.

 

Sales to foreign markets constitute a substantial portion of our net sales; therefore, our net sales and results of operations could be adversely affected by downturns in economic conditions in countries outside of the United States.

 

International sales include sales by our foreign subsidiaries, but exclude direct export sales. International sales accounted for approximately 34%, 37% and 34%, of net sales for the years ended December 31, 2006, 2005 and 2004, respectively, a significant portion of which were sales to Japan.

 

We anticipate that international sales will continue to account for a significant portion of our net sales. In addition, certain of our key domestic customers derive a significant portion of their revenues from sales in international markets. Therefore, our sales and results of operations could be adversely affected by economic slowdowns and other risks associated with international sales.

 

We have significant foreign operations, and outsource certain operations offshore, which pose significant risks.

 

We have significant international sales, service, engineering and manufacturing operations in Europe, Israel and Asia, and have outsourced a portion of our manufacturing to Mexico. We may expand the level of manufacturing and certain other operations that we do offshore in order to take advantage of cost efficiencies available to us in those countries. However, we may not achieve the significant cost savings or other benefits that we anticipate from this program. These foreign operations expose us to operational and political risks that may harm our business, including:

 

 

If any of these risks materialize, our operating results may be adversely affected.

 

Unfavorable currency exchange rate fluctuations may lead to lower operating margins or may cause us to raise prices, which could result in reduced sales.

 

Currency exchange rate fluctuations could have an adverse effect on our net sales and results of operations and we could experience losses with respect to our hedging activities. Unfavorable currency fluctuations could require us to increase prices to foreign customers, which could result in lower net sales by us to such customers. Alternatively, if we do not adjust the prices for our products in response to unfavorable currency fluctuations, our results of operations could be adversely affected. In addition, most sales made by our foreign subsidiaries are denominated in the currency of the country in which these products are sold and the currency they receive in payment for such sales could be less valuable at the time of receipt as a result of exchange rate fluctuations. We enter into forward foreign exchange contracts and may enter into local currency purchased options to reduce currency exposure arising from intercompany sales of inventory. However, we cannot be certain that our efforts will be adequate to protect us against significant currency fluctuations or that such efforts will not expose us to additional exchange rate risks.

 

Key personnel may be difficult to attract and retain.

 

Our success depends to a large extent upon the efforts and abilities of a number of key employees and officers, particularly those with expertise in the semiconductor manufacturing and similar industrial manufacturing industries. The loss of key employees or officers could have a material adverse effect on our business, financial condition and results of operations. We believe that our future success will depend in part on our ability to attract and retain highly skilled technical, financial, managerial and marketing personnel. We cannot be certain that we will be successful in attracting and retaining such personnel.

 

Our proprietary technology is important to the continued success of our business. Our failure to protect this proprietary technology may significantly impair our competitive position.

 

As of December 31, 2006, we owned 308 U.S. patents, 225 foreign patents and had 110 pending U.S. patent applications. Although we seek to protect our intellectual property rights through patents, copyrights, trade secrets and other measures, we cannot be certain that:

 

 

Protection of our intellectual property rights may result in costly litigation.

 

Litigation may be necessary in order to enforce our patents, copyrights or other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. We are, from time to time, involved in lawsuits enforcing or defending our intellectual property rights and may be involved in such litigation in the future. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, financial condition and results of operations.

 

We may need to expend significant time and expense to protect our intellectual property regardless of the validity or successful outcome of such intellectual property claims. If we lose any litigation, we may be required to seek licenses from others or change, stop manufacturing or stop selling some of our products.

 

The market price of our common stock has fluctuated and may continue to fluctuate for reasons over which we have no control.

 

The stock market has from time to time experienced, and is likely to continue to experience, extreme price and volume fluctuations. Prices of securities of technology companies have been especially volatile and have often fluctuated for reasons that are unrelated to the operating performance of the companies. The market price of shares of our common stock has fluctuated greatly since our initial public offering and could continue to fluctuate due to a variety of factors. In the past, companies that have experienced volatility in the market price of their stock have been the objects of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management’s attention and resources.

 

Our dependence on sole, limited source suppliers, and international suppliers, could affect our ability to manufacture products and systems.

 

We rely on sole, limited source suppliers and international suppliers for a few of our components and subassemblies that are critical to the manufacturing of our products. This reliance involves several risks, including the following:

 

 

We believe that in time we could obtain and qualify alternative sources for most sole, limited source and international supplier parts. Seeking alternative sources of the parts could require us to redesign our systems, resulting in increased costs and likely shipping delays. We may be unable to redesign our systems, which could result in further costs and shipping delays. These increased costs would decrease our profit margins if we could not pass the costs to our customers. Further, shipping delays could damage our relationships with current and potential customers and have a material adverse effect on our business and results of operations.

 

We are subject to governmental regulations. If we fail to comply with these regulations, our business could be harmed.

 

We are subject to federal, state, local and foreign regulations, including environmental regulations and regulations relating to the design and operation of our products. We must ensure that the affected products meet a variety of standards, many of which vary across the countries in which our systems are used. For example, the European Union has published directives specifically relating to power supplies. In addition, the European Union has issued directives relating to regulation of recycling and hazardous substances, which may be applicable to our products, or to which some customers may voluntarily elect to adhere to. In addition, China has adopted, and certain other Asian countries have indicated an intention to adopt, similar regulations. We must comply with any applicable regulation adopted in connection with these types of directives in order to ship affected products into countries that adopt these types of regulations. We believe we are in compliance with current applicable regulations, directives and standards and have obtained all necessary permits, approvals, and authorizations to conduct our business. However, compliance with future regulations, directives and standards, or customer demands beyond such requirements, could require us to modify or redesign certain systems, make capital expenditures or incur substantial costs. If we do not comply with current or future regulations, directives and standards:

 

 

Certain stockholders have a substantial interest in us and may be able to exert substantial influence over our actions.

 

As of December 31, 2006, John R. Bertucci, our Chairman, and certain members of his family, in the aggregate, beneficially owned approximately 11% of our outstanding common stock. As a result, these stockholders, acting together, may be able to exert substantial influence over our actions.

 

Some provisions of our restated articles of organization, as amended, our amended and restated by-laws and Massachusetts law could discourage potential acquisition proposals and could delay or prevent a change in control of us.

 

Anti-takeover provisions could diminish the opportunities for stockholders to participate in tender offers, including tender offers at a price above the then current market price of the common stock. Such provisions may also inhibit increases in the market price of the common stock that could result from takeover attempts. For example, while we have no present plans to issue any preferred stock, our board of directors, without further stockholder approval, may issue preferred stock that could have the effect of delaying, deterring or preventing a change in control of us. The issuance of preferred stock could adversely affect the voting power of the holders of our common stock, including the loss of voting control to others. In addition, our amended and restated by-laws provide for a classified board of directors consisting of three classes. The classified board could also have the effect of delaying, deterring or preventing a change in control of us.

 

Changes in financial accounting standards may adversely affect our reported results of operations.

 

A change in accounting standards or practices could have a significant effect on our reported results and may even affect our reporting of transactions completed before the change was effective. New accounting pronouncements and varying interpretations of existing accounting pronouncements have occurred and may occur in the future. Such changes may adversely affect our reported financial results or may impact our related business practice.

 

For example, Statement on Financial Accounting Standards No. 123R “Share-Based Payment” (“SFAS 123R”), which requires us to measure all employee stock-based compensation awards using a fair value method and record such expense in our consolidated financial statements, was adopted in the first quarter of 2006, and had a material adverse impact on our consolidated financial statements as reported under generally accepted accounting principles in the United States for the first quarter of 2006 and adversely impacted our consolidated financial statements for fiscal 2006.

 

None.

 

The following table provides information concerning MKS’ principal and certain other owned and leased facilities as of December 31, 2006:

 

 

 

In addition to manufacturing and other operations conducted at the foregoing leased or owned facilities, MKS provides worldwide sales, customer support and services from various other leased facilities throughout the world not listed in the table above. See “Business — Sales, Marketing and Support.”

 

On November 3, 1999, On-Line Technologies Inc. (“On-Line”), which we acquired in 2001, brought suit in federal district court in Connecticut against Perkin-Elmer Corp. (“Perkin-Elmer”) and certain other defendants for infringement of On-Line’s U.S. Patent No. 5,440,143 (the “143 patent”). The suit sought injunctive relief and damages for infringement. Perkin-Elmer filed a counterclaim seeking invalidity of the patent, costs and attorneys’ fees, and in June 2002, moved for summary judgment. In April 2003, the court granted the motion and dismissed the case. We appealed this decision to the Federal Circuit Court of Appeals, which, on October 13, 2004, reversed the lower court’s dismissal of our claim for patent infringement, and the case was remanded to the district court. On March 11, 2005, Perkin-Elmer stipulated that they do infringe a specified claim of the 143 patent. Perkin-Elmer filed a motion for summary judgment seeking to invalidate such claim, which motion was denied on March 23, 2006. The court established an October 2006 trial date. Perkin-Elmer then moved for the court to reconsider its decision and requested a stay of the trial. On September 15, 2006, the court reversed itself, granting Perkin-Elmer’s motion for reconsideration, and holding the specified claim invalid. Following a September 26, 2006 status conference, the court denied the defendants’ request to stay the trial of our remaining claims. The court continued the trial date and requested summary judgment briefing on the remaining claims following a court ordered 30-day delay for the parties to attempt to settle the case. In January 2007, the parties entered into a confidential settlement agreement, the terms of which do not have a material financial impact to us, and agreed to dismiss the case upon such terms. Accordingly, on January 22, 2007, the parties filed with the court a stipulation of dismissal, which the court granted on January 26, 2007.

 

We are subject to other legal proceedings and claims, which have arisen in the ordinary course of business.

 

In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our results of operations, financial condition or cash flows.

 

No matters were submitted to a vote of security holders during the fourth quarter of 2006 through the solicitation of proxies or otherwise.

 

Price Range of Common Stock

 

Our common stock is traded on the Nasdaq Global Market under the symbol MKSI. On February 16, 2007, the closing price of our common stock, as reported on the Nasdaq Global Market, was $24.04 per share. The following table sets forth for the periods indicated the high and low bid prices per share of our common stock as reported by the Nasdaq Global Market.

 

 

On February 16, 2007, we had approximately 205 stockholders of record.

 

Dividend Policy

 

We have never declared or paid any cash dividends. We currently intend to retain earnings, if any, to support our growth strategy and do not anticipate paying cash dividends in the foreseeable future. Payment of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs, plans for expansion, and changes in tax and regulatory rulings.

Comparative Stock Performance

 

The following graph compares the cumulative total shareholder return (assuming reinvestment of dividends) from investing $100 on December 31, 2001, and plotted at the last trading day of each of the fiscal years ended December 31, 2002, 2003, 2004, 2005 and 2006, in each of (i) the Company’s Common Stock; (ii) an industry group index of semiconductor equipment/material manufacturers (the “Hemscott Group Index”), compiled by Hemscott, Inc. (“Hemscott”); and (iii) the NASDAQ Market Index of companies (the “NASDAQ Market Index”). The graph was compiled by Hemscott. The stock price performance on the graph below is not necessarily indicative of future price performance. The Company’s Common Stock is listed on the NASDAQ Global Market under the ticker symbol “MKSI.”

 

Performance Graph

 

COMPARISON OF CUMULATIVE TOTAL RETURN OF
ONE OR MORE COMPANIES, PEER GROUPS,
INDUSTRY INDEXES AND/OR BROAD MARKETS

 

 

 

Assumes $100 invested on Dec. 31, 2001

Assumes dividend reinvested

Fiscal Year Ending Dec. 31, 2006

 

 

Selected Consolidated Financial Data

 

 

 

 

Overview

 

We are a leading worldwide provider of instruments, components, subsystems and process control solutions that measure, control, power, monitor and analyze critical parameters of semiconductor and other advanced manufacturing processes.

 

We are managed as one operating segment which is organized around three product groups: Instruments and Control Systems, Power and Reactive Gas Products and Vacuum Products. Our products are derived from our core competencies in pressure measurement and control, materials delivery, gas and thin-film composition analysis, electrostatic charge control, control and information management, power and reactive gas generation and vacuum technology. Our products are used to manufacture semiconductors and thin film coatings for diverse markets such as flat panel displays, optical and magnetic storage media, architectural glass, solar panels and electro-optical products. We also provide technologies for other markets, including medical imaging equipment and the energy generation and conservation markets.

 

We have a diverse base of customers that include semiconductor capital equipment manufacturers, semiconductor device manufacturers, capital equipment manufacturers of thin-film coatings used in flat panel displays, optical and magnetic data storage media, architectural glass, solar panels and electro-optical products, industrial and manufacturing companies, medical equipment manufacturers and university, government and industrial research laboratories. During the years ended December 31, 2006, 2005 and 2004, we estimate that approximately 70%, 71% and 74% of our net sales, respectively, were to semiconductor capital equipment manufacturers and semiconductor device manufacturers. We expect that sales to semiconductor capital equipment manufacturers and semiconductor device manufacturers will continue to account for a substantial majority of our sales.

 

During the fourth quarter of 2005 and continuing through the third quarter of 2006, we experienced significant increases in customer orders, which caused our sales for all quarters of 2006 to increase significantly from 2005 quarterly levels. We currently expect that our first quarter 2007 net sales could be approximately the same as our fourth quarter 2006 net sales. However, the semiconductor capital equipment industry is subject to rapid demand shifts, which are difficult to predict, and we are uncertain how long these sales levels may be maintained or the timing or extent of any future downturn or upturn in the semiconductor capital equipment industry.

 

A significant portion of our net sales is to operations in international markets. International net sales include sales by our foreign subsidiaries, but exclude direct export sales. International net sales accounted for approximately 34%, 37% and 34% of net sales for the years ended December 31, 2006, 2005 and 2004, respectively, a significant portion of which were sales in Japan. We expect that international net sales will continue to represent a significant percentage of our total net sales.

 

Recent Acquisitions

 

On January 3, 2006, we completed our acquisition of Ion Systems, Inc. (“Ion”), a leading provider of electrostatic management solutions located in Alameda, California, pursuant to an Agreement and Plan of Merger dated November 25, 2005. Ion’s ionization technology monitors electrostatic charges to reduce process contamination and improve yields, which complements our process monitoring and control technologies. The aggregate purchase price consisted of $68.1 million in cash, net of $5.1 million in cash acquired, and $0.8 million in acquisition related costs.

 

Additionally, on January 3, 2006, we completed our acquisition of Umetrics, AB (“Umetrics”), a leader in multivariate data analysis and modeling software located in Umea, Sweden, pursuant to a Sale and Purchase Agreement dated December 15, 2005. Umetrics’ multivariate data analysis and modeling software converts process data into useable information for yield improvement, when linked with our open and modular platform of process sensors and data collection, integration, data storage, and visualization capabilities. The purchase price consisted of $27.4 million in cash, net of $2.6 million in cash acquired, and $0.4 million in acquisition related costs.

 

On October 11, 2006, we completed our acquisition of Novx Corp. (“Novx”), a provider of electrostatic charge monitoring technology for semiconductor, data storage, telecommunication, medical device and other markets.

Novx’s technology expands our capability to monitor, detect and control electrostatic charge in advanced process environments, such as semiconductor and hard disk drive manufacturing. The total purchase price was $2.6 million.

 

Critical Accounting Policies and Estimates

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, inventory, warranty costs, stock-based compensation expense, intangible assets, goodwill and other long-lived assets, in-process research and development and income taxes. We base our estimates and judgments on historical experience and on various other factors that are believed to be 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.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

 

Revenue recognition and Accounts Receivable Allowances.  Revenue from product sales is recorded upon transfer of title and risk of loss to the customer provided that there is evidence of an arrangement, the sales price is fixed or determinable, and collection of the related receivable is reasonably assured. In most transactions, we have no obligations to our customers after the date products are shipped other than pursuant to warranty obligations. In some instances, we provide installation, training, support and services to customers after the product has been shipped. We defer the fair value of any undelivered elements until the undelivered element is delivered. Fair value is the price charged when the element is sold separately. Shipping and handling fees billed to customers, if any, are recognized as revenue. The related shipping and handling costs are recognized in cost of sales.

 

We monitor and track the amount of product returns, provide for accounts receivable allowances and reduce revenue at the time of shipment for the estimated amount of such future returns, based on historical experience. While product returns have historically been within our expectations and the provisions established, there is no assurance that we will continue to experience the same return rates that we have in the past. Any significant increase in product return rates could have a material adverse impact on our operating results for the period or periods in which such returns materialize. While we maintain a credit approval process, significant judgments are made by management in connection with assessing our customers’ ability to pay at the time of shipment. Despite this assessment, from time to time, our customers are unable to meet their payment obligations. We continuously monitor our customers’ credit worthiness, and use our judgment in establishing a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, there is no assurance that we will continue to experience the same credit loss rates that we have in the past. A significant change in the liquidity or financial position of our customers could have a material adverse impact on the collectability of accounts receivable and our future operating results.

 

Inventory.  We value our inventory at the lower of cost (first-in, first-out method) or market. We regularly review inventory quantities on hand and record a provision to write down excess and obsolete inventory to our estimated net realizable value, if less than cost, based primarily on our estimated forecast of product demand. Demand for our products can fluctuate significantly. A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases as a result of supply shortages or a decrease in the cost of inventory purchases as a result of volume discounts, while a significant decrease in demand could result in an increase in the charges for excess inventory quantities on hand. In addition, our industry is subject to technological change, new product development and product technological obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Therefore, any significant unanticipated changes in demand or

technological developments could have a significant impact on the value of our inventory and our reported operating results.

 

Warranty costs.  We provide for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. We provide warranty coverage for our products ranging from 12 to 36 months, with the majority of our products ranging from 12 to 24 months. We estimate the anticipated costs of repairing our products under such warranties based on the historical costs of the repairs and any known specific product issues. The assumptions we use to estimate warranty accruals are reevaluated periodically in light of actual experience and, when appropriate, the accruals are adjusted. Our determination of the appropriate level of warranty accrual is based upon estimates. Should product failure rates differ from our estimates, actual costs could vary significantly from our expectations.

 

Stock-Based Compensation Expense.  Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method, and therefore have not restated prior periods’ results. Under this method we recognize compensation expense for all equity-based awards granted after January 1, 2006 as well as awards granted prior to but not yet vested as of January 1, 2006, in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest on a straight-line basis over the requisite service period of the award. The adoption of this standard reduced our net income by $8.7 million, for the year ended December 31, 2006. Prior to SFAS 123R adoption, we accounted for share-based payments under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and accordingly, generally recognized compensation expense only when we granted options with a discounted exercise price.

 

Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. Management determined that blended volatility, a combination of historical and implied volatility, is more reflective of market conditions and a better indicator of expected volatility than historical or implied volatility. Therefore, expected volatility for the year ended December 31, 2006 was based on a blended volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note 2 to the consolidated financial statements for a further discussion on stock-based compensation.

 

Intangible assets, goodwill and other long-lived assets.  We review intangible assets and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Factors we consider important, which could indicate an impairment, include significant under performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the asset or the strategy for our overall business and significant and negative industry or economic trends. When we determine that the carrying value of the asset may not be recoverable based upon the existence of one or more of the above indicators of impairment, we compare the undiscounted cash flows to the carrying value of the asset. If an impairment is possible and indicated, the asset is written down to its estimated fair value. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The fair value initially assigned to intangible assets is determined based on estimates and judgment regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, we may be required to record an impairment charge to write down the asset to its estimated fair value.

 

We assess goodwill for impairment at least annually, or more frequently when events and circumstances occur indicating that the recorded goodwill at the reporting unit level may be impaired. Reporting units are defined as operating segments or one level below an operating segment, referred to as a component. We have determined that

our reporting units are components of our one operating segment. We allocate goodwill to reporting units at the time of acquisition and base that allocation on which reporting units will benefit from the acquired assets and liabilities. If the book value of a reporting unit exceeds its fair value, the implied fair value of goodwill is compared with the carrying amount of goodwill. If the carrying amount of goodwill exceeds the implied fair value, an impairment loss is recorded in an amount equal to that excess. The fair value of a reporting unit is estimated using the discounted cash flow approach, and is dependent on estimates and judgments related to future cash flows and discount rates. If actual cash flows differ significantly from the estimates used by management, we may be required to record an impairment charge to write down the goodwill to its estimated fair value.

 

In-process research and development.  We value tangible and intangible assets acquired through our business acquisitions, including in-process research and development (“IPR&D”), at fair value. We determine IPR&D through established valuation techniques for various projects for the development of new products and technologies and expense IPR&D when technical feasibility is not reached. The value of IPR&D is determined using the income approach, which discounts expected future cash flows from projects under development to their net present value. Each project is analyzed and estimates and judgments are made to determine the technological innovations included, the utilization of core technology, the complexity, cost and time to complete development, any alternative future use or current technological feasibility and the stage of completion. If we acquire other companies with IPR&D in the future, we will value the IPR&D through established valuation techniques and will incur future IPR&D charges if those products under development have not reached technical feasibility.

 

Income taxes.  We evaluate the realizability of our net deferred tax assets and assess the need for a valuation allowance on a quarterly basis. The future benefit to be derived from our deferred tax assets is dependent upon our ability to generate sufficient future taxable income to realize the assets. We record a valuation allowance to reduce our net deferred tax assets to the amount that may be more likely than not to be realized. To the extent we established a valuation allowance, an expense is recorded within the provision for income taxes line in the statement of operations. During the year ended December 31, 2002, we established a full valuation allowance for our net deferred tax assets. During the fourth quarter of 2004, after examining a number of factors, including historical results and near term earnings projections, we determined that it was more likely than not that we would realize all of our net deferred tax assets, except for those relating to certain state tax credits. An adjustment to the valuation allowance was recorded as a reduction to income tax expense. During the fourth quarter of 2006, the Company determined that it would begin utilizing the aforementioned state tax credits and reduced the valuation allowance to reflect the amount of the near term state tax credits to be utilized. The remaining valuation allowance at December 31, 2006 is $0.3 million, relating to the remaining state tax credits acquired with the purchase of Ion. In future periods, if we were to determine that it was more likely than not that we would not be able to realize the recorded amount of our remaining net deferred tax assets, an adjustment to the valuation allowance would be recorded as an increase to income tax expense in the period such determination was made.

 

Results of Operations

 

The following table sets forth, for the periods indicated, the percentage of total net sales of certain line items included in our consolidated statement of operations data:

 

 

Year Ended 2006 Compared to 2005 and 2004

 

Net Sales

 

 

Net sales increased $273.5 million during the year ended December 31, 2006 mainly due to an increase in worldwide demand from our semiconductor capital equipment manufacturer and semiconductor device manufacturer customers, which increased $188.6 million or 52.3% compared to the same period for the prior year. Additionally, net sales for thin-film and other non-semiconductor manufacturing applications increased $84.9 million or 57.1% compared to the same period for the prior year. During 2006, we acquired three companies. These acquisitions increased our total net sales by approximately $38.5 million for the year ended December 31, 2006 compared to the same period for the prior year. International net sales were $266.9 million for the year ended December 31, 2006 or 34.1% of net sales compared to $188.5 million for the same period of 2005 or 37.0% of net sales.

 

Net sales decreased $45.8 million during the year ended December 31, 2005 mainly due to a decrease in worldwide demand from our semiconductor capital equipment manufacturer customers, which decreased $58.8 million or 16.1% compared to the same period for the prior year. Primarily offsetting this decrease was a net sales increase of $9.4 million or 9.5% for other non-semiconductor manufacturing applications and a net sales increase of $6.3 million or 12.9% for semiconductor device manufacturer customers compared to the same period for the prior year. International net sales were approximately $188.5 million for the year ended December 31, 2005 or 37.0% of net sales compared to $187.8 million for the same period of 2004 or 33.8% of net sales.

 

Gross Profit

 

 

Gross profit increased during year ended December 31, 2006 mainly due to higher production volumes which reduced overhead costs as a percentage of sales by 3.0 percentage points. In addition, the positive impact of gross profit margins from our three acquisitions in 2006, favorable product mix and other reduced manufacturing costs increased our overall margin by approximately 0.8 percentage points during the year ended December 31, 2006.

 

Gross profit as a percentage of net sales decreased slightly during the year ended December 31, 2005 compared to the same period in 2004 mainly due to overhead costs representing a higher percentage of lower sales, partially offset by lower material and labor costs as a percentage of sales, which reflected the net effect of a gradual transition to lower cost material and manufacturing sources.

 

Research and Development

 

 

Our research and development is primarily focused on developing and improving our instruments, components, subsystems and process control solutions to improve process performance and productivity.

 

We have hundreds of products and our research and development efforts primarily consist of a large number of projects related to these products, none of which is individually material to us. Current projects typically have a duration of 12 to 30 months depending upon whether the product is an enhancement of existing technology or a new product. Our current initiatives include projects to enhance the performance characteristics of older products, to develop new products and to integrate various technologies into subsystems. These projects support in large part the transition in the semiconductor industry to larger wafer sizes and smaller integrated circuit geometries, which require more advanced process control technology. Research and development expenses consist primarily of salaries and related expenses for personnel engaged in research and development, fees paid to consultants, material costs for prototypes and other expenses related to the design, development, testing and enhancement of our products.

 

Research and development expense increased $13.8 million during the year ended December 31, 2006 mainly due to expenses of $5.4 million from the companies acquired in 2006, $4.9 million in increased compensation, resulting from increased incentive compensation, headcount and salaries, and $3.3 million in stock-based compensation expenses recorded during the current year.

 

Research and development expenses decreased $1.1 million for the year ended December 31, 2005 compared to the same period for 2004 primarily due to lower project material and other related costs. Staffing levels during 2005 were consistent with staffing levels during 2004.

 

We believe that the continued investment in research and development and ongoing development of new products are essential to the expansion of our markets, and expect to continue to make significant investment in research and development activities. We are subject to risks if products are not developed in a timely manner, due to rapidly changing customer requirements and competitive threats from other companies and technologies. Our success primarily depends on our products being designed into new generations of equipment for the semiconductor industry. We develop products that are technologically advanced so that they are positioned to be chosen for use in each successive generation of semiconductor capital equipment. If our products are not chosen to be designed into our customers’ products, our net sales may be reduced during the lifespan of those products.

 

Selling, General and Administrative

 

 

Selling, general and administrative expenses increased $34.7 million during the year ended December 31, 2006 primarily due to expenses of $15.8 million from the companies acquired in 2006, $11.3 million in increased compensation, resulting from increased incentive compensation, headcount and salaries, $7.6 million in stock-based compensation expenses recorded during the current year and higher costs of $2.1 million for our ERP implementation, offset by $2.6 million in foreign currency exchange gains as compared to the same period in the prior year.

 

Selling, general and administrative expenses increased $5.7 million during the year ended December 31, 2005 compared to the same period for the prior year mainly due to higher costs of $3.9 million primarily for IT related services and for our ERP implementation, increased foreign currency losses of $1.5 million, higher professional fees of $2.2 million principally related to higher audit costs and fees for compliance with the Sarbanes Oxley Act of 2002 (“Sarbanes Oxley”), partially offset by decreased legal fees of $2.6 million mainly related to litigation which had been subsequently resolved.

 

Amortization of Acquired Intangible Assets

 

 

Amortization expense for the year ended December 31, 2006 increased $3.5 million primarily due to the amortization related to $33.6 million in acquired intangible assets from the acquisitions in 2006, which included a $1.0 million order backlog intangible asset, which was amortized over 3 months during the first quarter of 2006.

 

Amortization expense for the years ended December 31, 2005 and 2004, respectively, represents amortization of identifiable intangible assets resulting from our completed acquisitions. The decrease during the year ended December 31, 2005 compared to the same period for the prior year was due to certain identifiable intangible assets becoming fully amortized during 2005. We did not acquire any material identifiable intangible assets in 2005 or 2004.

 

Purchase of in-process technology

 

 

In-process research and development of $0.8 million for the year ended December 31, 2006 arose from the acquisitions of Ion and Umetrics, which we made during 2006. The purchase price of these acquisitions was allocated to the assets acquired, including intangible assets, based on estimated fair values. The intangible assets included approximately $0.8 million for acquired in-process technology for projects, generally expected to have durations of 12 months, which did not have alternative future uses. Accordingly, these costs were expensed during 2006.

 

Income from Litigation Settlement

 

During the fourth quarter of 2005, we executed a settlement agreement with Advanced Energy Industries, Inc. (“Advanced Energy”) in connection with the patent infringement suit we had brought against Advanced Energy in federal district court in Delaware. Pursuant to the settlement agreement, Advanced Energy paid us $3.0 million in cash in October 2005.

 

Interest Income, Net

 

 

Net interest income increased $1.9 million during the year ended December 31, 2006 mainly related to higher interest rates in 2006.

 

Net interest income increased $4.5 million during the year ended December 31, 2005 compared to the same period for the prior year, mainly related to higher interest rates on higher average investment balances in those periods.

 

Other Income, Net

 

 

During 2001, we sold certain assets for proceeds of approximately $9.0 million, including a note receivable of approximately $3.9 million and warrants of $0.2 million. During 2002, due to the downturn in the semiconductor industry and its result on the acquirer’s operations, and the acquirer’s inability to raise financing, we considered the value of the note and warrants to be impaired. Accordingly, during 2002, we recorded a charge of $4.1 million to other expense for our estimate of the impairment on the note receivable and warrants. During the second quarter of 2004, we received $5.0 million and recorded a gain to other income related to the collection of the note receivable and accrued interest and the cancellation of the warrants.

 

Provision (Benefit) for Income Taxes

 

 

We recorded a provision for income taxes of $36.7 million for the year ended December 31, 2006 and $12.4 million for the year ended December 31, 2005, as compared to a tax benefit of $2.6 million for the year ended December 31, 2004. The provision for income taxes in 2006 and 2005 are comprised of federal, state and foreign income taxes. The benefit for income taxes in 2004 is comprised of tax expense from foreign operations and state taxes, offset by a deferred tax benefit of approximately $10.2 million.

 

As a result of incurring significant operating losses since 2001, during 2002 we determined that it was more likely than not that our deferred tax assets may not have been realizable, and since the fourth quarter of 2002 had established a full valuation allowance for our net deferred tax assets. During the fourth quarter of 2004, after examining a number of factors, including historical results and near term earnings projections, we determined that it was more likely than not that we would realize all of our net deferred tax assets, except for those related to certain state tax credits. An adjustment was made to reduce the valuation allowance to reflect the amount of the realizable net deferred tax assets at December 31, 2004. During the fourth quarter of 2006 the Company determined that it would begin utilizing the aforementioned state tax credits and reduced the valuation allowance to reflect the amount of the near term state tax credits to be utilized. The remaining valuation allowance at December 31, 2006 is $0.3 million, relating to the state tax credits acquired with the purchase of Ion.

 

Our effective tax rate for the years ended December 31, 2006, 2005 and 2004 was 28.0%, 26.5% and (3.9)%, respectively. The effective tax rate for 2006 is less than the statutory tax rate primarily due to certain discrete tax matters related to our international operations, the benefit from the federal research and development credits, the reduction in the valuation allowance for state tax credits and the profits of our international subsidiaries being taxed at rates lower than the U.S. statutory tax rate.

 

The effective tax rate in 2005 is less than the statutory tax rate primarily due to a tax benefit recorded as the result of the completion of the Internal Revenue Service (“IRS”) examination (see below), the benefit from U.S. research and development credits and the profits of our international subsidiaries being taxed at rates lower than the U.S. statutory tax rate.

 

During 2005, the IRS completed its examination of our federal tax returns for the tax years 1999 through 2002. As a result of this examination, during the year ended December 31, 2005, we recorded a benefit to income tax expense of $1.9 million and a $0.6 million reduction of goodwill related to a previous acquisition.

 

In the normal course of business, the Company and our subsidiaries are examined by various tax authorities, including the IRS. Any such examination could result in an unfavorable settlement of any particular issue and may require the use of cash. Unfavorable or favorable resolution of any such examination could result in an increase or a reduction, respectively, to our effective tax rate in the quarter of resolution. Although the Company believes that its tax positions are consistent with applicable U.S. federal and state and international laws, certain tax reserves are maintained at December 31, 2006 should these positions be challenged by the applicable tax authority and additional tax assessed on audit.

 

During the year ended December 31, 2006, we received a notification letter from the Israeli Ministry of Industry Trade and Labor (“MITL”) indicating that our Israeli operations were in compliance with requirements relating to the tax holiday granted to our manufacturing operations in Israel in 2001. This tax holiday is anticipated to expire in 2011 and is subject to meeting continued investment, employment and other requirements under the guidelines of the MITL. Additionally, we recorded the impact of both a change in German tax rules allowing interest deductions on certain loans and an adjustment relating to transfer pricing. As a result of these items we recorded a net benefit to income tax expense of $1.6 million for the year ended December 31, 2006.

 

Liquidity and Capital Resources

 

Cash, cash equivalents and short-term marketable securities totaled $290.0 million at December 31, 2006 compared to $292.6 million at December 31, 2005. This increase is mainly due to an increase of $78.2 million of cash generated from operations and $30.5 million of cash provided by financing activities primarily offset by $98.7 million of cash used for the acquisitions of business in 2006. The primary driver in our current and anticipated future cash flows is and will continue to be cash generated from operations, consisting mainly of our net income and changes in operating assets and liabilities. In periods when our sales are growing, higher sales to customers will result in increased trade receivables, and inventories will generally increase as we build products for future sales. This may result in lower cash generated from operations. Conversely, in periods when our sales are declining, our trade accounts receivable and inventory balances will generally decrease, resulting in increased cash from operations.

 

Net cash provided by operating activities of $78.2 million for the year ended December 31, 2006, resulted mainly from net income of $94.2 million, a $27.7 million increase in operating liabilities and non-cash charges of $31.3 million for depreciation and amortization and $13.1 million for stock-based compensation, offset by an increase in net operating assets of $77.4 million and a deferred tax benefit of $11.5 million. The $27.7 million net increase in operating liabilities is mainly caused by an increase of $15.4 million in accrued expenses and other current liabilities primarily as a result of higher accrued compensation and warranty costs, an increase of $6.5 million in taxes payable as a result of higher net income and an increase of $5.7 million in accounts payable primarily as a result of inventory procurement activities. The $13.1 million for stock-based compensation resulted from the adoption of FAS 123R as of January 1, 2006. The $77.4 million increase in operating assets consisted primarily of a $33.6 million increase in accounts receivable as a result of higher revenue and a $46.0 million increase in inventory as a result of increased product demand. Net cash provided by operating activities of $64.2 million for the year ended December 31, 2005, resulted mainly from net income of $34.6 million, non-cash charges of $26.2 million for depreciation and amortization and an increase in operating liabilities of $7.7 million, offset by an increase in operating assets of $6.2 million. The increase in operating liabilities is primarily the result of a $6.4 million increase in accounts payable and a $1.4 million increase in taxes payable. The increase in operating assets is primarily the result of a $4.7 million increase in accounts receivable and a $1.8 million increase in

inventories as a result of increased production volumes in late 2005 to support higher revenues expected in the first quarter of 2006.

 

Net cash used in investing activities of $114.3 million for the year ended December 31, 2006, resulted primarily from the purchase of three technology companies for $98.7 million, purchases of property, plant and equipment of $10.7 million and net purchases of $4.6 million of available for sale investments. Net cash provided by investing activities of $20.0 million for the year ended December 31, 2005 resulted primarily from the net maturities and sales of $29.2 million of available for sale investments offset by the purchase of property, plant and equipment of $10.3 million for investments in manufacturing equipment and for the consolidation of our IT infrastructure.

 

Net cash provided by financing activities of $30.5 million for the year ended December 31, 2006, consisted primarily of $23.3 million in proceeds from the exercise of stock options and purchases under our employee stock purchase plan and $5.2 million in net proceeds from short-term borrowings. Net cash provided by financing activities of $0.9 million for the year ended December 31, 2005 consisted primarily of $6.1 million in proceeds from the exercise of stock options and purchases under our employee stock purchase plan, partially offset by $2.0 million in principal payments on long-term debt and net payments of $2.7 million on short-term borrowings.

 

On August 1, 2006, we renewed an unsecured short-term LIBOR based loan agreement with a bank to be utilized primarily by our Japanese subsidiary for short-term liquidity purposes. The credit line, which expires on July 31, 2007, provides for us to borrow in multiple currencies of up to an equivalent of $35.0 million U.S. dollars. At December 31, 2006, we had outstanding borrowings of $16.8 million U.S. dollars, payable on demand, at an interest rate of 1.45%, with $18.2 million available for future borrowings.

 

Our Japanese subsidiary also has credit lines and short-term borrowing arrangements with a financial institution, which provide for aggregate borrowings as of December 31, 2006 of up to $12.6 million, which generally expire and are renewed in three month intervals. At December 31, 2006, total borrowings outstanding under these arrangements was $5.0 million, at an interest rate of 1.5%, with $7.6 million available for future borrowings.

 

We have provided financial guarantees for certain unsecured borrowings and have standby letters of credit, some of which do not have fixed expiration dates. At December 31, 2006, our maximum exposure as a result of these standby letters of credit and performance bonds was approximately $0.9 million.

 

Future payments due under debt, lease and purchase commitment obligations as of December 31, 2006 (in thousands) are as follows:

 

 

 

 

We believe that our working capital, together with the cash anticipated to be generated from operations, will be sufficient to satisfy our estimated working capital and planned capital expenditure requirements through at least the next 12 months.

 

On February 12, 2007, our Board of Directors approved a share repurchase program (the “Program”) for the repurchase of up to $300 million of our outstanding stock over the next two years. The repurchases may be made from time to time on the open market or through privately negotiated transactions. The timing and amount of any shares repurchased under the Program will depend on a variety of factors, including price, corporate and regulatory requirements, capital availability, and other market conditions. The Program may be discontinued at any time at our discretion and the discretion of our Board of Directors.

 

To the extent permitted by Massachusetts law, our Restated Articles of Organization, as amended, require us to indemnify any of our current or former officers or directors or any person who has served or is serving in any capacity with respect to any of our employee benefit plans. Because no claim for indemnification has been pursued by any person covered by the relevant provisions of our Restated Articles of Organization, we believe that the estimated exposure for these indemnification obligations is currently minimal. Accordingly, we have no liabilities recorded for these requirements as of December 31, 2006.

 

We also enter into agreements in the ordinary course of business which include indemnification provisions. Pursuant to these agreements, we indemnify, hold harmless and agree to reimburse the indemnified party, generally our customers, for losses suffered or incurred by the indemnified party in connection with certain patent or other intellectual property infringement claims, and, in some instances, other claims, by any third party with respect to our products. The terms of these indemnification obligations are generally perpetual after execution of the agreements. The maximum potential amount of future payments we could be required to make under these indemnification agreements is, in some instances, not contractually limited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification obligations. As a result, we believe the estimated fair value of these obligations is minimal. Accordingly, we have no liabilities recorded for these obligations as of December 31, 2006.

 

When, as part of an acquisition, we acquire all of the stock or all of the assets and liabilities of another company, we assume liability for certain events or occurrences that took place prior to the date of acquisition. The maximum potential amount of future payments we could be required to make for such obligations is undeterminable at this time. Other than obligations recorded as liabilities at the time of the acquisitions, historically we have not made significant payments for these indemnifications. Accordingly, no liabilities have been recorded for these obligations.

 

In conjunction with certain asset sales, we may provide routine indemnifications whose terms range in duration and often are not explicitly defined. Where appropriate, an obligation for such indemnifications is recorded as a liability. Because the amounts of liability under these types of indemnifications are not explicitly stated, the overall maximum amount of the obligation under such indemnifications cannot be reasonably estimated. Other than obligations recorded as liabilities at the time of the asset sale, historically we have not made significant payments for these indemnifications.

 

Derivatives

 

We conduct our operations globally. Consequently, the results of our operations are exposed to movements in foreign currency exchange rates. We hedge a portion of our forecasted foreign currency denominated intercompany sales of inventory, over a maximum period of 15 months, using forward foreign exchange contracts (“forward exchange contracts”) primarily related to Japanese and European currencies. These derivatives are designated as cash-flow hedges, and changes in their fair value are carried in accumulated other comprehensive income in our consolidated statements of stockholder’s equity until the hedged transaction affects earnings. When the hedged transaction affects earnings, the appropriate gain or loss from the derivative designated as a hedge of the transaction is reclassified from accumulated other comprehensive income to cost of sales in the consolidated statements of operations. As of December 31, 2006, the amount that will be reclassified from accumulated other comprehensive income to cost of sales over the next twelve months is an unrealized gain of $0.6 million, net of taxes. The ineffective portions of the derivatives are recorded in cost of sales and were $0 in 2006, 2005 and 2004, respectively.

 

We also hedge certain intercompany and other payables with forward exchange contracts. Typically, as these derivatives hedge existing amounts that are denominated in foreign currencies, the derivatives do not qualify for hedge accounting. The foreign exchange gain or loss on these derivatives was immaterial in 2006, 2005 and 2004.

 

Realized and unrealized gains and losses on forward exchange contracts that do not qualify for hedge accounting are recognized immediately in earnings. The cash flows resulting from forward exchange contracts that qualify for hedge accounting are classified in our consolidated statements of cash flows as part of cash flows from operating activities. Cash flows resulting from forward exchange contracts that do not qualify for hedge accounting are classified in our statements of cash flows as investing activities. We do not hold or issue derivative financial instruments for trading purposes.

 

We had forward exchange contracts with notional amounts totaling $20.3 million outstanding at December 31, 2006, of which, $14.6 million were outstanding to exchange Japanese yen for U.S. dollars. We had forward exchange contracts with notional amounts totaling $35.3 million outstanding at December 31, 2005, of which, $28.5 million were outstanding to exchange Japanese yen for U.S. dollars. We had forward exchange contracts with notional amounts totaling $26.3 million outstanding at December 31, 2004 of which $21.6 million were outstanding to exchange Japanese yen for U.S. dollars.

 

Gains and losses on forward exchange contracts that qualify for hedge accounting are classified in cost of goods sold and totaled a gain of $1.9 million and $0.8 million for the years ended December 31, 2006 and 2005, respectively, and a loss of $1.7 million and for the year ended December 31, 2004.

 

Off-Balance Sheet Arrangements

 

We do not have any financial partnerships with unconsolidated entities, such as entities often referred to as structured finance, special purpose entities or variable interest entities which are often established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had such relationships.

 

Recently Issued Accounting Pronouncements

 

In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes (FIN 48), to create a single model to address uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized for financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting for interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 as of January 1, 2007 as required. The cumulative effect, if any, of adopting FIN 48 will be recorded in retained earnings. Although our assessment of the impact of FIN 48 is not yet complete, we expect that its adoption will not have a material impact on our financial statements.

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 requires companies to evaluate the materiality of identified unadjusted errors on each financial statement and related financial statement disclosure using both the rollover approach and the iron curtain approach. The rollover approach quantifies misstatements based on the amount of the error in the current year financial statement whereas the iron curtain approach quantifies misstatements based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of the misstatement’s year(s) of origin. Financial statements would require adjustment when either approach results in quantifying a misstatement that is material. Correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. SAB 108 is effective for interim periods of the first fiscal year ending after November 15, 2006. The adoption of SAB 108, in the fourth quarter of 2006, did not have a material impact on our financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those

assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS 157 is effective for fiscal year beginning after November 15, 2007, with early adoption permitted. We are in the process of evaluating any potential impact of SFAS 157.

 

Market Risk and Sensitivity Analysis

 

Our primary exposures to market risks include fluctuations in interest rates on our investment portfolio, short and long term debt as well as fluctuations in foreign currency exchange rates.

 

  Foreign Exchange Rate Risk

 

We enter into forward exchange contracts to reduce currency exposure arising from intercompany sales of inventory.

 

There were forward exchange contracts with notional amounts totaling $20.3 million and $35.3 million outstanding at December 31, 2006 and 2005, respectively. Of such forward exchange contracts, $14.6 million and $28.5 million, respectively, were outstanding to exchange Japanese yen for U.S. dollars with the remaining amounts relating to contracts to exchange the British pound and Euro for U.S. dollars. The potential fair value loss for a hypothetical 10% adverse change in the forward currency exchange rate on our forward exchange contracts at December 31, 2006 and 2005 would be $2.0 million and $3.4 million, respectively. The potential losses in 2006 and 2005 were estimated by calculating the fair value of the forward exchange contracts at December 31, 2006 and 2005 and comparing that with those calculated using the hypothetical forward currency exchange rates.

 

At December 31, 2006 and 2005 we had $11.7 million and $59.4 million, respectively, in loans outstanding between subsidiaries that were subject to foreign exchange exposure. At December 31, 2006 and 2005 a hypothetical 10% adverse change in foreign exchange rates would result in a net transaction loss of $1.3 million and $6.6 million, respectively, which would be recorded in current earnings.

 

At December 31, 2006 and 2005, we had $21.8 million and $17.0 million, respectively, related to short-term borrowings and current portion of long-term debt denominated in Japanese yen. The carrying value of these short-term borrowings approximates fair value due to their short period to maturity. Assuming a hypothetical 10% adverse change in the Japanese yen to U.S. dollar year end exchange rate, the fair value of these short-term borrowings would increase by $2.4 million and $1.9 million, respectively. The potential increase in fair value was estimated by calculating the fair value of the short-term borrowings at December 31, 2006 and 2005, respectively, and comparing that with the fair value using the hypothetical year end exchange rate.

 

  Interest Rate Risk

 

Due to its short-term duration, the fair value of our cash and investment portfolio at December 31, 2006 and 2005 approximated its carrying value. Interest rate risk was estimated as the potential decrease in fair value resulting from a hypothetical 10% increase in interest rates for securities contained in the investment portfolio. The resulting hypothetical fair value was not materially different from the year-end carrying values.

 

Our total long-term debt outstanding, including the current portion, at December 31, 2006 and 2005, was $5.0 million and $6.7 million, respectively, and consisted mainly of a mortgage note and industrial development revenue bond. The interest rate on these debt instruments was 3.95% at December 31, 2006 and ranged between 3.0% to 5.6% at December 31, 2005. Due to the immaterial amounts of the outstanding debt, a hypothetical change of 10% in interest rates would not have a material effect on our near-term financial condition or results of operations.

 

From time to time, MKS has outstanding short-term borrowings with variable interest rates, primarily denominated in Japanese yen. At December 31, 2006 and 2005, we had $21.8 million and $17.0 million, respectively, outstanding related to these short-term borrowings at interest rates ranging from 1.45% to 1.50% and 1.21% to 1.31%, respectively. Due to the short-term nature and amount of this short-term debt, a hypothetical change of 10% in interest rates would not have a material effect on our near-term financial condition or results of operations.

 

To the Board of Directors and Shareholders of
MKS Instruments, Inc.:

 

We have completed integrated audits of MKS Instruments, Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006 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.(a)1. present fairly, in all material respects, the financial position of MKS Instruments, Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 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.(a)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 2 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation in fiscal 2006.

 

Internal control over financial reporting

 

Also, in our opinion, management’s assessment, included in Management’s Annual Report on Internal Control over Financial Reporting appearing under item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring 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 December 31, 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 accordance 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.

 

As described in Management’s Annual Report on Internal Control over Financial Reporting, management has excluded Ion Systems Inc. (“Ion”), Umetrics, AB. (“Umetrics”) and Novx Corp. (“Novx”) from its assessment of internal control over financial reporting as of December 31, 2006 because they were acquired by the Company in a purchase business combination during 2006. We have also excluded Ion, Umetrics and Novx from our audit of internal control over financial reporting. Ion, Umetrics and Novx are wholly-owned subsidiaries whose total assets and total revenues represent 12% and 5%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2006.

 

PricewaterhouseCoopers LLP

 

Boston, Massachusetts

February 28, 2007

MKS INSTRUMENTS, INC.

 

 

The accompanying notes are an integral part of the consolidated financial statements.

MKS INSTRUMENTS, INC.

 

 

The accompanying notes are an integral part of the consolidated financial statements.

MKS INSTRUMENTS, INC.

 

 

The accompanying notes are an integral part of the consolidated financial statements.

MKS INSTRUMENTS, INC.