Item 1. Business.
Overview
Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) is the leading supplier of ion implantation systems used in the fabrication of semiconductor chips. Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment for virtually all of the major semiconductor manufacturers in the United States (“U.S.”), Europe and Asia Pacific. The VIISta™ ion implanter products are designed to leverage single wafer processing technology for the full range of semiconductor implant applications. Varian Semiconductor has shipped more than 4,000 systems worldwide.
Varian Semiconductor provides support, training, and after-market products and services that help its customers obtain high utilization and productivity, reduce operating costs, and extend capital productivity of investments throughout multiple product generations. In fiscal year 2008, Varian Semiconductor was ranked number one in customer satisfaction in VLSI Research Inc.’s customer survey for all large suppliers of wafer processing equipment, an honor received in eleven of the past twelve years.
Varian Semiconductor’s business is cyclical. The business depends upon semiconductor manufacturers’ expectations and resulting capacity investments for future integrated circuit demand. From 2005 to 2007, the total available market for ion implanters grew as memory manufacturers increased capacity to meet demand. During this time, Varian Semiconductor realized significant market share gains through a superior product portfolio. In 2008, the total available market for the entire capital equipment industry is expected to decrease by over 25% due to excess manufacturing capacity. It is expected that Varian Semiconductor will realize modest market share growth in 2008. Calendar year 2008 market share reports are expected to be released in April 2009.
Varian Semiconductor maintains a website at www.vsea.com. The information contained on the Varian Semiconductor website is not included in, or incorporated by reference into, this Annual Report on Form 10-K. Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, are made available through the Varian Semiconductor website, free of charge, as soon as reasonably practicable following the electronic filing or furnishing of such materials by Varian Semiconductor to the Securities and Exchange Commission (“SEC”) and are available at the SEC’s website at www.sec.gov.
The Industry
The semiconductor industry is essentially two different, but connected industries-microchip and capital equipment (“capex”). The microchip industry is where microprocessors, dynamic random access memory (“DRAM”), operational amplifiers and hundreds of other electronic circuits are created on small squares of silicon known as “chips” or “die”. The manufacturers of these circuits can be categorized as either logic, memory, foundry, analog or discrete. Logic, memory and foundry represent the bulk of the industry. Logic manufacturers design and make chips that process information. Memory manufacturers design and make chips that store information. Foundry manufacturers are contractors that take chip designs from other companies and make the chips for them. Over the last several years the demand for memory chips has outstripped the demand for logic chips. As the demand for memory-intensive applications such as cameras, phones and MP3 players grows, it is expected that memory will continue to represent the bulk of chips made worldwide.
The capex industry is where Varian Semiconductor participates. The capex industry is comprised of companies that manufacture equipment used in the production of microchips. The two segments of the capex industry are known as Front End of the Line (“FEOL”) and Back End of the Line (“BEOL”). In the FEOL, the various circuit components such as transistors, diodes, resistors and capacitors are formed. In the BEOL, the wires, or interconnect, that join all of the components together to form the circuit are created. Varian manufactures tools
that form the circuit components in the FEOL. The entire semiconductor industry has grown so rapidly because it is continually able to provide more functionality for a lower cost. In order to achieve this dynamic and be successful, capex companies must innovate through aggressive research and development. The technology and applications that drive the entire industry are developed by the capex companies.
During the past five to ten years, however, the semiconductor capital equipment market has experienced a slowdown in growth as compared to historical levels. This is the result of improved productivity and efficiencies of capital equipment, the transition to larger 300mm (approximately 12 inch) wafers, the changing demand for next generation processing chips and the increasing technical difficulties with putting more and more transistors on a microchip.
Semiconductor manufacturing is highly competitive with each manufacturer seeking to provide products that consume the least amount of power, and have the lowest cost and fastest processing speed. Integrated circuit manufacturers generally rely on equipment suppliers for the timely development of equipment and processes to meet their rapidly changing and complex requirements. Today, a semiconductor fabrication factory, or “fab,” can cost over $3 billion. As the industry transitions to 32nm (32 billionths of a meter) devices, these costs are expected to increase.
The fabrication of integrated circuits requires a number of complex and repetitive processing steps, including deposition, photolithography, etch, metrology, anneal and ion implantation. Deposition is a process in which a film of either electrically insulating or electrically conductive material is deposited on the surface of a wafer. Photolithography is used to transfer a circuit pattern onto a light-sensitive material called photo-resist that, after development, can be used in turn to transfer the pattern onto the silicon surface. The etch process completes the transfer of the pattern into the various thin films used to make the integrated circuit. Metrology measures critical features and properties of the device to ensure correct fabrication. Anneal is used to incorporate implanted impurities into the silicon crystal matrix and make them electrically active. Ion implantation provides a means for introducing impurities into the silicon crystal, typically into selected areas defined by the photolithographic process. The selective implanting of ions into defined areas creates electrically conductive and non-conductive areas that form the transistors of the integrated circuits.
Semiconductor manufacturers have historically sought to increase the number of transistors on each microchip by “shrinking” device structures. Through this relentless miniaturization, microchips have chronologically increased their processing capability or memory storage capacity. This is accomplished by exploiting advancements in photolithography. Each new advancement in photolithography is described by the minimum resolvable geometry and is commonly referred to as a “device node.” State-of-the-art production is now accomplished at 45nm nodes with 32nm nodes currently in development at more technologically advanced fabs.
Improved productivity has been accomplished by transitioning to larger and larger silicon substrates, or wafers. From 25mm wafers used in the 1970’s to the current state-of-the-art wafer size at 300mm, each successive generation increases the number of microchips per wafer thereby increasing productivity. The use of a larger wafer generally requires a great deal of infrastructure changes in equipment and factory automation systems, so transitions only occur about every 10 years. The use of 200mm wafers in production began at the end of the 1980’s. The migration from 200mm to 300mm began at the end of the 1990’s. 300mm tool sales now represent the majority of all new tool sales.
To achieve higher yields, implant systems must be capable of repeating the original process on a consistent basis for all devices on the wafer and for every wafer. These characteristics are known in the industry as “uniformity” and “repeatability.” In addition, implant systems must process wafers without damaging the device structures or introducing device-damaging contamination, which is typically characterized by “cross contamination levels” and “particle defect adders.” In many cases, implant performance is measured directly from the electrical performance of actual devices or device test structures. This is called “electrical parametrics.” In production fabs, there are typically multiple ion implantation systems performing the same processes in order to meet the
production demands of the fab. In order to allow the greatest flexibility, semiconductor manufacturers require that each system perform equally well on each device step. This characteristic is known as “tool-to-tool” matching. In advanced device production, semiconductor manufacturers will often adjust the implant processes to compensate for variability in processes upstream from the implanter, making the implanter’s accuracy another important attribute. Uniformity, repeatability, accuracy, cross contamination, defect adders, parametrics and tool-to-tool matching are all critical in achieving commercially acceptable yields.
Semiconductor manufacturers generally measure the cost performance of their production equipment in terms of “cost of ownership,” which is determined by factoring in the fixed costs for acquisition and installation of the equipment, its variable operating costs and total wafer output. Equipment with higher wafer throughput increases total output and allows the semiconductor manufacturer to recover the purchase and installation costs of the equipment over a greater number of wafers and thereby reduces the cost of ownership of the equipment on a per wafer basis. Throughput is most accurately measured on a net or overall basis, which takes into account the processing speed of the equipment and any system setup and non-operational downtime for cleaning, maintenance or other repairs. The increased difficulty of achieving desired transistor performance at advanced nodes has made high yields important in selecting processing equipment. The most desired systems are those that can achieve process results within critical tolerance limits and still operate at desired throughput rates.
The continuing evolution of semiconductor devices to smaller geometries and more complex multi-level circuitry has significantly increased the cost and performance requirements of the capital equipment used to manufacture these devices. As wafer fabs are projected to increase in cost substantially for each subsequent device node, yield losses and depreciation costs will become a much larger percentage of the aggregate production costs for semiconductor manufacturers relative to labor, materials and other variable manufacturing costs. As a result, there has been increasing focus by the semiconductor industry on obtaining increased capability and productivity to maintain returns from semiconductor manufacturing equipment, thereby increasing the revenue generated and reducing the effective cost of ownership of such systems.
Products
Varian Semiconductor designs, markets, manufactures and services ion implantation systems which are used to build the transistors that are the basis of integrated circuits. Ion implanters have the ability to implant selected elements into silicon wafers at precise locations and depths. Ion implanters create a beam of electrically charged particles called ions. Ions are created by taking elements like phosphorous or boron and removing an electron from the atomic structure. The charge on an ion allows the implanter to create a beam. The ion implanter embeds the ions into the silicon crystal structure, changing the electrical properties of the silicon. Implanted ions, or dopant, forms transistors which are a building block of all electronic circuits. Since these transistors are the starting point of all subsequent process steps, repeatability, uniformity and yield are extremely important.
The most advanced microchip fabrication factories (known as device fabs, or chip fabs) might have as many as 30 separate implant steps. An implant is characterized by the dose (amount of dopant) and the energy (depth that dopant goes into the silicon wafer). Varian Semiconductor provides four different single wafer implanter products which cover the full range of required applications in these implant sectors: high current-high dose, low energy; ultra high dose-very high dose, very low energy; medium current-low dose, medium energy; high energy-low dose, very high energy. There is some overlap of each implanter’s application coverage with the next. However, each implanter is designed to provide maximum productivity and yield within their respective application ranges.
Varian Semiconductor currently offers the following products:
Medium Current
Recognized as the industry benchmark for medium current performance and productivity, Varian Semiconductor’s single wafer VIISta 900XP series of ion implanters provide superior overall throughput, precision doping capability and unmatched contamination control. These systems excel at threshold voltage (“Vt”), channel, retrograde well, pocket, and halo implants. Varian Semiconductor’s other medium current systems include the VIISta 810HP and VIISta 810XE ion implanters. In addition, Varian Semiconductor continues to provide support for its older generation VIISta and legacy medium current ion implanters still in use by its customers.
The medium current sector has increased in size recently due to two factors. To achieve higher device speeds, chip designers often increase manufacturing process complexity by utilizing multiple transistor designs in the same integrated circuit. Multiple transistors require multiple implants, particularly the Vt implant. Additionally, energies are decreasing for all implant recipes as chips become more complex. This allows certain retrograde well implants to be processed on more productive, less expensive, medium current tools.
Medium current implanters are used in logic, memory and foundry manufacturers. In calendar year 2007, medium current represented about 34% of the total available market (“TAM”) for ion implant, or $454 million.
High Current
The high current VIISta HCS series of single wafer ion implanter provides the highest productivity and best contamination performance. In addition, these systems feature superior implant angle accuracy, beam steering correction and high-tilt angle capability-all of which are required for advanced device fabrication. The VIISta HCS has excellent process control capability for advanced ultra shallow junction applications, and can be used for source/drain, source/drain extension, gate doping, pre-amorphization, and materials modification applications. In addition, Varian Semiconductor continues to provide support for its older generation VIISta and legacy high current ion implanters still in use by its customers.
The high current sector is expected to grow relative to the overall implant market due to an increase in the number of implant steps needed to produce many advanced microchips. Due to the very low energies and high dose concentrations that are necessary for increased transistor speed and lower device power consumption, the productivity of high current systems tends to decline with advancing technology nodes, requiring more high current implanters. Varian Semiconductor was the first to introduce single wafer systems to this market sector through its VIISta platform.
High current implanters are used in logic, memory and foundry manufacturers. In calendar year 2007, high current represented about 50% of the TAM for ion implant, or $672 million.
High Energy
The high energy VIISta HE features True ZeroTM degree implant and low contamination. The Varian Semiconductor high energy portfolio’s True ZeroTM capability provides a distinct advantage for semiconductor manufacturers that need increased device packing density in high-performance devices. The VIISta HE has outstanding process accuracy, offers excellent productivity, uniformity, angle control and medium current back-up flexibility. Varian Semiconductor’s high energy products cover retrograde well, triple well, buried layers, and pocket applications. Varian Semiconductor continues to provide support for its legacy high energy ion implanters still in use by its customers.
High energy implanters are used in most wafer fabs, but predominantly by memory manufacturers. In calendar year 2007, high energy represented about 11% of the TAM for ion implant, or $147 million.
Ultra High Dose
Medium current, high current and high energy tools utilize a focused ion beam to achieve the desired dose and energy for particular implant specie. For ultra high dose applications, the VIISta PLAD tool uses an altogether different technology. A plasma, or ionized gas, of the desired specie is created in a chamber where the wafer is held to a platen. A pulsed DC voltage is applied to the wafer platen which draws ions to the wafer at an energy level proportional to the DC pulse. This approach creates very high dose rates at low energies and provides conformal doping capability where the dopant covers all the angled surface features of the wafer uniformly. Varian Semiconductor has implemented many advanced control features on VIISta PLAD such as closed loop dosimetry to ensure accurate dosing of the wafer. With throughput up to six times greater than traditional beamline or modified-source beamline technologies, the VIISta PLAD has become an attractive solution for new critical very low-energy, very high-dose applications, such as dual poly gate.
Ultra high dose systems are currently used only by memory manufacturers. As applications develop, Varian Semiconductor expects ultra high dose tools to be used in all types of wafer fab facilities. In calendar year 2007, ultra high dose represented about 5% of the TAM for ion implant, or $64 million. The ultra high dose sector is expected to continue to grow in 2008.
VIISta Platform
The VIISta 900XP, VIISta HCS, VIISta PLAD and VIISta HE are based on the same platform, thereby providing a high degree of commonality in subsystems and overall architecture. The VIISta platform provides customers with a great deal of flexibility in managing overall bay productivity, resulting in a reduction in customers’ time to first silicon, greater productivity across all applications, and an increase on their return on investment. Varian Semiconductor has shipped more than 990 VIISta systems. The VIISta platform of ion implanters is the only single wafer platform solution for all production applications. All of the VIISta products feature the Varian Control System (“VCS™”), the Varian Positioning Systems (“VPS™”), and the VIISta single wafer end-station. This high degree of commonality across the VIISta platform facilitates process matching throughout the system set, and provides flexibility in managing capacity, product mix changes, spare parts and training.
Customer Support and Services
Varian Semiconductor provides support services designed to maximize the productivity of its customers’ equipment and to increase uptime through the effective management of machine maintenance, parts inventory and product support. All of these services provide a direct link to Varian Semiconductor’s manufacturing facility and research centers.
Varian Semiconductor provides a wide range of programs, from a complete turnkey solution that supports the wafer fab’s ion implant performance, to economical service plans for those who require less support. These programs are customized to specific customer requirements, provide dedicated labor to maintain and troubleshoot the ion implanter, and make available on-call 24/7 service for around-the-clock support. Since 1984, Varian Semiconductor has been developing upgrades for the installed base that extends the life of the capital equipment. These upgrades provide its customers with benefits that are focused around increasing productivity and reducing cost-of-ownership. Specifically, the benefits are realized as enhancements to throughput, yield, uptime, maintenance and ergonomics improvements.
For parts management, Varian Semiconductor has approximately 30 parts banks strategically placed around the world that support more than 200 customer fabs. The use of a global enterprise resource planning system provides Varian Semiconductor with a distribution structure that efficiently manages inventory, delivery and logistics services. Varian Semiconductor also offers a comprehensive consumable and non-consumable parts program that can be tailored to individual fab needs to minimize its customers’ cost of ownership from the ordering of individual piece parts over its eCommerce site, vShop, to complete stocking and inventory management programs like Fab Specific Parts Programs.
Through VEDoc™, an electronic documentation system, customers can easily access information about their Varian ion implanters. All assembly drawings, schematics, parts lists, maintenance and operation manuals, and video-illustrated maintenance procedures are available in a CD-ROM format.
Varian Semiconductor’s commitment to customer service also includes extensive and comprehensive customer training programs. Varian Semiconductor offers a full range of technical training, from the basic operation and maintenance of the toolset to electronic troubleshooting and alignments. Training is available for all ion implanter products manufactured at Varian Semiconductor (medium current, high current, high energy and PLAD tools), with specialized courses available in process applications.
Marketing and Sales
Varian Semiconductor markets, sells, installs and services ion implantation systems directly to semiconductor industry manufacturers and has sold ion implantation products to most of the 20 largest semiconductor manufacturers in the world. Varian Semiconductor’s sales objective is to work closely with customers to secure purchases of multiple systems as customers expand capacity, update existing facilities, introduce new manufacturing processes or build new wafer manufacturing facilities. Varian Semiconductor seeks to build customer loyalty and to achieve a high level of repeat business by offering highly reliable products that give its customers a competitive edge, comprehensive field support and responsive parts replacement and service programs.
Varian Semiconductor has historically sold at least half of its systems in any particular period to a relatively small number of customers, some of which include Chartered Semiconductor Manufacturing Ltd. (“Chartered”), Elpida Memory Inc. (“Elpida”), Hynix Semiconductor Inc. (“Hynix”), Hynix-Numonyx Semiconductor Ltd. (“Hynix-Numonyx”), Inotera Memories Inc. (“Inotera”), Intel Corp. (“Intel”), International Business Machines Corp. (“IBM”), Micron Technology Inc. (“Micron”), Qimonda AG (“Qimonda”), Rexchip Electronics Corp. (“Rexchip”), Samsung Electronics Company Ltd. (“Samsung”), Taiwan Semiconductor Manufacturing Corp. Ltd. (“TSMC”), Tech Semiconductor Singapore Pte. Ltd. (“Tech Semi”), United Microelectronics Corp. (“UMC”), and Winbond Electronics Corp. (“Winbond”). Some of these customers have individually accounted for more than 10% of Varian Semiconductor’s total revenue in some periods. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future.
Revenue from Varian Semiconductor’s ten largest customers in fiscal years 2008, 2007 and 2006 accounted for approximately 74%, 72% and 63% of total revenue, respectively. In fiscal year 2008, revenue from two customers accounted for 16% and 13%, respectively, of Varian Semiconductor’s total revenue. In fiscal year 2007, revenue from one customer accounted for 17% of Varian Semiconductor’s total revenue. In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10%, respectively, of Varian Semiconductor’s total revenue.
None of Varian Semiconductor’s customers have entered into a long-term agreement requiring it to purchase Varian Semiconductor’s products. Although Varian Semiconductor’s largest customers have varied from year to year, the loss of a significant customer or a reduction in orders from any significant customer, including reductions due to market, economic or competitive conditions in the semiconductor industry or in the industries that manufacture products utilizing integrated circuits, could adversely affect Varian Semiconductor’s business, financial condition and results of operations. In addition, sales of Varian Semiconductor’s systems depend, significantly in part, upon the decision of a prospective customer to increase manufacturing capacity in an existing fab facility, to introduce a new manufacturing process or to transfer a manufacturing process to a new fab facility, all of which typically involve a significant capital commitment. Due to these and other factors, Varian Semiconductor’s products typically have a lengthy sales cycle during which Varian Semiconductor may expend substantial funds and management effort.
Varian Semiconductor’s ability to respond with prompt and effective field support is critical to Varian Semiconductor’s sales efforts. Due to substantial operational and financial commitments, customers who purchase ion implantation systems require assurance that the manufacturer can provide the necessary installation and operational support. Varian Semiconductor’s strategy of supporting its installed base through its customer support and research and development groups has served to encourage the use of Varian Semiconductor’s systems in production applications and has accelerated penetration of certain key accounts. Varian Semiconductor believes that its marketing efforts are enhanced by the technical expertise of its research and development personnel, who provide customer process support and participate in a number of industry forums.
Varian Semiconductor markets, sells, distributes and services its products directly. Varian Semiconductor has five sales and service offices located in the U.S., five in Europe and 26 in Asia Pacific, for a total of 36 worldwide. Varian Semiconductor’s sales, marketing and service engineers are linked through Varian Semiconductor’s information technology systems, allowing Varian Semiconductor to review bookings and sales forecasts globally against detailed account management plans.
International sales accounted for 78% of Varian Semiconductor’s total revenues in each of fiscal years 2008, 2007 and 2006, and more specifically, sales to Asia Pacific have accounted for 70%, 71% and 67% of total revenues in fiscal years 2008, 2007 and 2006, respectively. (Refer to the footnotes to the financial statements for additional information on the geographic distribution of revenues and long-lived assets.)
Varian Semiconductor’s business is generally not seasonal in nature, but it is cyclical based on the capital equipment investment expenditures of major semiconductor manufacturers. These expenditure patterns are based on many factors, including anticipated market demand for integrated circuits, the development of new technologies and global economic conditions.
Backlog
Varian Semiconductor had backlog of $133.8 million and $179.0 million at the end of fiscal years 2008 and 2007, respectively. Varian Semiconductor includes in its backlog only those orders for which it has accepted purchase orders and assigned system shipment dates within the following twelve months. Orders are typically subject to cancellation or rescheduling by customers. Due to possible changes in system delivery schedules, cancellation of orders and delays in systems shipments, Varian Semiconductor’s backlog at any particular date is not necessarily an accurate predictor of revenue for any succeeding period.
Manufacturing
Varian Semiconductor manufactures its products at its facility in Gloucester, Massachusetts. Varian Semiconductor benefits from the use of advanced manufacturing methods and technologies, including lean manufacturing and demand flow technology.
Varian Semiconductor purchases materials from multiple suppliers worldwide. Varian Semiconductor closely monitors overall demand and supply processes worldwide to ensure continuous availability. Additionally, long-lead agreements with suppliers are employed to provide a strategic safety stock at supplier locations.
Varian Semiconductor concentrates on product design characterization, high-level assembly and tests to reduce cycle time and improve its responsiveness in an inherently cyclical capital equipment market. Varian Semiconductor believes that outsourcing non-core competency assemblies enables it to minimize its fixed costs and capital expenditures, while also providing the flexibility to increase or decrease production capacity. Varian Semiconductor purchases materials and components that are either standard products or built to Varian Semiconductor’s specifications. This strategy also allows Varian Semiconductor to focus on product differentiation through system design and quality control. Varian Semiconductor’s manufactured subsystems incorporate advanced technologies in robotics, vacuum and microcomputers. Varian Semiconductor works
closely with its suppliers to achieve mutual cost reductions through joint design efforts. Varian Semiconductor manufactures and tests selected components and systems in clean-room environments that are similar to the clean-rooms used by semiconductor manufacturers for wafer fabrication. This procedure is intended to reduce installation and production qualification times and the amount of particulates and other contaminants in the assembled system, which in turn improves yield and reduces downtime for the customer.
Quality efforts at Varian Semiconductor begin with product development. Varian Semiconductor uses three dimensional computer-aided design, finite element analysis and other computer-based modeling methods to engineer and validate new designs. Product design is tested throughout all stages of development and validated through use of a “phase-gate” product introduction process before the first production system is built. Concurrent engineering programs coupled with product transition strategies integrate new designs into manufacturing quickly and successfully.
Competition
The semiconductor capital equipment market is highly competitive and is characterized by a small number of large companies. The larger companies include Applied Materials, Tokyo Electron Limited, KLA-Tencor Corporation (“KLA-Tencor”), Nikon Corporation, Canon, Inc., Novellus Systems, Inc. (“Novellus”), Lam Research Corporation, and Hitachi High Technologies Corporation. Varian Semiconductor faces significant competition in the ion implantation market sector. Within ion implant, multiple implant suppliers participate in one or more implant sectors. Generally, for each system selection, Varian Semiconductor is competing with one or more major competitors. As reported by Gartner Dataquest for calendar year 2007, the revenue market share for ion implantation equipment was Varian Semiconductor 65%, Axcelis Technologies, Inc. (“Axcelis”) 12%, Applied Materials 3%, Sumitomo Eaton Nova Corporation 10%, Nissin Electric Company, Limited 9%, and Ulvac Technologies, Inc. 1%.
There are significant competitive factors in the ion implantation market that affect a company’s ability to succeed. Primary factors include the quality of strategic relationships with customers, the cost of ownership of the equipment, performance reliability of the equipment, the quality and cost of customer support, speed and cost-effectiveness of distribution and financial viability of the supplier. Secondary factors include, size of manufacturer, installed customer base and breadth of product line. Due to the constant innovation that has characterized semiconductor manufacturers, it is possible that the application needs and manufacturing technologies used by customers may change, significantly disrupting historical trends in the market. Varian Semiconductor believes it competes favorably in the ion implant business. To remain competitive, Varian Semiconductor recognizes it may require significant financial resources in order to offer a broad range of products, to maintain customer service and support centers worldwide and to invest in product and process research and development.
Research and Development
The semiconductor manufacturing industry is subject to rapid technological change requiring new product introductions and enhancements. Varian Semiconductor’s ability to remain competitive in this market will depend in part upon its ability to develop new and enhanced systems and to introduce these systems at competitive prices and on a timely and cost-effective basis. Accordingly, Varian Semiconductor devotes a significant portion of its personnel and financial resources to research and development programs and seeks to maintain close relationships with its customers to remain responsive to their product needs.
Varian Semiconductor’s current research and development efforts are directed at development of new systems and processes and improving existing system capabilities. Varian Semiconductor currently focuses its research and development efforts on the enhancement of its VIISta platform. The VIISta platform is designed to cover the complete range of implants required for the next several generations of integrated circuits. The VIISta single wafer platform allows customers to use a single platform for all implant applications including high current, ultra high dose, medium current and high energy.
Expenditures by Varian Semiconductor for research and development during fiscal years 2008, 2007 and 2006 were $111.2 million, $104.0 million, and $90.6 million, respectively. Varian Semiconductor expects in future years that research and development expenditures will continue to represent a substantial percentage of operating expenses. In addition to developing new high current, ultra high dose and high energy products, Varian Semiconductor continues to focus on maintaining its leadership position in the market for medium current, high current and ultra high dose implanters, improving its position in the high energy business and continuing to invest in additional new and next generation products.
Patent and Other Proprietary Rights
Varian Semiconductor pursues a policy of seeking patent, copyright, trademark and trade secret protection in the U.S. and other countries for developments, improvements and inventions originating within its organization that are incorporated in Varian Semiconductor’s products or that fall within its fields of interest. As of November 17, 2008, Varian Semiconductor owned approximately 154 patents in the U.S., 126 patents in other countries, and had 640 patent applications on file with various patent agencies worldwide. Varian Semiconductor intends to file additional patent applications as appropriate.
Varian Semiconductor relies on a combination of patent, copyright, trademark, trade secret and other laws, and contractual restrictions on disclosure, copying and transferring title to protect its rights. Varian Semiconductor has trademarks, both registered and unregistered, that are maintained and enforced to provide customer recognition for its products in the marketplace. Varian Semiconductor also has agreements with third parties that provide for licensing of patented or proprietary technology. These agreements include royalty-bearing licenses and technology cross-licenses. The termination of certain of such licenses could have a material adverse effect on Varian Semiconductor’s business.
Varian Semiconductor’s competitors, like companies in many high-technology businesses, routinely review the products of others for possible conflict with their own patent rights. There has also been substantial litigation regarding patent and other intellectual property rights in semiconductor-related industries. Varian Semiconductor, its customers or suppliers could be subject to additional claims of patent infringement, and any such claim could require that Varian Semiconductor pay substantial damages or remove certain features from its products or both.
Pursuant to the dispute resolution provisions of an Agreement dated January 1, 1992 (“the Agreement”) between Varian Semiconductor and Applied Materials, Varian Semiconductor in September 2002 filed an arbitration demand with the American Arbitration Association asserting that Applied Materials breached the Agreement by failing to pay royalties on products Varian Semiconductor believed were covered by the Agreement’s patent license to Applied Materials. In its arbitration demand, Varian Semiconductor sought to recover back royalties, interest and attorneys’ fees. On May 2, 2003, the arbitration panel issued its decision that certain of Applied Materials’ products were subject to royalty obligations under the Agreement, and on September 1, 2004, the arbitration panel ruled that the patents at issue in the arbitration were valid and enforceable. Applied Materials made an initial payment of $22.0 million for back royalties and interest on October 4, 2004 and a final payment of $2.6 million for back interest and royalties on November 8, 2004. Applied Materials also was required to pay quarterly unit-based royalty payments to Varian Semiconductor on sales of certain products found to be within the scope of the Agreement through expiration of the Agreement on March 20, 2007.
Royalty-bearing license agreements produced revenue of $0.1 million in fiscal year 2008, $7.5 million in fiscal year 2007 and $9.5 million in fiscal year 2006. The last of the principal patents covered by these licenses expired on March 20, 2007.
Environmental Matters
For a discussion of environmental matters, see “Risk Factors,” in Item 1A
Item 1A. Risk Factors.
Recent deterioration in the global economy and credit markets may adversely affect Varian Semiconductor’s future results of operations.
Varian Semiconductor’s operations may be adversely affected by the recent deterioration in the global economy causing Varian Semiconductor’s customers to delay or cease spending on Varian Semiconductor’s products. The recent tightening of the credit markets may negatively impact Varian Semiconductor’s operations by affecting the solvency of Varian Semiconductor’s customers and key suppliers and the ability of Varian Semiconductor’s customers to obtain credit to finance purchases of Varian Semiconductor’s products. If the global economy and credit markets continue to deteriorate, Varian Semiconductor’s financial condition and results of operations could be adversely impacted.
The semiconductor industry is cyclical, and a slowdown in demand for Varian Semiconductor’s semiconductor manufacturing equipment may negatively affect financial results.
The semiconductor industry historically has been cyclical in nature and has experienced periodic downturns. The industry may experience volatility in product pricing and in product demand. Volatility may result in significant reductions and delays in the purchase of semiconductor manufacturing equipment and the construction of new fab facilities. If such significant reductions and delays in purchasing occur and Varian Semiconductor has procured materials prior to the receipt of the customer purchase order, significant inventory charges could be incurred, thereby negatively impacting Varian Semiconductor’s financial results. In addition, even though Varian Semiconductor’s revenues may fluctuate significantly from period to period, in order to remain competitive, Varian Semiconductor continues to invest in research and development and to maintain its worldwide customer service and support capabilities. These investments in the business may adversely affect Varian Semiconductor’s financial results.
Varian Semiconductor faces intense competition in the semiconductor equipment industry.
Significant competitive factors in semiconductor equipment manufacturing include the strength of customer relationships, pricing, technological performance and timing, distribution capabilities and financial viability. Varian Semiconductor believes that in order to remain competitive in this industry, it will need to devote significant financial resources to research and development, to offer and market a broad range of products, and maintain and enhance customer service and support centers worldwide. The semiconductor equipment industry is increasingly dominated by large manufacturers who have resources to support customers worldwide, and some of Varian Semiconductor’s competitors have substantially greater financial resources and more extensive engineering, manufacturing, marketing, service and support than does Varian Semiconductor. With fewer resources, Varian Semiconductor may not be able to match the product offerings or customer service and technical support offered by its competitors. In addition, there are several smaller companies that provide innovative technology that may have performance advantages over Varian Semiconductor’s systems. If these manufacturers continue to improve their product performance and pricing, enter into strategic relationships, expand their current targeted geographic territory or consolidate with large equipment manufacturers, sales of Varian Semiconductor’s products may be adversely affected.
Varian Semiconductor derives a substantial portion of its revenues from a small number of customers, and its business may be harmed by the loss of any one significant customer.
From time to time within the same accounting period, Varian Semiconductor has sold significant percentages of its systems to its major customers, some of which include Chartered, Elpida, Hynix, Hynix-Numonyx, IBM, Inotera, Intel, Micron, Qimonda, Rexchip, Samsung, Tech Semi, TSMC, UMC and Winbond. During some quarters, some of these customers have individually accounted for more than 10% of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. Furthermore, Varian Semiconductor may
have difficulty attracting additional large customers because its sales depend, in large part, upon the decision of a prospective customer to increase manufacturing capacity in an existing fabrication facility or to transfer a manufacturing process to a new fabrication facility, both of which typically involve a significant capital commitment. Once a semiconductor manufacturer has selected a particular supplier’s capital equipment, the manufacturer generally relies upon that equipment for the specific production line application. Consequently, Varian Semiconductor may experience difficulty in selling to a prospective customer if that customer initially selects a competitor’s capital equipment.
Varian Semiconductor’s quarterly results of operations are likely to fluctuate, and as a result, Varian Semiconductor may fail to meet the expectations of its investors and securities analysts, which may cause the price of its common stock to decline.
Varian Semiconductor has experienced and expects to continue to experience significant fluctuations in its quarterly financial results. From time to time, customers may accelerate, postpone or cancel shipments, or production difficulties may delay shipments. A cancellation, delay in shipment or delay in customer acceptance of the product upon installation in any quarter may cause revenue in such quarter to fall significantly below expectations, which could cause the market price of Varian Semiconductor’s common stock to decline. Varian Semiconductor’s financial results also fluctuate based on gross profit realized on sales. Gross profit as a percentage of revenue may vary based on a variety of factors, including the mix and average selling prices of products sold, costs to manufacture and customize systems and inventory management. In addition, a number of other factors may impact Varian Semiconductor’s quarterly financial results, including, but not limited to the following:
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changing global economic conditions and worldwide political instability;
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general conditions in the semiconductor equipment industry;
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the extent that customers use Varian Semiconductor’s products and services in their business;
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unexpected procurement or manufacturing difficulties;
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pricing of key components;
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fluctuations in foreign exchange rates;
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a technical change that Varian Semiconductor is unable to address with its products;
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a failure to achieve continued market acceptance of Varian Semiconductor’s key products;
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ability to develop, introduce and market new, enhanced and competitive products in a timely manner;
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introduction of new products by Varian Semiconductor’s competitors;
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strategic technology investment decisions;
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legal or technical challenges to Varian Semiconductor’s products and technology;
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adverse weather conditions at its manufacturing facilities or customers’ facilities;
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changes in the effective tax rate; and
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new or modified accounting regulations.
Varian Semiconductor’s operating expenses also fluctuate on a quarterly basis. A high percentage of Varian Semiconductor’s expenses are relatively fixed, thus, even a minimal number of cancelled, postponed or delayed shipments could have a significant adverse impact on financial results. In addition, Varian Semiconductor may continue to heavily invest in such areas such as research and development, despite lower revenue levels. As such, financial results could be adversely impacted.
It is difficult for Varian Semiconductor to predict the quarter in which it will be recognizing revenue from large product orders.
Varian Semiconductor customarily sells a relatively small number of systems within any period. Consequently, Varian Semiconductor’s revenue and financial results could be negatively impacted for a particular quarter if anticipated orders from even a few customers are not received in time to permit shipment and/or there are delays in customer acceptance of the product upon installation or future obligations included in the contract do not permit revenue to be recognized on current tool sales under generally accepted accounting principles (“GAAP”). Generally, Varian Semiconductor recognizes all or a portion of the revenue from a product upon shipment provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations, and there are no uncertainties regarding customer acceptance. [Please refer to the full revenue recognition policy in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Critical Accounting Policies and Significant Accounting Estimates section.] As a result, it is often difficult to determine the timing of product revenue recognition. In addition, Varian Semiconductor’s product order backlog at the beginning of each quarter may not include all systems needed to achieve expected revenues for that quarter. Because Varian Semiconductor may build systems according to forecast, the absence of a significant backlog for an extended period of time could adversely affect financial results.
Varian Semiconductor’s future business depends, in part, on its ability to successfully introduce and manage the transition to new products, and Varian Semiconductor may not succeed in accomplishing these goals.
Varian Semiconductor believes that its future success will depend on its ability to develop, manufacture and successfully introduce new systems and product lines with improved capabilities and to continue enhancing existing products; in particular, products that respond to the trend toward single wafer processing and 300mm wafer processing at more advanced nodes. Varian Semiconductor derives virtually all of its revenue from sales and servicing of systems and related products and services. Varian Semiconductor must accurately forecast the demand for new products while managing the transition from older products. In addition, Varian Semiconductor may be unable to complete the development or meet the technical specifications of new systems or enhancements or to manufacture and ship these systems or enhancements in volume and on time, which may harm its reputation and business. If any of Varian Semiconductor’s new products have reliability or quality problems, Varian Semiconductor may incur additional warranty and service expenses, experience a decline in product orders or incur higher manufacturing costs to correct such problems, all of which could adversely affect financial results.
Varian Semiconductor is subject to the risks of operating internationally and it derives a substantial portion of its revenues from outside the U.S.
International revenues account for a substantial portion of Varian Semiconductor’s revenue. Because Varian Semiconductor relies on sales to customers in Asia Pacific for a significant portion of its revenue, its business is very likely to be adversely impacted by economic downturns and instability in that region. Varian Semiconductor’s business in Asia Pacific is affected by demand in each country. In addition, international sales are subject to risks, including, but not limited to:
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changes in legal and regulatory requirements;
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political and economic instability and acts of terrorism;
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difficulties in accounts receivable collection;
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natural disasters or public health crises;
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difficulties in staffing for cultural diversity and managing international operations;
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foreign trade disputes; and
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fluctuations in foreign exchange rates.
If Varian Semiconductor is unable to protect its proprietary rights adequately, it may lose its ability to compete effectively in the semiconductor equipment industry.
Varian Semiconductor relies on obtaining and maintaining patent, copyright and trade secret protection for significant new technologies, products and processes and obtaining key licenses because of the length of time and expense associated with bringing new products through the development process to market. Varian Semiconductor intends to continue to file applications as appropriate for patents covering new products and manufacturing processes. However, Varian Semiconductor cannot provide assurance of the following:
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that patents will be issued from any pending or future patent applications owned by, or licensed to, Varian Semiconductor;
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that the claims allowed under any issued patents will be sufficiently broad to protect Varian Semiconductor’s technology position against competitors;
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that any issued patents owned by or licensed to Varian Semiconductor will not be challenged, invalidated or circumvented; and
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that the rights granted under Varian Semiconductor’s patents will provide it with competitive advantages.
Varian Semiconductor also has agreements with third parties for licensing of patented or proprietary technology. These agreements include royalty-bearing licenses and technology cross-licenses.
In addition, Varian Semiconductor maintains and enforces its trademarks to increase customer recognition of its products. If its trademarks are used by unauthorized third parties, Varian Semiconductor’s business may be harmed. Varian Semiconductor also relies on contractual restrictions on disclosure, copying and transferring title, including confidentiality agreements with vendors, strategic partners, co-developers, employees, consultants and other third parties to protect its proprietary rights. If these contractual agreements are breached, Varian Semiconductor may not have adequate remedies for any such breaches. Varian Semiconductor also cannot provide assurance that its trade secrets will not otherwise become known to or be independently developed by others.
Patent claims may be expensive to pursue, defend or settle and may substantially divert Varian Semiconductor’s resources and the attention of management.
Varian Semiconductor could incur substantial costs and diversion of management resources in defending patent suits brought against it or in asserting its patent rights against others. If the outcome of any such litigation is unfavorable to Varian Semiconductor, its business may be harmed. Varian Semiconductor may not be aware of pending or issued patents held by third parties that relate to its products or technologies. In the event that a claim is asserted against Varian Semiconductor, it may need to acquire a license to or contest the validity of a competitor’s patent. Varian Semiconductor cannot be certain that it could acquire such a license on commercially acceptable terms, if at all, or that it would prevail in such a proceeding. From time to time, Varian Semiconductor has received notices from and has issued notices to such third parties alleging infringement of patent and other intellectual property rights relating to its products. If Varian Semiconductor is subject to future claims of patent infringement, it may be required to make substantial settlement or damage payments and may have to devote substantial resources to reengineering its products.
Varian Semiconductor depends on limited groups of suppliers or single source suppliers, the loss of which could impair its ability to manufacture products and systems.
Varian Semiconductor obtains some of the components and subassemblies included in its products from a limited group of suppliers, or in some cases, a single source supplier. The loss of any supplier (or the temporary inability of any supplier to meet Varian Semiconductor’s production requirements, including any single source supplier) would require obtaining one or more replacement suppliers and may also require devoting significant resources to product development to incorporate new parts from other sources into Varian Semiconductor’s products. The need to change suppliers or to alternate between suppliers might cause delays in delivery or significantly increase Varian Semiconductor’s costs. Although Varian Semiconductor has insurance to protect against loss due to business interruption from some sources as necessary, Varian Semiconductor cannot provide assurance that such coverage will be adequate or that it will remain available on commercially acceptable terms. Although Varian Semiconductor seeks to reduce its dependence on these limited source suppliers, disruption or loss of these sources could negatively impact its business and damage customer relationships.
Varian Semiconductor’s outsource providers may fail to perform as it expects.
Outsource providers have an increasing role in Varian Semiconductor’s manufacturing operations, research and development initiatives and in transactional and administrative functions. Although Varian Semiconductor aims at selecting reputable providers and securing their performance on terms documented in written contracts, it is possible that one or more of these providers could fail to perform as Varian Semiconductor expects and such failure could have an adverse impact on Varian Semiconductor’s business. In addition, the expansive role of outsource providers has required and will continue to require Varian Semiconductor to implement changes to its existing operations and to adopt new procedures to deal with and manage the performance of these outsource providers. Any delay or failure in the implementation of our operational changes and new procedures could adversely affect Varian Semiconductor’s customer relationships and/or have a negative effect on Varian Semiconductor’s operating results.
Varian Semiconductor’s indemnification obligations under the Distribution Related Agreements could be substantial, and Varian Semiconductor may not be fully indemnified in accordance with the Distribution Related Agreements for the expenses it incurs.
Under the terms of the Distribution Related Agreements, each of Varian Medical Systems, Inc. (“VMS”) (formerly VAI), Varian, Inc. (“VI”) and Varian Semiconductor has agreed to indemnify the other parties, and certain related persons, from and after the spin-off with respect to certain indebtedness, liabilities and obligations, which could be significant. The availability of such indemnities will depend upon the future financial strength of the companies. There is a risk that one or more of these companies will not be able to satisfy their indemnification obligations. In addition, the Distribution Related Agreements generally provide that if a court prohibits a company from satisfying its indemnification obligations, then such obligations will be shared equally by the other companies.
Failure to comply with present or future environmental regulations could subject Varian Semiconductor to penalties and environmental remediation costs.
Varian Semiconductor is subject to a variety of foreign, federal, state and local laws regulating the discharge of materials into the environment and the protection of the environment. These regulations include discharges into the soil, water and air and the generation, handling, storage, and transportation and disposal of waste and hazardous substances. These laws increase the costs and potential liabilities associated with the conduct of Varian Semiconductor’s operations.
VAI has been named by the U.S. Environmental Protection Agency and third parties as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended
(“CERCLA”), at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also in various stages of environmental investigation and/or remediation under the direction of, or in consultation with foreign, federal, state and local agencies at certain current or former VAI facilities. The Distribution Related Agreements provide that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.
For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued estimated environmental investigation and remediation costs for these sites and facilities. As to other sites and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has sufficient accruals to cover Varian Semiconductor’s portion of these costs.
Accrued amounts are only estimates of anticipated future environmental-related costs, and the amounts actually spent may be greater than such estimates. Accordingly, Varian Semiconductor may need to make additional accruals and subsequent payments to cover its indemnification obligations that would exceed current estimates. In addition, Varian Semiconductor’s present and past facilities have been in operation for many years, and over that time in the course of those operations, such facilities have used substances which are or might be considered hazardous. Varian Semiconductor also may have generated and disposed of wastes which are or might be considered hazardous. Therefore, it is possible that additional environmental issues may arise in the future that Varian Semiconductor cannot now predict.
Varian Semiconductor’s ability to manage potential growth or decline, integration of potential acquisitions, and potential disposition of product lines and technologies creates risks.
The cyclical nature of the semiconductor industry may cause Varian Semiconductor to experience rapid growth or decline in demand for products and services. As a result, Varian Semiconductor may face significant challenges in maintaining adequate financial and business controls, materials management, management processes, information systems and procedures on a timely basis, training, managing and appropriately sizing the work force. There can be no assurance that Varian Semiconductor will be able to perform such actions successfully.
An important element of Varian Semiconductor’s management strategy is to review acquisition prospects that would complement existing products, augment market coverage and distribution ability, or enhance technological capabilities. In the future, Varian Semiconductor may make acquisitions of complementary companies, products or technologies, or may reduce or dispose of certain product lines or technologies that no longer fit Varian Semiconductor’s long-term strategies. Managing an acquired business, disposing of product technologies or reducing personnel entails numerous operational and financial risks, including difficulties in assimilating acquired operations and new personnel or separating existing business or product groups, diversion of management’s attention to other business concerns, amortization of acquired intangible assets, the incurrence of debt and contingent liabilities and potential loss of key employees or customers of acquired or disposed operations, among others. Varian Semiconductor’s success will depend, to a significant extent, on the ability of its executive officers and other members of its senior management to identify and respond to these challenges effectively. In addition, any acquisitions could result in dilutive issuances of equity securities. There can be no assurance that Varian Semiconductor will be able to achieve and manage successfully any such growth, decline, integration of potential acquisitions, disposition of product lines or technologies, or reduction in personnel, or that management, personnel or systems will be adequate to support continued operations. Any such inabilities or inadequacies may have a material adverse effect on Varian Semiconductor’s business, operating results, financial condition, cash flows and/or the price of Varian Semiconductor common stock.
Varian Semiconductor manufactures its products at one primary manufacturing facility and is thus subject to risk of disruption.
Varian Semiconductor has one primary manufacturing facility, located in Gloucester, Massachusetts, and its operations are subject to disruption for a variety of reasons, including, but not limited to natural disasters, work stoppages, operational facility constraints and terrorism. Such disruption may cause delays in shipments of products to Varian Semiconductor’s customers and may result in cancellation of orders or loss of customers and could seriously harm Varian Semiconductor’s business.
If Varian Semiconductor loses key employees or is unable to attract and retain key employees, it may be unable to pursue business opportunities.
Varian Semiconductor’s future success depends to a significant extent on the continued service of key managerial, technical and engineering personnel. Competition for such personnel is intense, particularly in the labor markets around Varian Semiconductor’s facilities in Massachusetts. The available pool of qualified candidates is limited and Varian Semiconductor may not be able to retain its key personnel or to attract, train, assimilate or retain other highly qualified engineers and technical and managerial personnel in the future. The loss of these persons or Varian Semiconductor’s inability to hire, train or retrain qualified personnel could harm Varian Semiconductor’s business and results of operations.
Varian Semiconductor has anti-takeover defenses that could delay or prevent an acquisition and could adversely affect the price of its common stock.
Provisions of Varian Semiconductor’s certificate of incorporation and by-laws and of Delaware law could delay, defer or prevent an acquisition or change in control of Varian Semiconductor or otherwise adversely affect the price of its common stock. For example, Varian Semiconductor’s Board of Directors is classified into three classes, and stockholders do not have the right to call special meetings of stockholders. Varian Semiconductor’s certificate of incorporation also permits its Board of Directors to issue shares of preferred stock without stockholder approval. In addition to delaying or preventing an acquisition, the issuance of a substantial number of preferred shares could adversely affect the price of the common stock. Varian Semiconductor has also adopted a stockholders’ rights plan which could significantly dilute the equity interests of a person seeking to acquire control of Varian Semiconductor without the approval of the Board of Directors.
Varian Semiconductor does not anticipate paying dividends on its common stock in the future.
Varian Semiconductor has not paid and does not anticipate paying dividends on its common stock. Varian Semiconductor’s Board of Directors has discretion to make decisions to pay dividends to common stockholders in the future. The decision will depend on a number of factors, including results of operations, financial conditions and contractual restrictions that the Board, in its opinion, deems relevant.
Varian Semiconductor’s financial results may be adversely impacted by higher than expected tax rates or exposure to additional income tax liabilities.
As a global company, Varian Semiconductor’s effective tax rate is highly dependent upon the geographic composition of worldwide earnings and tax regulations governing each region. Varian Semiconductor is subject to income taxes in both the U.S. and various foreign jurisdictions and significant judgment is required to determine worldwide tax liabilities. Varian Semiconductor’s effective tax rate could be adversely affected by changes in the distribution of earnings between countries with differing statutory tax rates, in the valuation of deferred tax assets, in tax laws or by material audit assessments, which could affect profitability. For example, due to the global business realignment, the distribution of worldwide earnings has changed and has caused the tax rate to become more sensitive to the geographic distribution of profits. Under audit, Varian Semiconductor could face significant challenges regarding the geographic composition of these earnings from one or more
jurisdictions. In addition, Varian Semiconductor’s effective tax rate has benefited from the research and development (“R & D”) tax credit which will expire on December 31, 2009. If the R & D credit is not extended, Varian Semiconductor’s tax liability may increase. Further, the carrying value of deferred tax assets, which are predominantly in the U.S., is dependent on Varian Semiconductor’s ability to generate future taxable income in the U.S. Varian Semiconductor is also subject to regular examination of its tax returns by the Internal Revenue Service (IRS) and other taxing authorities. The IRS and other tax authorities have increasingly focused attention on intercompany transfer pricing with respect to sales of products, services, and the use of intangible assets. Varian Semiconductor could face significant future challenges on these transfer pricing issues in one or more jurisdictions. Varian Semiconductor regularly assesses the likelihood of favorable or unfavorable outcomes resulting from these examinations to determine the adequacy of its provision for income taxes. Although Varian Semiconductor believes that its tax estimates are reasonable, there can be no assurance that any final determination will not be materially different from the treatment reflected in its historical income tax provisions and accruals.
Item 2.
Item 2. Properties.
Varian Semiconductor’s headquarters and manufacturing facility is located in Gloucester, Massachusetts. In addition, Varian Semiconductor has five sales and service offices located in the U.S. and 31 located outside of the U.S., including offices in France, Germany, the Netherlands, Japan (nine), Korea (four), Taiwan (six), China (four), Switzerland (two), Singapore and Malaysia (two). These offices and facilities aggregate approximately 674 thousand square feet, of which 233 thousand square feet is leased. Since fiscal year 1994, the manufacturing facilities have been registered to the internationally recognized Quality Management System ISO 9001 standard. ISO 9001:2000 revised certification was obtained in fiscal year 2002. The most recent recertification obtained in August 2008 encompasses design, development, manufacture of ion implanters, including customer training and support.
Varian Semiconductor’s management does not believe there is any material, long-term, excess capacity in Varian Semiconductor’s facilities, although utilization is subject to change based on customer demand. Furthermore, Varian Semiconductor’s management believes that Varian Semiconductor’s facilities and equipment generally are well maintained, in good operating condition, suitable for Varian Semiconductor’s purposes, and adequate for its present operations.
The following table reflects Varian Semiconductor’s locations by geographic segment:
Item 3.
Item 3. Legal Proceedings.
Varian Semiconductor’s operations are subject to various foreign, federal, state and/or local laws relating to the protection of the environment. These include laws regarding discharges into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. In addition, several
countries are reviewing proposed regulations that would require manufacturers to dispose of their products at the end of a product’s useful life. These laws have the effect of increasing costs and potential liabilities associated with the conduct of certain operations.
Varian Semiconductor is presently a party to legal disputes. While Varian Semiconductor believes it has meritorious claims and/or defenses with respect to each dispute, it cannot predict the outcome of each such dispute. Management believes that the ultimate outcome of these disputes, individually and in the aggregate, will not have a material adverse effect on the financial condition or results of operations of Varian Semiconductor.
From time to time, Varian Semiconductor may become involved in a number of legal actions and could incur an uninsured liability in one or more of them. Accordingly, while the ultimate outcome of these legal matters is not determinable, management believes the resolution of these matters will not have a material adverse effect on the financial condition or results of operations of Varian Semiconductor.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders of Varian Semiconductor, through solicitation of proxies or otherwise, during the last quarter of fiscal year 2008.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Since April 5, 1999, Varian Semiconductor’s common stock has traded on The Nasdaq Global Select Market under the symbol “VSEA.”
The following table sets forth the high and low sale prices per share of Varian Semiconductor’s common stock during each quarter for the two most recent fiscal years.
The reported closing price of Varian Semiconductor’s common stock on The Nasdaq Global Select Market on October 3, 2008 was $21.70 per share. The number of stockholders of record on November 17, 2008 was 2,336.
Varian Semiconductor has never declared or paid cash dividends on its common stock and does not expect to pay any cash dividends on its common stock in the foreseeable future.
In October 2004, Varian Semiconductor’s Board of Directors authorized the repurchase, from time to time, of up to $100 million of Varian Semiconductor’s common stock on the open market. Subsequently, the Board of Directors voted on increases to the amount of funds that may be expended in repurchasing Varian Semiconductor’s common stock to a total of $800 million. The program does not have a fixed expiration date. During fiscal year 2008, Varian Semiconductor spent $179 million on the repurchase of 4,751,480 shares at a weighted-average price per share of $37.74.
Varian Semiconductor did not repurchase any shares during the quarter ended October 3, 2008 or between October 4, 2008 and November 17, 2008, the latest practicable date prior to the filing date.
See Item 12 of Part III of this Annual Report on Form 10-K for information regarding securities authorized for issuance under our equity compensation plans.
COMPARISON OF FIVE-YEAR CUMULATIVE STOCKHOLDERS’ RETURNS
PERFORMANCE GRAPH FOR VARIAN SEMICONDUCTOR
The comparative stock performance graph below compares the cumulative stockholder return on our common stock for the period from October 3, 2003 through October 3, 2008 with the cumulative total return on (1) the Nasdaq Global Select Market Composite and (2) the S&P North American Technology Semiconductor Index, which is a published industry index. The cumulative total return computations set forth in the performance graph assume the investment of $100 in our common stock, the Nasdaq Global Select Market Composite and the S&P North American Technology Semiconductor Index on October 3, 2003. The stock price performance shown on the graph and table below is not necessarily indicative of future price performance.
Item 6.
Item 6. Selected Financial Data.
The information included in the following table reflects selected consolidated summary financial data for each of the last five fiscal years. This data should be read in conjunction with the consolidated financial statements and notes thereto included in “Item 15 - Exhibits and Financial Statement Schedules,” and with “Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This Annual Report on Form 10-K contains certain forward-looking statements. For purposes of the safe harbor provisions under The Private Securities Litigation Reform Act of 1995, any statements using the terms “believes,” “anticipates,” “expects,” “plans” or similar expressions, are forward-looking statements. The forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected. There are a number of important factors that could cause Varian Semiconductor’s actual results to differ materially from those indicated by forward-looking statements made in this report and presented by management from time to time. Some of the important risks and uncertainties that may cause Varian Semiconductor’s financial results to differ are described in Item 1A. “Risk Factors.”
Overview
Varian Semiconductor is the leading supplier of ion implantation equipment used in the fabrication of semiconductor chips. Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment for virtually all of the major semiconductor manufacturers in the world. The VIISta ion implanter products are designed to leverage single wafer processing technology for the full range of semiconductor implant applications. Varian Semiconductor has shipped more than 4,000 systems worldwide.
Varian Semiconductor provides support, training, and after-market products and services that help its customers obtain high utilization and productivity, reduce operating costs and extend capital productivity of investments through multiple product generations. In fiscal year 2008, Varian Semiconductor was ranked number one in customer satisfaction in VLSI Research Inc.’s customer survey for all large suppliers of wafer processing equipment, an honor received in eleven of the past twelve years.
Varian Semiconductor’s business is cyclical. The business depends upon semiconductor manufacturers’ expectations and resulting capacity investments for future integrated circuit demand. Historically, Varian Semiconductor’s business has experienced significant volatility and Varian Semiconductor believes the semiconductor capital equipment business will continue to be volatile, largely due to fluctuations in the level of investment by memory manufacturers. The significant decline in spending by memory manufacturers during fiscal year 2008 was the primary driver for the decrease in fiscal year 2008 revenues of 21% versus fiscal year 2007. Varian Semiconductor believes that fiscal year 2009 revenues will further decline due not only to continued overcapacity in the memory market, but also to the global credit crisis and decrease in end-user demand for semiconductors. Varian Semiconductor’s revenues have historically been derived from a limited number of customers, some of which require financing to continue upgrade and/or expansion plans that require the purchase of Varian Semiconductor’s tools. Varian Semiconductor’s after-market business is also likely to be adversely affected, as fabs will be running at lower utilization levels, thus requiring fewer parts, upgrades and services.
Varian Semiconductor believes that its management team has the industry experience to quickly and effectively react to sizing adjustments required by the volatility in the market. As such, Varian Semiconductor has already begun resizing its business in fiscal year 2008 and expects to continue to closely monitor the industry. During fiscal year 2008, Varian Semiconductor incurred $1.6 million in restructuring charges, primarily related to a reduction in force. Furthermore, Varian Semiconductor has the financial strength and liquidity to continue investing in product development such that Varian Semiconductor can continue to maintain its leading industry position.
Varian Semiconductor’s business is tied closely to its market share and the total available market for ion implanters. Varian Semiconductor has increased its market share substantially in recent years. Most recently, overall market share grew from 43.1% in calendar year 2006 to 64.5% in calendar year 2007. Varian Semiconductor expects that when calendar year 2008 semiconductor capital expenditure reports are released in April 2009, they will show that Varian Semiconductor continued its market share gains but, that the total
available market for ion implanters was substantially reduced versus 2007. In addition, Varian Semiconductor believes, mainly through references to leading industry analyst reports, that the total available market for ion implanters will further decline in 2009.
Wafer size and market. Most advanced devices below 90nm are produced on 300mm wafers. Memory manufacturers typically produce integrated circuits used for flash and dynamic random access memory, or DRAM, which store and retrieve information, while logic manufacturers typically produce integrated circuits used to process data. Foundry manufacturers have the capability to produce both memory and logic wafers.
Market Share and Total Available Market. The table below shows Varian Semiconductor’s calendar year 2007, 2006 and 2005 market share, as reported by Gartner Dataquest in April 2008, April 2007 and April 2006, respectively. Market share estimates are calculated on a subset of revenue, and information reported by Gartner Dataquest may not be consistent on a company by company basis. The table below also shows the total available market for ion implanter sales in calendar years 2007, 2006 and 2005, also reported by Gartner Dataquest in April 2008, April 2007 and April 2006, respectively. The total available market represents estimated worldwide total revenue for ion implanters sold by all companies which sell ion implanters during each of the calendar years.
Market share and total available market research data is also published by VLSI Research Inc. In April 2008, VLSI Research Inc. reported that Varian Semiconductor’s overall market share was 64% and that the total available market was $1.3 billion for calendar year 2007.
Varian Semiconductor’s 21 point increase in market share in calendar year 2007 led to increased revenues during 2007 compared to 2006. Varian Semiconductor’s increase in high current market share is a result of the industry shift to single wafer implanters at advanced technology nodes (65nm and below). Varian Semiconductor began developing single wafer high current tools in 1994 and is currently the industry leader. The increase in medium current market share is primarily related to Varian Semiconductor’s market share growth in Taiwan. The decrease in high energy market share is primarily related to customer mix in the total available market for high energy tools. Varian Semiconductor’s position in the newly designated ultra high-dose market has resulted from the success of its new plasma doping tool known as the VIISta PLAD, which is currently used by memory manufacturers. Calendar year 2008 market share reports are expected to be released in April 2009. Varian Semiconductor believes it has continued to increase its overall market share during calendar year 2008.
Critical Accounting Policies and Significant Accounting Estimates
Varian Semiconductor’s discussion and analysis of its financial condition and results of operations are based upon Varian Semiconductor’s consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the U.S. The preparation of these consolidated financial statements requires Varian Semiconductor to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On a continual basis, Varian Semiconductor makes estimates and judgments on revenues, inventories, accounts
receivable, long-lived assets, income taxes, warranty obligations, deferred revenue, post-retirement benefits, contingencies, stock-based compensation and foreign currencies. Varian Semiconductor operates in a highly cyclical and competitive industry that is influenced by a variety of diverse factors including, but not limited to, technological advances, product life cycles, customer and supplier lead times, and geographic and macroeconomic trends. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor bases its estimates on historical experience and on various other assumptions that are believed to 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. See also the factors discussed in Item 1A. “Risk Factors.”
Varian Semiconductor believes that the following sets forth the critical accounting policies used by Varian Semiconductor in the preparation of its consolidated financial statements.
Revenue Recognition
Product revenue includes established products, new products, upgrades and spare parts.
Varian Semiconductor recognizes revenue from product sales upon shipment, provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectability is reasonably assured, and there are no uncertainties regarding customer acceptance.
For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance. For new products, revenue allocated to the equipment is recognized upon customer acceptance. Spare parts and upgrade sales are recognized as revenue upon the later of delivery or the transfer of title and risk of loss to the customer.
Varian Semiconductor generally follows predetermined criteria for changing the classification of a new product to an established product. Varian Semiconductor generally recognizes products as established after demonstrating success in achieving customer acceptance of the same tool type and specification, for the same or similar application. In most circumstances, once a new product achieves the predetermined criteria, the product is considered established. Furthermore, prior installation costs on the tool type can also influence the evaluation of tool maturity on a going forward basis.
Products are classified as established if the installation process and the post-delivery acceptance provisions are deemed routine, because acceptance provisions are generally a replication of pre-shipment procedures, and there is a demonstrated history of achieving the predetermined established product criteria. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions cannot be replicated in Varian Semiconductor’s facilities or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes.
Service revenue includes revenue from maintenance and service contracts, extended warranties, paid service and system installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Extended warranty revenue is deferred and recognized ratably over the applicable warranty term. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation and customer acceptance. It takes approximately three to six weeks for Varian Semiconductor technicians to complete the installation of Varian Semiconductor products and
perform tests agreed to with customers. Certain customers formally document their acceptance of Varian Semiconductor’s products at this time. Other customers elect to perform additional internal testing prior to formal acceptance, and this process generally takes eight to twelve weeks.
Royalty and license revenue is recognized when contractual obligations are met, and in the case of royalties, upon receipt of a royalty report from the customer, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured.
Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair value of those elements. All elements may not be delivered and recognized as revenue during the same period. In such cases, Varian Semiconductor defers the fair value of the undelivered element until that element is delivered. The amount allocated to installation labor is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue. If fair value cannot be determined for any of the undelivered elements, the entire value of the arrangement is deferred.
Inventory and Purchase Order Commitments
Varian Semiconductor values its inventory at the lower of cost or market. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor also provides for losses on those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under the commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. Once inventory is written down and a new cost basis has been established, it is not written back up if demand increases. If market conditions are less favorable than those projected by management, additional inventory provisions may be required. If market conditions are more favorable than those projected by management, and specific inventory previously written down is subsequently sold, gross profit could benefit by the amount of the specific write-down to carrying value previously recorded. In the case of purchase order commitments, more favorable market conditions or successful negotiations with suppliers will result in a reduction of provisions in the period the excess purchase order commitments are reduced.
Valuation Allowance on Deferred Tax Assets and Income Tax Provision
Varian Semiconductor records a valuation allowance against deferred tax assets if it is more likely than not that a portion of the deferred tax asset will not be realized. On a quarterly basis, Varian Semiconductor evaluates both the positive and negative evidence bearing upon the realizability of its deferred tax assets. Varian Semiconductor considers future taxable income, ongoing prudent and feasible tax planning strategies, and the ability to utilize tax losses and credits in assessing the need for a valuation allowance. A valuation allowance related to certain state tax credit carryforwards has been recorded. Although, due to the global reorganization, Varian Semiconductor has increased its utilization of state tax credits, management has concluded that it is more likely than not that a portion of these credits will not be utilized since historically the annual amount of state credits generated exceeds the amount of credits that can be used. Varian Semiconductor records a benefit to the tax provision and corresponding reduction in the valuation allowance related to the utilization of state tax credits generated in prior years. Should Varian Semiconductor determine that it is not able to realize all or part of its other deferred tax assets in the future, a valuation allowance would be required resulting in an expense recorded within the provision for income taxes in the statement of income in the period in which such determination was
made. It is possible that the amount of the deferred tax asset considered realizable could be reduced in the near term if future taxable income is reduced. Varian Semiconductor’s effective tax rate is affected by levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, U.S. foreign income exclusion, investment tax credits and other tax incentives specific to domestic and foreign operations.
Product Warranties
Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes including actively monitoring and evaluating the quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.
Stock-based Compensation
Varian Semiconductor applies the provisions of SFAS No. 123(R) which establishes accounting for stock-based awards exchanged for employee and director services. Stock-based compensation cost is measured at grant date and based on the fair value of the award. The straight-line method is applied to all grants with service conditions, while the graded vesting method is applied to all grants with both service and performance conditions.
The choice of a valuation technique and the approach utilized to develop the underlying assumptions for that technique, involve significant judgments. These judgments reflect management’s assessment of the most accurate method of valuing the stock options Varian Semiconductor issues, based on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. Varian Semiconductor’s judgments could change over time as additional information becomes available, or the facts underlying the assumptions change over time. Any change in judgments could have a material impact on Varian Semiconductor’s financial statements. Varian Semiconductor believes that these estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.
Results of Operations
Fiscal Year
Varian Semiconductor’s fiscal year is a 52- or 53-week period that ends on the Friday nearest September 30. Fiscal year 2008 was comprised of a 53-week period ended on October 3, 2008. Fiscal year 2007 was comprised of a 52-week period ended on September 28, 2007. Fiscal year 2006 was comprised of a 52-week period ended on September 29, 2006.
Fiscal Year 2008 Compared to Fiscal Year 2007 and
Fiscal Year 2007 Compared to Fiscal Year 2006
Revenue
The following table sets forth revenue by revenue stream and territory for fiscal years 2008, 2007 and 2006:
Product
Varian Semiconductor’s product sales decreased $208.7 million or 22% during fiscal year 2008 compared to fiscal year 2007. The decrease in fiscal year 2008 was primarily due to lower tool sales to memory customers in Asia Pacific. On a unit basis, the number of tools recorded in revenue decreased 33% during fiscal year 2008, compared to fiscal year 2007. Despite the decline in tool sales, revenue from parts and upgrades sales increased 8% during fiscal year 2008, primarily due to a higher installed base of tools.
In fiscal year 2007, revenue increased 50%, due to a unit increase in system sales of 51%, primarily due to memory customers. In addition, there was an increase in sales of parts and upgrades mainly due to a higher installed base of tools and higher fab utilization. Market share gains, particularly in the high current sector, and expansion of the total available market, were the primary reasons for the increase in Varian Semiconductor’s sales in fiscal year 2007.
Service
Service revenue decreased 5% in fiscal year 2008 compared to fiscal year 2007, primarily due to lower installation revenue associated with lower sales volume, partially offset by an increase in paid service. Service revenue increased by 9% in fiscal year 2007 as compared to fiscal year 2006, primarily as a result of increases in installation revenue on account of increased tool sales. Generally, installation revenue is influenced by shipment volume of systems, product mix, customer mix, timing of customer acceptance and the fair value of installations. As products mature and the installation requires less effort to complete, the fair value of installation revenue per system is reduced, which reduces installation revenue per tool.
Royalty and License
In fiscal year 2008, Varian Semiconductor recorded less than $0.1 million in royalty and license revenues, compared to $7.5 million and $9.5 million in fiscal years 2007 and 2006, respectively. Until March 2007, Applied Materials was required by a royalty agreement to make quarterly unit-based royalties payments to
Varian Semiconductor on sales of certain products within the scope of the agreement. In fiscal years 2007 and 2006, Varian Semiconductor recognized $4.5 million and $6.4 million, respectively, as royalty revenue related to this agreement. Varian Semiconductor does not expect to earn any royalty and license revenue in fiscal year 2009.
Revenue by Territory
The Asia Pacific region accounts for a significant percentage of Varian Semiconductor’s revenues. Fluctuations in revenue from this region in fiscal year 2008 as compared to fiscal year 2007, and in fiscal year 2007 compared to fiscal year 2006, are primarily due to substantial capacity additions by memory customers in fiscal year 2007. In addition, the North America region accounts for a large percentage of Varian Semiconductor’s revenues. Revenue from this region decreased in fiscal year 2008 as compared to fiscal year 2007, and increased in fiscal year 2007 compared to fiscal year 2006, primarily on account of sales to both memory and logic customers.
Customers
Revenue from Varian Semiconductor’s ten largest customers in fiscal years 2008, 2007 and 2006 accounted for approximately 74%, 72% and 63% of revenue, respectively. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue for the foreseeable future. In fiscal year 2008, revenue from two customers accounted for 16% and 13%, respectively, of Varian Semiconductor’s total revenue. In fiscal year 2007, revenue from one customer accounted for 17% of Varian Semiconductor’s total revenue. In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10%, respectively, of Varian Semiconductor’s total revenue.
In addition, Varian Semiconductor’s accounts receivable is comprised of relatively few customer accounts. As of October 3, 2008, four customers accounted for 16%, 12%, 11% and 10% of the total accounts receivable balance. As of September 28, 2007, one customer accounted for 15% of the accounts receivable balance.
Shipment Mix
Varian Semiconductor’s tools are used by logic, memory and foundry manufacturers of integrated circuits. Logic manufacturers make chips that process information, while memory manufacturers make chips that store information. Both memory and logic manufacturers are owned by the companies that design the chips. Foundry manufacturers are contractors that take chip designs from other companies and make the chips for them. Over the last several years the demand for memory chips has outstripped logic due to the growth in memory intensive applications such as cameras, phones and MP3 players. Varian Semiconductor believes that substantial capacity additions by memory customers in fiscal year 2007 led to excess supply of memory devices. In turn, this excess capacity has led to a significant decrease in tool purchases from memory manufacturers in fiscal year 2008 as compared to fiscal year 2007. Virtually all of Varian Semiconductor’s tool shipments are 300 mm tools, which began to replace 200 mm tools at the end of the 1990s. The following table sets forth tool shipments by market, as a percent of total tool shipments, for fiscal years 2008, 2007 and 2006. Percentages are based on the number of tools shipped during the respective period.
Cost of Product Revenue
Cost of product revenue was $386.7 million and gross margin was 49% for fiscal year 2008, compared to the cost of product revenue of $511.1 million and gross margin of 47% for fiscal year 2007. The increase in gross margin from fiscal year 2007 to fiscal year 2008 was primarily due to a favorable product mix and lower warranty expense. Generally, as tool sales become a lower portion of product revenue, product gross margin increases. This is due to the fact that tools generally have lower gross margins than parts and upgrades. These positive factors more than offset factory absorption and inventory charges resulting from lower tool sales.
For fiscal year 2007, the cost of product revenue was $511.1 million and gross margin was 47% compared to cost of product revenue of $371.1 million and gross margin of 42% in fiscal year 2006. The increase in gross margin from fiscal year 2006 to fiscal year 2007 was primarily due to product mix and more efficient factory operations due to higher sales volume. Improved supply chain management and more efficient regional service support also contributed to the increases in gross margin in fiscal year 2007. These positive factors more than offset the decreases in gross margin attributable to the overall sales mix.
Cost of Service Revenue
Cost of service revenue was $51.6 million and gross margin was 37% for fiscal year 2008, compared to cost of service revenue of $54.8 million and gross margin of 36% for fiscal year 2007. The increase in service gross margin in fiscal year 2008 was related to a greater mix of higher margin paid service business. This positive factor more than offset lower margins on service contracts and installation.
In fiscal year 2007, the cost of service revenue was $54.8 million and gross margin was 36%, compared to cost of service revenue of $50.1 million and gross margin of 37% for fiscal year 2006. The service gross margin decreased in fiscal year 2007 compared to fiscal year 2006, due to decreased margin on installations which was influenced by product and regional mix.
Research and Development
Research and development expenses were $111.2 million for fiscal year 2008, compared to $104.0 million for fiscal year 2007, an increase of $7.2 million, or 7%. The increase in research and development spending is attributable to Varian Semiconductor’s rapid product development cycle (which aims to introduce new products every nine to twelve months) and continuing efforts to improve productivity and technical development of its products. Additionally, Varian Semiconductor is actively investing in finding new applications for its products. Varian Semiconductor focuses on maintaining its leadership position in the markets for medium current, high current and ultra high dose implanters, improving its position in the high energy business and continuing to invest in additional new and next generation products.
Research and development expenditures were $104.0 in fiscal year 2007, compared to $90.6 million in fiscal year 2006, an increase of $13.4 million, or 15%. Similar to fiscal year 2008, the increase in research and development spending in fiscal year 2007 as compared to fiscal year 2006 is attributable to Varian Semiconductor’s rapid product development cycle.
Marketing, General and Administrative
Marketing, general and administrative expenses were $130.7 million for fiscal year 2008, compared to $128.1 million for fiscal year 2007, an increase of $2.6 million, or 2%, from fiscal year 2007 to fiscal year 2008. The increase in expense from fiscal year 2007 to fiscal year 2008 was due to increases in headcount mainly in international locations across several functions and equity compensation.
Marketing, general and administrative expenses were $128.1 million for fiscal year 2007, compared to $116.1 million for fiscal year 2006, an increase of $12.0 million, or 10%. The increase in expense from fiscal year 2006 to fiscal year 2007 was due to increases in headcount and incentive compensation in support of the increase in overall business activity. Additionally, information technology and finance professional consulting expenses were higher due to spending related to Varian Semiconductor’s implementation of its global reorganization plan.
Restructuring Costs
Varian Semiconductor’s business is cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. The semiconductor industry has historically experienced periodic downturns and, in response, Varian Semiconductor has occasionally recorded restructuring charges in connection with cost reduction initiatives implemented in response to those downturns. Restructuring charges typically consist of severance, benefits and outplacement services offered to terminated employees and sometimes include charges for remaining lease payments on facilities that are closed. Prior to any restructuring announcements, the restructuring is approved by the appropriate level of management necessary to commit to the specific actions of the reduction in force.
In the fiscal third quarter of 2008, Varian Semiconductor incurred a restructuring charge of $0.6 million in connection with cost reduction initiatives implemented in response to an industry downturn. The restructuring charge, part of an ongoing benefit arrangement, is accounted for under SFAS No. 112, “Accounting for Postemployment Benefits.” The expense related to a reduction of headcount in the United States of approximately 30 people.
In the fiscal fourth quarter of 2008, Varian Semiconductor reduced headcount by an additional 19 people, resulting in a charge of $0.6 million.
In fiscal year 2009, Varian Semiconductor expects a continuation of cost reduction initiatives. As of November 20, 2008, Varian Semiconductor had already incurred an additional $3.1 million in restructuring charges relating to further headcount reduction.
Varian Semiconductor began relocating its European operations in Houten, the Netherlands to Schaffhausen, Switzerland, in the fiscal fourth quarter of 2008. The restructuring is accounted for under SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and is comprised primarily of one-time termination benefits and a contract termination expense, a facility lease. Accordingly, a charge of $0.4 million, primarily severance related, was recorded in the fiscal fourth quarter of 2008.
Varian Semiconductor estimates that the European restructuring activity, inclusive of fiscal year 2008 fourth quarter activity ($0.4 million), will cost $2.4 million. The estimate includes contract termination costs of approximately $0.3 million (a facility lease), one-time termination benefits of $1.6 million (severance), and other associated costs of $0.1 million.
The following table summarizes the components of these charges including ongoing benefit arrangements, one-time termination benefits, contract termination costs, and other associated costs.
Cash outlays related to one-time termination benefits and contract termination costs to exit the Houten facility will continue through fiscal years 2010, and 2013, respectively.
Varian Semiconductor did not recognize restructuring costs during fiscal year 2007 or 2006.
Interest Income
Varian Semiconductor earned interest income of $10.5 million for fiscal year 2008, compared to $20.8 million for fiscal year 2007. The decrease in interest income for fiscal year 2008 was related to a decrease in average cash and investment balances, primarily attributable to share repurchases of $179.5 million during fiscal year 2008 and lower interest rates. At October 3, 2008, Varian Semiconductor had $47.5 million in cash equivalents and investments whose interest was exempt from US federal taxation. The rates of return on these cash equivalents were approximately 33% lower than rates earned on comparable fully-taxable cash equivalents.
In fiscal year 2007, Varian Semiconductor earned $20.8 million in interest income, compared to $22.3 million for fiscal year 2006. The decrease in interest income for fiscal year 2007 was related to a decrease in average cash and investment balances, primarily attributable to share repurchases of $426.5 million during fiscal year 2007. In fiscal year 2007, Varian Semiconductor held higher average tax-exempt cash equivalents and investments compared to fiscal year 2006, contributing to a reduction in interest income in fiscal year 2007. At September 28, 2007, Varian Semiconductor had $62.5 million in tax-exempt cash equivalents and investments. In addition, interest income in fiscal year 2006 included $1.6 million related to the release of tax refunds by the IRS upon the conclusion of a multi-year tax examination.
Interest Expense
Varian Semiconductor incurred $1.7 million in interest expense for fiscal year 2008, compared to $1.3 million for fiscal year 2007, and $0.8 million for fiscal year 2006. In fiscal years 2008 and 2007, Varian Semiconductor incurred higher interest expense compared to respective prior fiscal years, primarily due to finance charges on forward contracts used to hedge balance sheet related foreign exchange exposure.
Other Income (Expense), Net
During fiscal year 2008, Varian Semiconductor recorded other expense of $0.1 million related to foreign currency exchange losses offset by miscellaneous income. During fiscal year 2007, Varian Semiconductor recorded other income of $0.3 million related to foreign currency exchange gains offset by miscellaneous charges. During fiscal year 2006, Varian Semiconductor recorded other income of $0.9 million, primarily related to a gain on the sale of certain non-operating real estate owned by Varian Semiconductor.
Provision for Income Taxes
In fiscal year 2007, Varian Semiconductor implemented a plan to realign the legal entities within its worldwide affiliated group. The objective of this realignment was to make its legal structure more consistent with the geographic mix of its customers and suppliers. In effecting this realignment, Varian Semiconductor established operations in Switzerland that provide operational and financial services to all of its international locations.
Varian Semiconductor’s effective income tax rate was 38.8% in fiscal year 2008, 48.6% in fiscal year 2007 and 24.4% in fiscal year 2006. The 2008 and 2007 tax provisions were impacted by tax charges related to Varian Semiconductor’s realignment of its global business structure and establishment of international operations that provide operational and financial services to all of its international locations. A significant element of the new structure involves the sharing of certain expenses related to the ongoing development of intangible property. Tax charges to implement the new structure impacted the fiscal year 2008 and 2007 effective tax rates by 8.6 percentage points and 15.4 percentage points, respectively. These charges consisted primarily of additional royalty payments that will be taxed in the United States and the loss of certain U.S. tax deductions related to research and development and certain other administration expenses.
The fiscal year 2008 effective tax rate includes discrete benefits of approximately $4.7 million related to current and prior year research and development tax credits, other discrete benefits of $0.3 million, and a discrete charge of approximately $1.0 million to write-down the deferred tax asset for Swiss start-up losses upon receipt of the final Swiss incentive ruling. The fiscal year 2007 rate benefited from discrete items of approximately $2.0 million, primarily related to the retroactive extension of the research and development tax credit in that year. The fiscal year 2006 effective rate of 24.4% included a discrete benefit of $9.0 million related to the conclusion of an IRS examination.
During the fourth quarter of fiscal 2008, Varian Semiconductor Switzerland GmbH finalized the terms of a ruling with the Swiss tax authorities. This ruling grants a tax holiday for five years, beginning January 1, 2008, and extendable for another five years provided that certain commitments are met. Under the terms of the ruling, Varian Semiconductor’s income in Switzerland will be taxed at a rate that is approximately 50% of the Swiss statutory rate. This rate will vary depending on the character of income earned and the distribution channels used by Varian Semiconductor Switzerland GmbH.
Varian Semiconductor adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”) on September 29, 2007. Upon adoption of FIN 48, Varian Semiconductor increased the liability for net unrecognized tax benefits by $1.7 million, and accounted for the increase as a cumulative effect of change in accounting principle that resulted in a reduction in retained earnings of $1.7 million at September 29, 2007. Varian Semiconductor also reclassified $4.0 million of current income taxes payable to long-term income taxes payable and $1.3 million of long-term income taxes payable to non-current deferred tax assets. The net increase in the reserve for unrecognized tax benefits during fiscal year 2008 was $11.6 million for positions taken in the current year. Of the $52.4 million of unrecognized tax benefits, $48.1 million would impact the effective tax rate, if recognized. The difference between the total amount of unrecognized tax benefits and the amount that would impact the effective rate consists of items that are offset by deferred tax assets, $2.8 million of which relate to state tax credits which are fully offset by a valuation allowance.
Varian Semiconductor includes interest and penalties related to unrecognized tax benefits within its provision for income taxes. As of October 3, 2008, the total amount of accrued interest and penalties was $3.1 million. As of September 29, 2007, Varian Semiconductor had accrued $1.7 million of interest and penalties related to unrecognized tax benefits.
In the normal course of business, Varian Semiconductor and its subsidiaries are examined by various federal, state and foreign tax authorities, including the Internal Revenue Service (“IRS”). Varian Semiconductor is subject to audit by the IRS and various state and foreign authorities for fiscal years 2003 through 2007. The IRS recently concluded an examination of certain refund claims, primarily related to the extraterritorial income exclusion, filed by Varian Semiconductor for fiscal years 2000 through 2004. The IRS issued a notice of disallowance relating to a portion of these claims, and Varian Semiconductor filed a formal protest with the Appeals Office of the IRS. An Appeals hearing date has not been set. It is unknown whether agreement on these claims will be reached within the next twelve months. The favorable resolution of these claims could result in a benefit to the tax provision in the range of $0.0 to $5.8 million. Final agreement could reduce the amount of unrecognized tax benefits by approximately $5.8 million. In addition, Varian Semiconductor has been verbally notified by the IRS that it is planning to conduct an examination of fiscal year 2007. Audit fieldwork is expected to begin in the second quarter of fiscal year 2009.
Net Income
As a result of the foregoing factors, for fiscal year 2008 Varian Semiconductor recorded net income of $98.4 million, compared to net income of $142.2 million for fiscal year 2007 and net income of $94.7 million for fiscal year 2006. The net income per diluted share was $1.32 for fiscal year 2008, compared to net income per diluted share of $1.73 for fiscal year 2007 and $1.10 for fiscal year 2006.
Liquidity and Capital Resources
Varian Semiconductor generated $168.0 million of cash from operations during fiscal year 2008, compared to $108.3 million during fiscal year 2007. In fiscal year 2008, cash provided by operations was derived primarily from net income of $98.4 million, and non-cash expenses such as stock-based compensation of $23.1 million, and depreciation and amortization of $17.1 million. In addition, cash generated from operations resulted from decreases in accounts receivable of $61.3 million and inventories of $4.9 million, due to significantly lower sales primarily in the fourth quarter of fiscal year 2008. The cash flow effects of net income, non-cash items and the changes in accounts receivable and inventories were partially offset by a decrease in accounts payable of $20.6 million and a decrease in deferred revenue of $23.6 million. The decrease in deferred revenue is also due to lower sales primarily in the fourth quarter of fiscal year 2008. Furthermore, accounts payable decreased in fiscal year 2008 as Varian Semiconductor scaled back buying materials due to a lower manufacturing build schedule.
During fiscal year 2007, Varian Semiconductor generated $108.3 million of cash from operations. Cash provided by operations in fiscal year 2007 was derived primarily from net income of $142.2 million, non-cash expenses such as stock based compensation of $19.7 million and depreciation and amortization of $14.4 million. Increases in accounts receivable of $61.8 million and inventories of $51.6 million were related to higher business volume. These increases were partially offset by increases in accrued expenses and deferred revenue. The increase in accrued expenses is associated with an anticipated long-term tax liability relating to the global realignment. The increase in deferred revenue of $8.1 million was related to the increase in volume and timing of tool shipments and the increase in accrued expenses was related to incentive compensation in support of the increase in overall business activity.
In fiscal year 2006, cash provided by operations was derived primarily from net income of $94.7 million, plus non-cash expenses such as stock-based compensation of $18.9 million, depreciation and amortization of $13.0 million, and the tax benefit from stock options exercised and employee stock purchase plan issuances of $10.8 million. Also contributing to cash from operations were a decrease in other current assets of $14.7 million and an increase in accounts payable of $12.6 million. The cash flow effects of net income, non-cash items and the changes in other current assets and accounts payable were partially offset by increases in inventory of $11.8 million and decreases in accrued expenses of $5.9 million. The decrease in other current assets is primarily related to the receipt of refunds from the IRS associated with the conclusion of a multi-year tax examination. The increase in accounts payable and inventory is related to a higher manufacturing build schedule for the first quarter of fiscal year 2007 as opposed to the schedule for the first quarter of fiscal year 2006. Additionally, increases in inventory are also due to increased field inventory primarily for new customers.
During fiscal year 2008, Varian Semiconductor generated $42.7 million from the net sale and maturity of investments and used $9.5 million for the purchase of plant, property and equipment. During fiscal year 2007, Varian Semiconductor generated $108.7 million from the net sale and maturity of investments and used $10.9 million for the purchase of property, plant and equipment. In fiscal year 2008, Varian Semiconductor generated less cash from the net sale and maturity of investments compared to fiscal year 2007, because management decided to scale back stock repurchases in the second half of fiscal year 2008.
In fiscal year 2006, Varian Semiconductor used $9.1 million for the net purchase of investments and $12.0 million for the purchase of property, plant and equipment. In fiscal year 2007, Varian Semiconductor generated more cash from the net sale and maturity of investments compared to fiscal year 2006. In fiscal year 2007, cash provided by investing activities in part supported Varian Semiconductor’s repurchase of $426.5 million of its stock.
During fiscal year 2008, Varian Semiconductor used $170.1 million of cash for financing activities. During fiscal year 2008, Varian Semiconductor used $179.5 million to repurchase 4.8 million shares of stock at a weighted-average price per share of $37.74. As of April 21, 2008, Varian Semiconductor’s Board of Directors amended the share repurchase program by increasing the amount of funds that may be expended in repurchasing common
stock from $700 to $800 million. The program does not have a fixed expiration date. This was partially offset by the issuance of stock upon the exercise of stock options and under the employee stock purchase plan of $7.3 million and the excess tax benefit from stock based compensation of $2.5 million. During fiscal year 2007, Varian Semiconductor used $355.2 million of cash for financing activities. Varian Semiconductor repurchased $426.5 million of its stock during fiscal year 2007. During fiscal year 2007, Varian Semiconductor repurchased 11.3 million shares at a weighted-average price per share of $37.58. This was partially offset by the issuance of stock upon the exercise of stock options and under the employee stock purchase plan of $54.2 million and the excess tax benefit from stock based compensation of $17.6 million. Compared to fiscal year 2007, exercise of stock options decreased in fiscal year 2008 because of a significantly lower average stock price. Varian Semiconductor’s stock repurchase plan is influenced by its growth and investment plans, stage in the industry cycle, attractiveness of share price, and liquidity needs.
During fiscal year 2006, Varian Semiconductor used $54.5 million of cash for financing activities. Varian Semiconductor repurchased $108.9 million of its stock during the fiscal year as part of its authorized share repurchase program. This was partially offset by the issuance of stock upon the exercise of stock options and under the employee stock purchase plan of $50.3 million and the excess tax benefit from stock based compensation of $4.5 million.
On May 23, 2008, Varian Semiconductor entered into a credit agreement with multiple financial institutions providing for borrowings of a maximum principal amount of up to $100 million under an unsecured revolving credit facility. Amounts may be borrowed, repaid and re-borrowed from time to time during the five year commitment period ending May 23, 2013. Borrowings will bear interest at a rate per annum equal to either: (1) the greater of (a) the prime rate and (b) the federal funds rate plus 0.50%; or (2) the sum of (a) LIBOR, with certain adjustments and (b) an “applicable rate,” defined in the credit agreement as a percentage spread based on Varian Semiconductor’s leverage ratio. The credit agreement contains events of default and covenants. The credit facility is intended to provide ongoing working capital and cash for acquisitions, stock repurchases, capital expenditures and other general corporate purposes. As of October 3, 2008, there were no outstanding borrowings under the credit agreement.
As of October 3, 2008 and September 28, 2007, Varian Semiconductor’s subsidiary in Japan had two credit facilities available with two different financial institutions. At October 3, 2008, maximum available borrowings under each of the two facilities were as follows: Yen 500,000,000 ($4.7 million) and Yen 400,000,000 ($3.8 million). The loans are not collateralized and contain no restrictive covenants, although each loan is guaranteed by Varian Semiconductor. The interest rate for the Yen 500,000,000 facility is the 3-month Tokyo interbank offered rate (TIBOR) + 1.00% (approximately 1.88% at October 3, 2008 and 1.84% at September 28, 2007). The interest rate for the Yen 400,000,000 credit facility is based on the short-term prime rate (approximately 0.97% at October 3, 2008 and 1.875% at September 28, 2007, when the facility was Yen 1,000,000,000). There were no outstanding borrowings under either facility at October 3, 2008 or September 28, 2007.
Varian Semiconductor also has borrowing capacity in Europe and Taiwan. Varian Semiconductor’s subsidiary in Europe maintains a credit facility that includes overdraft protection of Euro 2.5 million which at October 3, 2008 translated to $3.5 million. Interest accrues at the Euro base rate + 1.5% and was approximately 7.9% at October 3, 2008. Borrowings under this facility are payable on demand. Varian Semiconductor’s subsidiary in Taiwan maintains a credit facility of $1.0 million. Any outstanding U.S. Dollar borrowings under the Taiwan facility accrue interest at the local base rate + 2.0% plus taxes, which was approximately 7.4% at October 3, 2008. Any New Taiwan Dollar borrowings accrue interest at the local base rate + 2.0% plus taxes, which was approximately 4.12% at October 3, 2008. Both U.S. Dollar and New Taiwan Dollar borrowings are payable within six months of drawdown. Neither credit facility is collateralized nor do they contain any restrictive covenants, although each facility is guaranteed by Varian Semiconductor. There were no outstanding borrowings as of October 3, 2008 or September 28, 2007 under either facility.
In February 2003, Varian Semiconductor purchased its previously leased facility located in Newburyport, Massachusetts. The purchase price consisted of cash payments totaling $3.4 million, the assumption of the seller’s outstanding loan of $5.1 million and the transfer of other prepaid assets of $0.8 million. The loan has a fixed interest rate of 9.05% with monthly payments of principal and interest until the loan matures in January 2013. The loan may be prepaid in full, but not in part, at any time after November 5, 2006. Prepayment would require Varian Semiconductor to pay a prepayment penalty equal to the greater of two percent of the outstanding principal balance or the excess of the present value of all future loan payments over the outstanding principal balance of the loan. The $2.8 million carrying amount of the loan had an estimated fair value of $2.9 million at October 3, 2008. The fair value of the loan was estimated using a discounted cash flow analysis. The interest rate was estimated based on current market conditions and Varian Semiconductor’s financial condition at October 3, 2008. As of October 3, 2008, Varian Semiconductor also had a standby letter of credit outstanding for $0.9 million as a guarantee for the debt on this facility.
Varian Semiconductor’s liquidity is affected by many factors, some based on the normal operations of the business and others related to the uncertainties of the industry and global economies. Varian Semiconductor believes that cash, cash equivalents and investments of $278.2 million at October 3, 2008 will be sufficient to satisfy working capital requirements, commitments for capital expenditures, any future common stock repurchases and other purchase commitments, environmental contingencies and cash requirements for the foreseeable future. Varian Semiconductor believes that it has the ability to hold cash equivalents and investments through maturity and therefore believes that any reduction in value of investments is temporary in spite of the current disruption in the credit markets.
Off-Balance Sheet Arrangements
Varian Semiconductor does not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, Varian Semiconductor is not exposed to any financing, liquidity, market or credit risk that could arise if Varian Semiconductor had engaged in such relationships.
Contractual Obligations
Under GAAP, some obligations and commitments are not required to be included in the consolidated balance sheets and statements of income. These obligations and commitments, while entered into in the normal course of business, may have a material impact on liquidity. The following commitments as of October 3, 2008 have not been included in the consolidated balance sheets and statements of income included under Item 8. “Financial Statements and Supplementary Data”.
Varian Semiconductor adopted Financial Accounting Standards Board “FASB” Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109”, (“FIN 48”) on September 29, 2007. As of October 3, 2008, the non-current tax payable under FIN48 was $43.8 million. Varian Semiconductor is unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes.
In addition, Varian Semiconductor in fiscal year 2008 recorded a charge of $1.6 million related to adverse purchase price commitments.
Transactions with Affiliates and Related Parties
Operations prior to April 2, 1999 had been part of the former VAI, which now operates as VMS. On April 2, 1999, VAI contributed its SEB to Varian Semiconductor, then distributed to the holders of record of VAI common stock one share of common stock of Varian Semiconductor for each share of VAI common stock owned on March 24, 1999. At the same time, VAI contributed its Instruments Business (“IB”) to VI and distributed to the holders of record of VAI common stock one share of common stock of IB for each share of VAI common stock owned on March 24, 1999. VAI retained its Health Care Systems business and changed its name to VMS effective as of April 2, 1999. These transactions were accomplished under the terms of a Distribution Agreement by and among Varian Semiconductor, VAI, hereafter referred to as VMS for periods following the spin-off and VI (the “Distribution Agreement”). For purposes of providing an orderly transition and to define certain ongoing relationships between and among Varian Semiconductor, VMS and VI after the spin-off, Varian Semiconductor, VMS and VI also entered into the Distribution Related Agreements.
The Distribution Related Agreements provide that from and after the spin-off, VMS, VI and Varian Semiconductor will indemnify each and their respective subsidiaries, directors, officers, employees and agents against all losses arising in connection with shared liabilities (including certain environmental and legal liabilities). All shared liabilities will be managed and administered by VMS and expenses and losses, net of proceeds and other receivables, will be borne one-third each by VMS, VI, and Varian Semiconductor. The Distribution Related Agreements also provide that Varian Semiconductor shall assume all of its liabilities, other than shared liabilities (including accounts payable, accrued payroll and pension liabilities) in accordance with their terms. During fiscal years 2008, 2007 and 2006, Varian Semiconductor was charged $1.0 million, $0.9 million and $1.4 million, respectively, by VMS in settlement of these obligations.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS No. 157”), which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2 delaying the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value on a recurring basis. Varian Semiconductor will adopt the delayed portions of SFAS No. 157 during fiscal year 2010, while all other portions of the standard will be adopted during fiscal year 2009, as required. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. Earlier adoption is permitted, provided the company has not yet issued financial statements, including interim periods, for that fiscal year. Varian Semiconductor’s financial assets and liabilities impacted by SFAS No. 157 relate primarily to investments and hedging derivatives. Varian Semiconductor does not believe there will be any material impact on its financial position, results of operations and liquidity as a result of adopting the provisions of SFAS No. 157.
In October 2008, the FASB issued FSP SFAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active”. FSP SFAS No. 157-3 clarifies the application of SFAS No. 157, which Varian Semiconductor adopted October 4, 2008 for fiscal year 2009, in situations where the market is not active. Varian Semiconductor will consider the guidance provided by FSP SFAS No. 157-3 in its determination of estimated fair values for the fiscal year 2009.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115.” This Statement permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The decision to measure items at fair value can be made on an instrument-by-instrument basis, but once the decision is made, it is permanent. This statement will be effective for Varian Semiconductor’s fiscal year 2009. Varian Semiconductor does not estimate a significant impact on its financial statements relating to SFAS No. 159.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” This statement requires enhanced disclosure requirements for derivative instruments and hedging activities including how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This statement will be effective for Varian Semiconductor’s fiscal year 2010. Varian Semiconductor is in the process of evaluating the impact of this statement on its financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Foreign Currency Exchange Risk
As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could impact Varian Semiconductor’s financial results. However, based on the results of an annual test, a 10% change in the exchange rate of the U.S. dollar against other major currencies would not have a material effect on Varian Semiconductor’s results of operations. Historically, Varian Semiconductor’s primary exposures have resulted from non-U.S. dollar-denominated sales and purchases in Asia Pacific and Europe. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to nine months in original maturity. No forward exchange contract exceeds one year in original maturity.
Varian Semiconductor hedges currency exposures that are associated with certain of its assets and liabilities denominated in various non-U.S. dollar currencies. The aggregate exchange losses for the fiscal years ended 2008, 2007 and 2006 were $288,000, $311,000 and $146,000, respectively.
Forward exchange contracts outstanding are summarized as follows:
Varian Semiconductor uses derivative instruments to protect its foreign operations from fluctuations in earnings and cash flows caused by volatility in currency exchange rates. Varian Semiconductor hedges its current exposures and a portion of its anticipated foreign currency exposures with hedging instruments having terms of up to twelve months.
Varian Semiconductor’s international sales, except for those in Japan, are primarily denominated in the U.S. dollar. For foreign currency-denominated sales, however, the volatility of the foreign currency markets represents risk to Varian Semiconductor. Upon forecasting the exposure, Varian Semiconductor enters into hedges with forward sales contracts whose critical terms are designed to match those of the underlying exposure. These hedges are evaluated for effectiveness at least quarterly using the change in value of the forward contracts to the change in value of the underlying transaction, with the effective portion of the hedge accumulated in other comprehensive income. Any measured ineffectiveness is included immediately in other income and expense in the consolidated statements of income. There was an immaterial amount of ineffectiveness recognized during the fiscal years ended October 3, 2008 and September 28, 2007. There were six forward foreign exchange sell contracts designated as hedges of anticipated product sales in Japanese Yen outstanding at October 3, 2008 totaling an equivalent of $21.6 million. In addition, there was one forward foreign exchange purchase contract in the amount of $2.8 million offsetting one of the six forward sell contracts. At September 28, 2007, there were four forward foreign exchange sell contracts outstanding designated as hedges of anticipated product sales in Japanese Yen, totaling an equivalent of $12.6 million. In addition, there were two forward foreign exchange purchase contracts totaling an equivalent of $6.5 million offsetting two of the four forward sell contracts.
There were approximately $0.1 million net unrealized gains on these forward Yen contracts as of October 3, 2008. There was a negligible net unrealized loss on these forward Yen contracts as of September 28, 2007. The fair value of forward exchange contracts generally reflects the estimated amounts that Varian Semiconductor would receive or pay to terminate the contracts at the reporting date. The notional amounts of forward exchange contracts are not a measure of Varian Semiconductor’s exposure.
Interest Rate Risk
Although payments under certain of Varian Semiconductor’s overseas borrowing facilities are tied to market indices, Varian Semiconductor is not exposed to material interest rate risk from these borrowing facilities. Varian Semiconductor has no material cash flow exposure due to rate changes for cash equivalents and short-term investments. Varian Semiconductor maintains cash investments primarily in U.S. Treasury, government agency and investment-grade corporate and municipal securities, as well as short-term time deposits with investment grade financial institutions. Cash equivalents at October 3, 2008 and September 28, 2007 were $110.2 million and $84.5 million, respectively. At October 3, 2008, Varian Semiconductor’s short-term investments were $69.0 million and consisted primarily of corporate bonds, certificates of deposit and government agency and U.S. Treasury securities with ratings of AA or better. At September 28, 2007, Varian Semiconductor’s short-term investments were $88.4 million and consisted primarily of U.S. Treasury, government agency and corporate bonds and certificates of deposit with ratings of AA or better. At October 3, 2008, Varian Semiconductor’s long-term investments were $69.5 million and consisted primarily of U.S. Treasury, government agency, and corporate bonds with ratings of AA or better. At September 28, 2007, Varian Semiconductor’s long-term investments were $96.2 million and consisted primarily of U.S. Treasury, government agency and corporate bonds with ratings of AA or better.
In February 2003, Varian Semiconductor purchased its facility located in Newburyport, Massachusetts. As part of the purchase price, Varian Semiconductor assumed the seller’s outstanding loan of $5.1 million. The loan has a fixed interest rate of 9.05% with monthly payments of principal and interest until the loan matures in January 2013. The loan may be prepaid in full, but not in part, at any time after November 5, 2006. The loan is secured by the property. The $2.8 million remaining principal amount of the loan had an estimated fair value of $2.9 million at October 3, 2008. The fair value of the loan was estimated using a discounted cash flow analysis. The interest rate was estimated based on current market conditions and Varian Semiconductor’s financial condition at October 3, 2008.
Commodity Price Risk
Varian Semiconductor is not exposed to material commodity price risk.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The response to this item is submitted as a separate section to this report. See “Item 15. Exhibits and Financial Statement Schedules.”
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Disclosure Controls and Procedures
The management of Varian Semiconductor, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the disclosure controls and procedures of Varian Semiconductor as of October 3, 2008. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to Varian Semiconductor’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of Varian Semiconductor’s disclosure controls and procedures as of October 3, 2008, Varian Semiconductor’s Chief Executive Officer and Chief Financial Officer concluded that, as of such date, Varian Semiconductor’s disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control over Financial Reporting
No change in Varian Semiconductor’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended October 3, 2008 that has materially affected, or is reasonably likely to materially affect, Varian Semiconductor’s internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Management of Varian Semiconductor is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Management, with the participation of the Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of Varian Semiconductor’s internal control over financial reporting as of October 3, 2008. In their evaluation, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework.
Based on management’s evaluation using the COSO criteria, management concludes that Varian Semiconductor maintained effective internal control over financial reporting as of October 3, 2008. This evaluation has been audited by PricewaterhouseCoopers LLP, an independent registered accounting firm, as stated in their report which appears herein.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The response to this item is contained in part under the caption “Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K and in part in Varian Semiconductor’s Proxy Statement for the Annual Meeting of Stockholders to be held on February 5, 2009 (the “2009 Proxy Statement”) under the captions “Election of Directors,” “Information About Stockholder Proposals for 2010 Annual Meeting” and “Corporate Governance” which sections are incorporated herein by this reference.
The information required by this Item pursuant to Item 405 of Regulation S-K will appear under the heading “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2009 Proxy Statement, which section is incorporated herein by reference.
Varian Semiconductor has adopted a written code of ethics that applies to its principal executive officer, principal financial officer, and principal accounting officer or controller, or persons performing similar functions. Varian Semiconductor’s code of ethics, which also applies to its directors and all of its officers and employees, can be found on its web site, which is located at www.vsea.com, and is also an exhibit to this report. Varian Semiconductor intends to make all required disclosures concerning any amendments to, or waivers from, its code of business conduct and ethics on its web site.
Item 11.
Item 11. Executive Compensation.
The response to this item is contained in the 2009 Proxy Statement under the caption “Executive Compensation,” including “Compensation Discussion and Analysis,” “Director Compensation,” “Compensation Committee Interlocks and Insider Participation” and “Compensation Committee Report” which sections are incorporated herein by this reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The response to this item is contained in the 2009 Proxy Statement under the caption “Security Ownership of Certain Beneficial Owners” and “Equity Compensation Plan Information,” which sections are incorporated herein by this reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The response to this item is contained in the 2009 Proxy Statement under the captions “Director Independence” and “Transactions with Related Persons,” which section is incorporated herein by this reference.
Item 14.
Item 14. Principal Accountant Fees and Services.
The response to this item is contained in the 2009 Proxy Statement under the caption “Independent Registered Public Accounting Firm’s Fees,” which section is incorporated herein by this reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
The following documents are filed as part of this Annual Report on Form 10-K:
(1) Consolidated Financial Statements: (see index on page of this report)
•
Report of Independent Registered Public Accounting Firm
•
Consolidated Balance Sheets as of October 3, 2008 and September 28, 2007
•
Consolidated Statements of Income for fiscal years ended October 3, 2008, September 28, 2007 and September 29, 2006
•
Consolidated Statements of Cash Flows for fiscal years ended October 3, 2008, September 28, 2007 and September 29, 2006
•
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for fiscal years ended October 3, 2008, September 28, 2007 and September 29, 2006
•
Notes to Consolidated Financial Statements
(2) Consolidated Financial Statement Schedule: (see index on page of this report)
The following financial statement schedule of Varian Semiconductor and its subsidiaries for fiscal years 2008, 2007 and 2006 is filed as a part of this Annual Report on Form 10-K and should be read in conjunction with the consolidated financial statements of Varian Semiconductor and its subsidiaries.
•
Schedule II-Valuation and Qualifying Accounts
All other required schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.
(3) The list of Exhibits filed as a part of this Annual Report on Form 10-K are set forth in the Exhibit Index immediately preceding such Exhibits, and is incorporated herein by this reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
By:
/s/ ROBERT J. HALLIDAY
Robert J. Halliday
Executive Vice President and Chief Financial Officer
Date: November 25, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
The following financial statements of the Registrant and its subsidiaries are required to be included in Item 8:
All other required schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
Varian Semiconductor Equipment Associates, Inc.:
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(1) present fairly, in all material respects, the financial position of Varian Semiconductor Equipment Associates, Inc. and its subsidiaries at October 3, 2008 and September 28, 2007, and the results of their operations and their cash flows for each of the three years in the period ended October 3, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of October 3, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide 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.
/S/ PRICEWATERHOUSECOOPERS LLP
Boston, Massachusetts
November 25, 2008
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes to the audited consolidated financial statements are an integral part of these statements.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes to the consolidated financial statements are an integral part of these statements.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes to the consolidated financial statements are an integral part of these statements.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
The accompanying notes to the consolidated financial statements are an integral part of these statements.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Company
Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits to customers located both in the United States (“U.S.”) and in international markets. Varian Semiconductor faces risk factors similar to all companies in the semiconductor manufacturing equipment market including, but not limited to, competition, market downturn, technological change, international operations and related foreign currency risks and the ability to recruit and retain key employees.
Note 2. Summary of Significant Accounting Policies
Fiscal Year
Varian Semiconductor’s fiscal year is a 52- to 53-week period that ends on the Friday nearest September 30. Fiscal year 2008 is comprised of a 53-week period ended on October 3, 2008. Fiscal year 2007 is comprised of a 52-week period ended on September 28, 2007. Fiscal year 2006 is comprised of a 52-week period ended on September 29, 2006.
Principles of Consolidation
The consolidated financial statements include the accounts of Varian Semiconductor and its wholly owned subsidiaries. All material intercompany accounts and transactions are eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, Varian Semiconductor evaluates its estimates and assumptions including, but not limited to, deferred revenue, loss contingencies, warranty accruals, the reserve for excess and obsolete inventory, income taxes payable, deferred tax assets, stock-based compensation, and allowance for doubtful accounts. Actual results may differ from those estimates.
Revenue Recognition
Product revenue includes established products, new products, upgrades and spare parts.
Varian Semiconductor recognizes revenue from product sales upon shipment, provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectability is reasonably assured, and there are no uncertainties regarding customer acceptance.
For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance. For new products, revenue allocated to the equipment is recognized upon customer acceptance. Spare parts and upgrade sales are recognized as revenue upon the later of delivery or the transfer of title and risk of loss to the customer.
Varian Semiconductor generally follows predetermined criteria for changing the classification of a new product to an established product. Varian Semiconductor generally recognizes products as established after demonstrating success in achieving customer acceptance of the same tool type and specification, for the same or similar application. In most circumstances, once a new product achieves the predetermined criteria, the product is considered established. Furthermore, prior installation costs on the tool type can also influence the evaluation of tool maturity on a going forward basis.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Products are classified as established if the installation process and the post-delivery acceptance provisions are deemed routine, because acceptance provisions are generally a replication of pre-shipment procedures, and there is a demonstrated history of achieving the predetermined established product criteria. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions cannot be replicated in Varian Semiconductor’s facilities or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes.
Service revenue includes revenue from maintenance and service contracts, extended warranties, paid service and system installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Extended warranty revenue is deferred and recognized ratably over the applicable warranty term. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation and customer acceptance. It takes approximately three to six weeks for Varian Semiconductor technicians to complete the installation of Varian Semiconductor products and perform tests agreed to with customers. Certain customers formally document their acceptance of Varian Semiconductor’s products at this time. Other customers elect to perform additional internal testing prior to formal acceptance, and this process generally takes eight to twelve weeks.
Royalty and license revenue is recognized when contractual obligations are met, and in the case of royalties, upon receipt of a royalty report from the customer, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured.
Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair value of those elements. All elements may not be delivered and recognized as revenue during the same period. In such cases, Varian Semiconductor defers the fair value of the undelivered element until that element is delivered. The amount allocated to installation labor is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue. If fair value cannot be determined for any of the undelivered elements, the entire value of the arrangement is deferred.
Deferred Revenue
Deferred revenue includes customer advances and amounts that have been billed per the contractual terms but have not been recognized as revenue. Varian Semiconductor also defers the fair value of extended warranties bundled with equipment sales as deferred revenue. Deferred revenue for extended warranties is recognized ratably over the applicable warranty term, which generally is from 13 to 24 months from the date the customer accepts the products.
Evaluation Tools
Varian Semiconductor periodically supplies evaluation tools to potential new customers, usually for a period of six months to one year. While the tool is at the customer’s semiconductor manufacturing factory (“fab”), Varian Semiconductor and the customer work closely together through complex processes to qualify the tool for that particular customer's requirements. These qualification costs are included in marketing, general and
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administrative expenses in the period incurred. Varian Semiconductor generally reduces the carrying value of the evaluation tool ratably over a period of four years until it is determined that a sale may likely result. This cost is recorded as a component of marketing, general and administrative expenses and the carrying value of the evaluation tool is included in inventory. Customer evaluations are often successful and upon fulfillment of all four revenue recognition criteria, Varian Semiconductor recognizes the revenue from the evaluation tool and remaining tool cost through revenue and cost of product revenue, respectively.
Stock-based Compensation
Varian Semiconductor applies the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share Based Payment.” SFAS No. 123(R) establishes accounting for stock-based awards exchanged for employee and director services. Stock-based compensation cost is measured at grant date and based on the fair value of the award. The straight-line method is applied to all grants with service conditions, while the graded vesting method is applied to all grants with both service and performance conditions.
The choice of a valuation technique and the approach utilized to develop the underlying assumptions for that technique, involve significant judgments. These judgments reflect management’s assessment of the most accurate method of valuing the stock options Varian Semiconductor issues, based on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. Varian Semiconductor's judgments could change over time as additional information becomes available, or the facts underlying the assumptions change over time. Any change in judgments could have a material impact on Varian Semiconductor's financial statements. Varian Semiconductor believes that these estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.
Cash, Cash Equivalents and Investments
Varian Semiconductor considers currency on hand, demand deposits and all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments.
Short-term investments consist primarily of certificates of deposit, Treasury and government agency securities and corporate bonds with ratings AA or better. All short-term investments have been classified as available-for-sale and are carried at fair market value, which approximates cost, due to the short period of time to maturity and the relative risk of the investments. As of October 3, 2008, Varian Semiconductor had the ability but not the intent to liquidate certain investments in order to meet its liquidity needs for the next twelve months. Accordingly, those investments with contractual maturities greater than one year from the date of acquisition have been classified as long-term.
Accounts Receivable and Allowance for Doubtful Accounts
Substantially all of Varian Semiconductor’s accounts receivable balance relates to trade receivables. Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is Varian Semiconductor’s best estimate of the amount of probable credit losses in its existing accounts receivable. Varian Semiconductor maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments for products and services. Accounts with known financial issues are first reviewed and specific estimates are recorded. The remaining accounts receivable
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balances are then grouped in categories by the amount of days the balance is past due and the estimated loss is calculated as a percentage of the total category based upon past history. Account balances are charged off against the allowance when it is probable the receivable will not be recovered.
Inventory and Purchase Order Commitments
Varian Semiconductor values its inventory at the lower of cost or market using the first-in, first-out method. On a quarterly basis, Varian Semiconductor assesses the realizability of all inventories to determine whether adjustments for impairment are required. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor also provides for losses on those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under the commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. Once inventory is written down and a new cost basis has been established, it is not written back up if demand increases.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Major improvements are capitalized, while maintenance and repairs are expensed in the period the cost is incurred. Plant and equipment are depreciated over their estimated useful lives using the straight-line method. Leasehold improvements are amortized using the straight-line method over their estimated useful lives, or the remaining term of the lease, whichever is less. When assets are retired or otherwise disposed of, the assets and related accumulated depreciation are relieved from the accounts and resulting gains or losses are included in operating income in the consolidated statements of income.
Goodwill and Other Long-Lived Assets
At October 3, 2008 and September 28, 2007, goodwill was $12.3 million. In accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized. Varian Semiconductor tests for the impairment of goodwill on an annual basis or whenever events or changes in circumstances suggest that the carrying amount may not be recoverable. Varian Semiconductor tests for goodwill impairment at the entity level, as its subsidiaries do not constitute separate businesses and all possess similar economic characteristics. The test is performed by deducting the fair value of all assets and liabilities from the total estimated fair value to determine residual goodwill. As of October 3, 2008, Varian Semiconductor completed its annual goodwill impairment test and determined that no impairments existed.
Whenever events or changes in circumstances indicate that the carrying amounts of a long-lived asset may not be recoverable, Varian Semiconductor reviews these assets for impairment. If the future undiscounted cash flows are less than the carrying amount of that asset, impairment exists. Varian Semiconductor recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets. Fair value is normally assessed using a discounted cash flow model.
Product Warranties
Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes including actively monitoring and evaluating the
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quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.
Environmental Liabilities
Liabilities are recorded when environmental assessments and/or remedial efforts are probable and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or Varian Semiconductor’s commitment to a formal plan of action. In situations where the various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate then future costs, the lower limit of an estimated range is accrued on a non-discounted basis. All other liabilities, where Varian Semiconductor has generally sufficient knowledge to estimate the scope of costs and future activities, are accrued on a discounted basis. Should new information become available and/or different assumptions are applied in the estimation of environmental liabilities, revisions to the accrued environmental liability would be required.
Income Taxes
Varian Semiconductor uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statement and tax bases of assets and liabilities. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on Varian Semiconductor’s income tax provision and net income in the period in which the determination is made.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), on September 29, 2007. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes.” The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained upon audit, including resolutions of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. The Company reevaluates these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit and new audit activity. Any change in these factors could result in the recognition of a tax benefit or an additional charge to the tax provision. FIN 48 also provides guidance on classification, interest and penalties, accounting in interim periods, disclosure and transition.
Derivative Financial Instruments
Varian Semiconductor’s foreign subsidiaries operate and sell Varian Semiconductor’s products in various global markets. As a result, Varian Semiconductor is exposed to changes in foreign currency exchange rates. Varian Semiconductor utilizes foreign currency forward exchange contracts to hedge against currency exposures that are
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associated with certain of its assets and liabilities denominated in various non-U.S. dollar currencies. The effect of exchange rate changes on forward exchange contracts is expected to offset the effect of exchange rate changes on the underlying hedged items. Varian Semiconductor believes these financial instruments do not subject it to speculative risk that would otherwise result from changes in currency exchange rates. Varian Semiconductor does not use derivative financial instruments for speculative or trading purposes.
All of Varian Semiconductor’s derivative financial instruments are recorded at fair value based upon quoted market prices for comparable instruments. For derivative instruments designated and qualifying as cash flow hedges of anticipated foreign currency denominated transactions, the effective portion of the gain or loss on these hedges is reported as a component of accumulated other comprehensive income in stockholders’ equity, and is reclassified into earnings when the hedged transaction affects earnings. If the transaction being hedged fails to occur, or if a portion of any derivative is ineffective, the gain or loss on the associated financial instrument is recorded immediately in earnings. For derivative instruments used to hedge existing foreign currency denominated assets or liabilities, the gain or loss on these hedges is recorded immediately in earnings to offset the changes in the fair value of the assets or liabilities being hedged. There were six forward foreign exchange sell contracts designated as hedges of anticipated product sales in Japanese Yen outstanding at October 3, 2008, totaling an equivalent notional value of $21.6 million. In addition, there was one forward foreign exchange purchase contract in the amount of an equivalent notional value of $2.8 million offsetting one of the six forward sell contracts.
Foreign Currency Translation
For international operations, the U.S. dollar is the functional currency. Monetary assets and liabilities of foreign subsidiaries are translated into U.S. dollars at current exchange rates. Nonmonetary assets such as inventories and property, plant, and equipment are translated at historical rates. Income and expense items are translated at effective rates of exchange prevailing during each year, except that inventories and depreciation charged to operations are translated at historical rates. Foreign exchange gains and losses are recorded in the Consolidated Statements of Income in other income (expense), net.
Concentration of Risk
Financial instruments that potentially expose Varian Semiconductor to concentrations of credit risk consist principally of trade accounts receivable, cash investments and forward foreign exchange contracts. In recent fiscal years, Varian Semiconductor has sold over half of its systems to its ten largest customers, and its trade accounts receivable is primarily comprised of these respective customers. However, the concentration of credit risk is limited as the customer base is dispersed among many geographic regions and is comprised primarily of large multinational companies. Furthermore, for some higher risk customers, Varian Semiconductor may require a letter of credit to reduce credit exposure. Varian Semiconductor performs ongoing credit evaluations and generally does not require collateral from its customers. As of October 3, 2008, four customers accounted for 16%, 12%, 11% and 10% of the total accounts receivable balance. As of September 28, 2007, one customer accounted for 15% of the accounts receivable balance.
In fiscal year 2008, revenue from two customers accounted for 16% and 13% of Varian Semiconductor’s total revenue. In fiscal year 2007, revenue from one customer accounted for 17% of Varian Semiconductor’s total revenue. In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10% of Varian Semiconductor’s total revenue.
Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. The carrying
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amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments. Cash equivalents at October 3, 2008 and September 28, 2007 were $110.2 million and $84.5 million, respectively. Cash and cash equivalents are invested with multiple financial institutions. Investments consist primarily of U.S. Treasury, government agency and corporate bonds and certificates of deposit with ratings AA or better. All investments have been classified as available-for-sale and are carried at fair market value due to the short period of time to maturity and the relative risk of the investments. Varian Semiconductor manages its cash equivalents and investments as a single portfolio of highly marketable securities that is intended to be available to meet Varian Semiconductor’s current cash requirements. Varian Semiconductor also places forward foreign exchange contracts with investment grade financial institutions in order to minimize currency risk exposure.
Varian Semiconductor obtains some of the components and subassemblies that are included in its products from a limited group of suppliers, or in some cases a single source supplier. The loss of any supplier, including any single source supplier, would require obtaining one or more replacement suppliers and may also require devoting significant resources to product development to incorporate new parts from other sources into Varian Semiconductor’s products. The need to change suppliers or to alternate between suppliers might cause delays in delivery or significantly increase Varian Semiconductor’s costs. Although Varian Semiconductor has insurance to protect against loss due to business interruption from these and other sources, Varian Semiconductor cannot provide assurance that such coverage will be adequate or that it will remain available on commercially acceptable terms. Although Varian Semiconductor seeks to reduce its dependence on these limited source suppliers, disruption or loss of these sources could negatively impact its business and damage customer relationships.
Research and Development Costs
Research and development is comprised mainly of costs of internally-funded projects as well as continuing product development support. Costs incurred generally consist of employee and material costs, depreciation of equipment and other engineering related expenses. Research and development costs are expensed as incurred.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS No. 157”), which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2 delaying the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value on a recurring basis. Varian Semiconductor will adopt the delayed portions of SFAS No. 157 during fiscal year 2010, while all other portions of the standard will be adopted during fiscal year 2009, as required. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. Earlier adoption is permitted, provided the company has not yet issued financial statements, including interim periods, for that fiscal year. Our financial assets and liabilities impacted by SFAS No. 157 relate primarily to investments and hedging derivatives. Varian Semiconductor does not believe there will be any material impact on its financial position, results of operations and liquidity as a result of adopting the provisions of SFAS No. 157.
In October 2008, the FASB issued FSP SFAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active”. FSP SFAS No. 157-3 clarifies the application of SFAS No. 157, which Varian Semiconductor adopted October 4, 2008 for fiscal year 2009, in situations where the market is not active. Varian Semiconductor will consider the guidance provided by FSP SFAS No. 157-3 in its determination of estimated fair values for the fiscal year 2009.
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In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115.” This Statement permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The decision to measure items at fair value can be made on an instrument-by-instrument basis, but once the decision is made, it is permanent. This statement will be effective for Varian Semiconductor’s fiscal year 2009. Varian Semiconductor does not estimate a significant impact on its financial statements relating to SFAS No. 159.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” This statement requires enhanced disclosure requirements for derivative instruments and hedging activities including how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This statement will be effective for Varian Semiconductor’s fiscal year 2010. Varian Semiconductor is in the process of evaluating the impact of this statement on its financial statements.
Note 3. Stock-Based Compensation
Effective October 1, 2005, Varian Semiconductor adopted on a modified prospective basis the provisions of SFAS No. 123(R), “Share-Based Payment (Revised 2004),” (“SFAS No. 123(R)”) and related guidance, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options, restricted stock awards and employee stock purchases related to Varian Semiconductor’s Employee Stock Purchase Plan (“ESPP”) based on estimated fair values. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense on a straight-line or graded basis over the employee’s requisite service period.
Under the modified prospective transition method, stock-based compensation expense recognized during the fiscal year ended September 29, 2006 includes: (a) ESPP awards with the offering period commencing on July 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, (b) stock options and restricted stock awards granted prior to, but not yet vested as of September 30, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and (c) stock options, restricted stock and ESPP awards granted, subsequent to September 30, 2005, based on the grant-date fair value, in accordance with the provisions of SFAS No. 123(R).
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The estimated fair value of Varian Semiconductor’s stock-based awards, less expected forfeitures, is amortized over the awards’ vesting period. The effect of recording stock-based compensation for the fiscal years ended October 3, 2008, September 28, 2007 and September 29, 2006 was as follows:
Varian Semiconductor estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the risk-free interest rate over the option’s expected term, the expected annual dividend yield and the expected stock price volatility. Varian Semiconductor’s expected term is calculated using historical data and assumes that all outstanding options will be exercised at the midpoint of the vesting date and the full contractual term and is further adjusted for demographic data. Varian Semiconductor interpolates the risk-free interest rate from the U.S. Treasury zero-coupon bond that coincides with the expected term. Varian Semiconductor does not have a history of paying dividends, nor does it expect to in the future. Varian Semiconductor has determined that a blended volatility, using Varian Semiconductor’s historical and implied volatility measures and a peer group implied volatility, best reflects expected volatility over the expected term of the option. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards.
The fair value of each option granted during the fiscal years ended October 3, 2008, September 28, 2007 and September 29, 2006 were estimated on the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions:
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Stock Incentive Plan
The 2006 Stock Incentive Plan (the “Plan”), which replaced the Amended and Restated Omnibus Stock Plan upon shareholder approval on February 9, 2006, provides for the grant of non-qualified share-based awards to eligible employees, consultants and non-employee directors of Varian Semiconductor. As of October 3, 2008, a total of 7,752,154 shares were reserved for future issuance under the Plan.
Stock option awards granted under the Plan generally have a life no longer than eight years after the date of the grant and generally vest as to 25% one year from date of grant with the remaining 75% vesting in twelve equal quarterly installments so that all options are vested at the end of four years. Varian Semiconductor normally settles employee stock option exercises with newly issued common shares.
Restricted stock awards are granted under the Plan at $0.01 per share and generally vest as to 25% one year from the date of grant with the remaining 75% vesting in twelve equal quarterly installments. In December 2007, the Board of Directors approved a performance-based restricted stock award to certain executives of Varian Semiconductor. Varian Semiconductor assessed the probability of these executives meeting the performance goals on a quarterly basis throughout the performance period. The terms of the award require that vesting occurs only if specified performance targets and service conditions, as established by the Compensation Committee, are satisfied for the fiscal year ending October 3, 2008. Following the end of the performance period, Varian Semiconductor determined that the performance conditions were not met, thus all previously recorded expense for the associated grants was reversed and the awards have been cancelled.
Stock compensation expense associated with restricted common stock and restricted stock units is charged for the difference between the market value on the date of grant and the issuance price, less estimated forfeitures, and is amortized over the awards’ vesting period on a straight-line basis for all grants with service conditions, while the graded vesting method applies to all grants with both service and performance conditions.
The following table summarizes the stock option and restricted stock activity for the fiscal year ended October 3, 2008:
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The total intrinsic value is based on Varian Semiconductor’s closing stock price of $21.70 as of October 3, 2008, and represents the amounts that would have been received by the option holders had all option holders exercised their options as of that date.
As of October 3, 2008, the unrecognized compensation cost related to unvested stock options was $21.4 million including estimated forfeitures. This unrecognized compensation will be recognized over an estimated weighted average amortization period of 3.6 years.
As of October 3, 2008, the unrecognized compensation cost related to unvested restricted stock was $19.8 million including estimated forfeitures. This unrecognized compensation will be recognized over an estimated weighted average amortization period of 2.3 years.
The total intrinsic value of options exercised during the fiscal year ended October 3, 2008 was $4.8 million, with intrinsic value defined as the difference between the market price on the date of exercise and the grant date strike price. The total amount of cash received from the exercise of these options was $3.9 million. The actual tax benefit realized for the tax deductions from option exercises totaled $1.5 million for fiscal year ended October 3, 2008. The total intrinsic value of options exercised during the fiscal years ended September 28, 2007 and September 29, 2006 was $69.5 million and $32.9 million, respectively. The total amount of cash received in fiscal years ended September 28, 2007 and September 29, 2006 from the exercise of these options was $51.0 million and $47.3 million, respectively. The actual tax benefit realized for the tax deductions from option exercises totaled $24.0 million and $11.6 million for the fiscal years ended September 28, 2007 and September 29, 2006, respectively.
The total fair value of restricted stock grants that vested during the fiscal year ended October 3, 2008 was $16.9 million. The total fair value of restricted stock grants that vested during the fiscal years ended September 28, 2007 and September 29, 2006 was $16.1 million and $5.1 million, respectively.
During the fiscal year ended October 3, 2008, Varian Semiconductor awarded a total of 12,500 restricted stock units which vested upon grant.
Employee Stock Purchase Plan
Employees of Varian Semiconductor who elect to participate in the ESPP are able to purchase common stock at the lower of 85% of the fair market value of Varian Semiconductor’s common stock on the first or last day of the applicable offering period. Typically, each offering period lasts six months. The ESPP permits an enrolled employee to have withheld from his or her salary an amount between 1% and 10% of compensation, which is used to purchase shares of common stock and is intended to meet the requirements of Section 423 of the Internal Revenue Code. As of October 3, 2008, there were a total of 933,871 shares of common stock reserved for issuance under the ESPP. The fair value of shares issued under the ESPP was estimated on the commencement date of each offering period using the Black-Scholes option-pricing model with the following assumptions:
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Note 4. Cash, Cash Equivalents and Investments
Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments. Cash equivalents at October 3, 2008 and September 28, 2007 were $110.2 million and $84.5 million, respectively.
Investments consist primarily of U.S. Treasury, government agency and corporate bonds and certificates of deposit with ratings AA or better. All investments have been classified as available-for-sale and are carried at fair market value due to the short period of time to maturity and the relative risk of the investments. As of October 3, 2008, Varian Semiconductor had the ability, but not the intent, to liquidate certain investments in order to meet its liquidity needs for the next twelve months. Accordingly, those investments with contractual maturities greater than one year from the date of acquisition have been classified as long-term.
As of October 3, 2008, a net unrealized loss on investments of $3.7 million was recorded as accumulated other comprehensive loss. As of September 28, 2007, a net unrealized gain on investments of $58 thousand was recorded as accumulated other comprehensive gain.
Varian Semiconductor has determined that the unrealized losses at October 3, 2008, as aggregated by security type in the table below, are temporary. This assessment is based upon the nature of the investments and the causes of the unrealized losses. The investments are in corporate and US Treasury and agency bonds, as stated in the investment policy. The unrealized losses relate to the decline in fair value due to differences between the securities’ interest rates at acquisition and current interest rates, plus the temporary inability to sell certain securities in the prevailing financial environment.
Net realized gain for the fiscal year ended October 3, 2008 was approximately $0.4 million. Net realized loss for the fiscal year ended September 28, 2007 was approximately $0.05 million, and the net realized gain for the fiscal year ended September 29, 2006 was $0.23 million.
Investments by security type at October 3, 2008 were as follows:
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Investments by security type at September 28, 2007 were as follows:
The investment maturities are as follows:
Note 5. Accounts Receivable
Accounts receivable consist of the following:
Note 6. Inventories
The components of inventories are as follows:
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Note 7. Property, Plant and Equipment
The components of property, plant, and equipment are as follows:
Depreciation expense was $17.1 million, $14.4 million and $13.0 million for fiscal years 2008, 2007 and 2006, respectively. There were no capital leases in fiscal years ending October 3, 2008 and September 28, 2007.
Note 8. Notes Payable
On May 23, 2008, Varian Semiconductor entered into a credit agreement with multiple financial institutions providing for borrowings of a maximum principal amount of up to $100 million under an unsecured revolving credit facility. Amounts may be borrowed, repaid and re-borrowed from time to time during the five year commitment period ending May 23, 2013. Borrowings will bear interest at a rate per annum equal to either: (1) the greater of (a) the prime rate and (b) the federal funds rate plus 0.50%; or (2) the sum of (a) LIBOR, with certain adjustments and (b) an “applicable rate,” defined in the credit agreement as a percentage spread based on Varian Semiconductor’s leverage ratio. The credit agreement contains events of default and covenants. The credit facility is intended to provide ongoing working capital and cash for acquisitions, stock repurchases, capital expenditures and other general corporate purposes. As of October 3, 2008, there were no outstanding borrowings under the credit agreement.
As of October 3, 2008 and September 28, 2007, Varian Semiconductor’s subsidiary in Japan had two credit facilities available with two different financial institutions. At October 3, 2008, maximum available borrowings under each of the two facilities were as follows: Yen 500,000,000 ($4.7 million) and Yen 400,000,000 ($3.8 million). The loans are not collateralized and contain no restrictive covenants, although each loan is guaranteed by Varian Semiconductor. The interest rate for the Yen 500,000,000 facility is the 3-month Tokyo interbank offered rate (TIBOR) + 1.00% (approximately 1.88% at October 3, 2008 and 1.84% at September 28, 2007). The interest rate for the Yen 400,000,000 credit facility is based on the short-term prime rate (approximately 0.97% at October 3, 2008 and 1.875% at September 28, 2007, when the facility was Yen 1,000,000,000). There were no outstanding borrowings under either facility at October 3, 2008 or September 28, 2007.
Varian Semiconductor also has borrowing capacity in Europe and Taiwan. Varian Semiconductor’s subsidiary in Europe maintains a credit facility that includes overdraft protection of Euro 2.5 million which at October 3, 2008 translated to $3.5 million. Interest accrues at the Euro base rate + 1.5% and was approximately 7.9% at October 3, 2008. Borrowings under this facility are payable on demand. Varian Semiconductor’s subsidiary in Taiwan maintains a credit facility of $1.0 million. Any outstanding U.S. Dollar borrowings under the Taiwan facility accrue interest at the local base rate + 2.0% plus taxes, which was approximately 7.4% at October 3, 2008. Any New Taiwan Dollar borrowings accrue interest at the local base rate + 2.0% plus taxes, which was
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approximately 4.12% at October 3, 2008. Both U.S. Dollar and New Taiwan Dollar borrowings are payable within six months of drawdown. Neither credit facility is collateralized nor do they contain any restrictive covenants, although each facility is guaranteed by Varian Semiconductor. There were no outstanding borrowings as of October 3, 2008 or September 28, 2007 under either facility.
Note 9. Accrued Expenses
The components of accrued expenses are as follows:
Note 10. Restructuring
Varian Semiconductor’s business is cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. The semiconductor industry has historically experienced periodic downturns and, in response, Varian Semiconductor has occasionally recorded restructuring charges in connection with cost reduction initiatives implemented in response to those downturns. Restructuring charges typically consist of severance, benefits and outplacement services offered to terminated employees and sometimes include charges for remaining lease payments on facilities that are closed. Prior to any restructuring announcements, the restructuring is approved by the appropriate level of management necessary to commit to the specific actions of the reduction in force.
In the fiscal third quarter of 2008, Varian Semiconductor incurred a restructuring charge of $0.6 million in connection with cost reduction initiatives implemented in response to an industry downturn. The restructuring charge, part of an ongoing benefit arrangement, is accounted for under SFAS No. 112, “Accounting for Postemployment Benefits.” The expense related to a reduction of headcount in the United States of approximately 30 people.
In the fiscal fourth quarter of 2008, Varian Semiconductor reduced headcount by an additional 19 people resulting in a charge of $0.6 million.
In fiscal year 2009, Varian Semiconductor expects a continuation of cost reduction initiatives. As of November 20, 2008, Varian Semiconductor had already incurred an additional $3.1 million in restructuring charges relating to further headcount reduction.
Varian Semiconductor began relocating its European operations in Houten, the Netherlands to Schaffhausen, Switzerland, in the fiscal fourth quarter of 2008. The restructuring is accounted for under SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and is comprised primarily of one-time termination benefits and a contract termination expense, a facility lease. Accordingly, a charge of $0.4 million, primarily severance related, was recorded in the fiscal fourth quarter of 2008.
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Varian Semiconductor estimates that the European restructuring activity, inclusive of fiscal year 2008 fourth quarter activity ($0.4 million), will cost $2.4 million. The estimate includes contract termination costs of approximately $0.3 million (a facility lease), one-time termination benefits of $1.6 million (severance), and other associated costs of $0.1 million.
The following table summarizes the components of these charges including ongoing benefit arrangements, one-time termination benefits, contract termination costs, and other associated costs.
Cash outlays related to one-time termination benefits and contract termination costs to exit the Houten facility will continue through fiscal years 2010, and 2013, respectively.
Varian Semiconductor did not recognize restructuring costs during fiscal year 2007 or 2006.
Note 11. Product Warranties
Varian Semiconductor warrants that its products will be free from defects in materials and workmanship and will conform to its standard published specifications in effect at the time of delivery for a period of three to twelve months from the date the customer accepts the products. Additionally, Varian Semiconductor warrants that maintenance services will be performed in a workmanlike manner consistent with generally accepted industry standards for a period of 90 days from the completion of any agreed-upon services. Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. Varian Semiconductor’s warranty obligation is affected by a number of factors, including product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should these factors or other factors affecting warranty costs differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.
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Product warranty activity for fiscal years 2008 and 2007 was as follows:
Note 12. Deferred Revenue
The components of deferred revenue are as follows:
Note 13. Long-Term Accrued Expenses and Other Long-Term Liabilities
$63.6 million in long-term accrued expenses and other long-term liabilities at October 3, 2008 are comprised of accruals of $42.3 million for long-term tax liabilities. In addition, post-employment liabilities, environmental and other costs not expected to be expended within the next year are included in long-term accrued expenses and other long-term liabilities. The current portion is recorded within accrued expenses. $53.9 million in long-term accrued expenses and other long-term liabilities at September 28, 2007 are comprised of accruals of $28.5 million for long-term tax liabilities.
Note 14. Long-term Debt
In February 2003, Varian Semiconductor purchased its previously leased facility located in Newburyport, Massachusetts. The purchase price consisted of cash payments totaling $3.4 million, the assumption of the seller’s outstanding loan of $5.1 million and the transfer of other prepaid assets of $0.8 million. The loan has a
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fixed interest rate of 9.05% with monthly payments of principal and interest until the loan matures in January 2013. The loan may be prepaid in full, but not in part, at any time after November 5, 2006. Prepayment would require Varian Semiconductor to pay a prepayment penalty equal to the greater of two percent of the outstanding principal balance or the excess of the present value of all future loan payments over the outstanding principal balance of the loan. The $2.8 million carrying amount of the loan had an estimated fair value of $2.9 million at October 3, 2008. The fair value of the loan was estimated using a discounted cash flow analysis. The interest rate was estimated based on current market conditions and Varian Semiconductor’s financial condition at October 3, 2008.
The loan payments are as follows:
As of October 3, 2008, Varian Semiconductor also had a standby letter of credit outstanding for $0.9 million as a guarantee for the debt on this facility.
Note 15. Forward Exchange Contracts
As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could impact Varian Semiconductor’s financial results. However, based on the results of an annual test, a 10% change in the exchange rate of the U.S. dollar against other major currencies would not have a material effect on Varian Semiconductor’s results of operations. Historically, Varian Semiconductor’s primary exposures have resulted from non-U.S. dollar-denominated sales and purchases in Asia Pacific and Europe. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to nine months in original maturity. No forward exchange contract exceeds one year in original maturity.
Varian Semiconductor hedges currency exposures that are associated with certain of its assets and liabilities denominated in various non-U.S. dollar currencies. The aggregate exchange losses for the fiscal years ended 2008, 2007 and 2006 were $288,000, $311,000 and $146,000, respectively.
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Forward exchange contracts outstanding are summarized as follows:
Varian Semiconductor uses derivative instruments to protect its foreign operations from fluctuations in earnings and cash flows caused by volatility in currency exchange rates. Varian Semiconductor hedges its current exposures and a portion of its anticipated foreign currency exposures with hedging instruments having terms of up to twelve months.
Varian Semiconductor’s international sales, except for those in Japan, are primarily denominated in the U.S. dollar. For foreign currency-denominated sales, however, the volatility of the foreign currency markets represents risk to Varian Semiconductor. Upon forecasting the exposure, Varian Semiconductor enters into hedges with forward sales contracts whose critical terms are designed to match those of the underlying exposure. These hedges are evaluated for effectiveness at least quarterly using the change in value of the forward contracts to the change in value of the underlying transaction, with the effective portion of the hedge accumulated in other comprehensive income. Any measured ineffectiveness is included immediately in other income and expense in the consolidated statements of income. There was an immaterial amount of ineffectiveness recognized during the fiscal years ended October 3, 2008 and September 28, 2007. At October 3, 2008, there were six forward exchange sell contracts outstanding designated as hedges of anticipated product sales in Japanese Yen, totaling an equivalent of $21.6 million. In addition, there was one forward foreign exchange purchase contract totaling an equivalent of $2.8 million offsetting one of the six forward sell contracts. At September 28, 2007, there were four forward foreign exchange sell contracts outstanding designated as hedges of anticipated product sales in Japanese Yen totaling an equivalent of $12.6 million. In addition, there were two forward foreign exchange purchase contracts totaling an equivalent of $6.5 million offsetting two of the four forward sell contracts.
There were approximately $0.1 million net unrealized gains on these forward Yen contracts as of October 3, 2008. There was a negligible net unrealized loss on these forward Yen contracts as of September 28, 2007. The
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fair value of forward exchange contracts generally reflects the estimated amounts that Varian Semiconductor would receive or pay to terminate the contracts at the reporting date. The notional amounts of forward exchange contracts are not a measure of Varian Semiconductor’s exposure.
Note 16. Income Taxes
Provision for income taxes:
Total pre-tax income consists of the following:
Varian Semiconductor’s effective tax rate is based on its current profitability outlook and its expectations of earnings from operations in the U.S. and other tax jurisdictions throughout the world.
In fiscal year 2007, Varian Semiconductor implemented a plan to realign the legal entities within its worldwide affiliated group. The objective of this realignment was to make its legal structure more consistent with the geographic mix of its customers and suppliers. In effecting this realignment, Varian Semiconductor has established operations in Switzerland that will provide operational and financial services to all of its international locations. The realignment of Varian Semiconductor’s entities has caused the tax rate to become more sensitive to the geographic distribution of profits. The impact of this realignment caused Varian Semiconductor’s effective tax rate to increase by 8.6 percentage points in fiscal year 2008 and 15.4 percentage points in fiscal year 2007.
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The effective tax rate on income before taxes differs from the U.S. federal statutory tax rate as a result of the following:
At October 3, 2008 and September 28, 2007, Varian Semiconductor has provided U.S. tax on all available net unremitted foreign earnings. As a result, Varian Semiconductor has approximately $58 million and $15 million of previously taxed income at October 3, 2008 and September 28, 2007, respectively. It is Varian Semiconductor’s intention to indefinitely reinvest these earnings in non-U.S. operations. However, Varian Semiconductor may decide to repatriate a portion of these previously taxed earnings to the extent that it does not incur an additional withholding tax liability. At September 29, 2006, Varian Semiconductor had $35.2 million of unremitted book earnings that were considered to be permanently reinvested of which approximately $4.6 million were previously taxed income.
The components of the deferred tax assets and liabilities were as follows:
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Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts. Deferred tax assets include state tax credit carryforwards of $17.0 million, $18.6 million and $13.9 million at October 3, 2008, September 28, 2007 and September 29, 2006, respectively. These credits begin to expire in fiscal year 2009.
Varian Semiconductor records a valuation allowance against deferred tax assets if it is more likely than not that a portion of the deferred tax asset will not be realized. On a quarterly basis, Varian Semiconductor evaluates both the positive and negative evidence bearing upon the realizability of its deferred tax assets. Varian Semiconductor considers future taxable income, ongoing prudent and feasible tax planning strategies and the ability to utilize tax losses and credits in assessing the need for a valuation allowance. A valuation allowance related to certain state tax credit carryforwards has been recorded. Although, due to the global reorganization, Varian Semiconductor has increased its utilization of state tax credits, management has concluded that it is more likely than not that a portion of these credits will not be utilized, since historically the annual amount of state credits generated exceeds the amount of credits that can be used. Varian Semiconductor records a benefit to the tax provision and corresponding reduction in the valuation allowance related to the utilization of state tax credits generated in prior years. Should Varian Semiconductor determine that it is not able to realize all or part of its other deferred tax assets in the future, a valuation allowance would be required resulting in an expense recorded within the provision for income taxes in the statement of income in the period in which such determination was made. It is possible that the amount of the deferred tax asset considered realizable could be reduced in the near term, if future taxable income is reduced. Varian Semiconductor’s effective tax rate is affected by levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, U.S. foreign income exclusion, investment tax credits and other tax incentives specific to domestic and foreign operations.
In fiscal years 2008, 2007 and 2006, tax deductions associated with certain exercises of stock options, activity related to Varian Semiconductor’s ESPP and vesting of certain restricted stock shares resulted in a tax benefit recorded to capital in excess of par value of $2.6 million, $21.7 million and $10.8 million, respectively. Varian Semiconductor has elected to account for the indirect benefits of stock-based compensation on the research tax credit, extraterritorial income deduction and qualified production deduction through the income statement rather than through paid-in-capital.
Varian Semiconductor adopted FIN 48 on September 29, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes the recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Upon adoption of FIN 48, Varian Semiconductor increased the liability for net unrecognized tax benefits by $1.7 million and accounted for the increase as a cumulative effect of change in accounting principle that resulted in a reduction in retained earnings of $1.7 million at September 29, 2007. Varian Semiconductor also reclassified $4.0 million of current income taxes payable to long-term income taxes payable and $1.3 million of long-term income taxes payable to non-current deferred tax assets.
As of September 29, 2007, the total gross unrecognized tax benefits related to various federal, state and foreign income tax matters was $40.8 million. Of this amount, the amount that would impact the effective tax rate, if recognized, was $38.5 million. The difference between the total amount of unrecognized tax benefits and the amount that would impact the effective tax rate consists of items that are offset by deferred tax assets of $2.3 million, of which $0.9 million relates to state tax credits which are fully offset by a valuation allowance.
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The aggregate changes in the balances of gross unrecognized tax benefits were as follows:
The net increase in the reserve for unrecognized tax benefits during fiscal year 2008 was $11.6 million for positions taken in the current year. Of the $52.4 million of unrecognized tax benefits, $48.1 million would impact the effective tax rate, if recognized. The difference between the total amount of unrecognized tax benefits and the amount that would impact the effective rate consists of items that are offset by deferred tax assets, $2.8 million of which relate to state tax credits which are fully offset by a valuation allowance. Varian Semiconductor will reexamine the tax provision and the effect of estimated unrecognized tax benefits on its financial position at the end of each reporting period.
Except for the matters currently in the Appeals Office of the Internal Revenue Service (“IRS”), as discussed below, Varian Semiconductor does not anticipate that the total unrecognized tax benefits will significantly change due to increases in reserves, the settlements of audits or the expiration of statute of limitations in the next twelve months.
In the normal course of business, Varian Semiconductor and its subsidiaries are examined by various federal, state and foreign tax authorities, including the IRS. Varian Semiconductor is subject to audit by the IRS and various state and foreign authorities for fiscal years 2003 through 2007. The IRS recently concluded an examination of certain refund claims, primarily related to the extraterritorial income exclusion, filed by Varian Semiconductor for fiscal years 2000 through 2004. The IRS issued a notice of disallowance relating to a portion of these claims and Varian Semiconductor filed a formal protest with the Appeals Office of the IRS. An Appeals hearing date has not been set. It is unknown whether agreement on these claims will be reached within the next twelve months. The favorable resolution of these claims could result in a benefit to the tax provision in the range of $0.0 to $5.8 million. Final agreement could reduce the amount of unrecognized tax benefits by approximately $5.8 million.
As of September 29, 2007, Varian Semiconductor had accrued $1.7 million of interest and penalties related to unrecognized tax benefits. As of October 3, 2008, the total amount of accrued interest and penalties was $3.1 million. Varian Semiconductor includes interest and penalties related to unrecognized tax benefits within its provision for income taxes.
Note 17. Computation of Net Income Per Share
Basic net income per share is calculated based on net income and the weighted average number of shares of common stock outstanding during the reporting period. Diluted net income per share includes additional dilution from stock issuable pursuant to the exercise of stock options outstanding and unvested restricted stock. Options to purchase common shares with exercise prices that exceeded the market value of the underlying common stock are excluded from the computation of diluted earnings per share. For purposes of the diluted net income per share
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calculation, the additional shares issuable upon exercise of stock options are determined using the treasury stock method which, as required by SFAS No. 123(R), includes as assumed proceeds share-based compensation expense and the tax effect of such compensation.
The calculation of assumed proceeds, used to determine diluted weighted average shares outstanding under the treasury stock method since the adoption of SFAS No. 123(R), is adjusted by tax windfalls and shortfalls associated with outstanding stock awards. Windfalls and shortfalls are computed by comparing the tax deductible amount of outstanding stock awards to their grant date fair values and multiplying the result by the applicable statutory tax rate. A positive result creates a windfall, which increases the assumed proceeds and a negative result creates a shortfall, which reduces the assumed proceeds.
A reconciliation of the numerator and denominator used in the net income per share calculations is presented as follows:
For fiscal years 2008, 2007 and 2006, 1.0 million, 0.3 million and 2.0 million potentially dilutive shares, respectively, were excluded from the computation of diluted earnings per share.
Note 18. Share Repurchase Plan
In October 2004, Varian Semiconductor’s Board of Directors authorized the repurchase, from time to time, of up to $100 million of Varian Semiconductor’s common stock on the open market. Subsequently, the Board of Directors voted on increases to the amount of funds that may be expended in repurchasing Varian Semiconductor’s common stock to a total of $800 million. The program does not have a fixed expiration date.
Share repurchases under the program during fiscal years ended October 3, 2008 and September 28, 2007 were as follows:
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In addition to the repurchases made during fiscal year 2008, Varian Semiconductor has not repurchased any shares between October 4, 2008 and November 17, 2008, the latest practicable date prior to the filing date of this annual report on Form 10-K.
Note 19. Retirement Plans
Varian Semiconductor has a defined contribution retirement plan covering substantially all of its U.S. employees. Varian Semiconductor makes a guaranteed contribution, and in some years a discretionary contribution, to each participant’s account, generally calculated on fiscal year earnings and as a percentage of the participant’s base pay. Participants are entitled, upon termination or retirement, to their portion of the retirement fund assets, which are held by a third-party custodian. Effective April 2, 1999, Varian Semiconductor assumed responsibility for all of the retirement plans for active employees of Varian Semiconductor; the responsibility for all others, principally retirees of Varian Associates, Inc. (“VAI”), remained with VAI and, subsequently, Varian Medical Systems, Inc. (“VMS”). Additionally, Varian Semiconductor has two subsidiaries which sponsor defined benefit pension plans.
Liabilities for post-employment and post-retirement benefits of $6.6 million and $5.4 million have been included in the consolidated financial statements as of October 3, 2008 and September 28, 2007, respectively. In fiscal years 2008, 2007 and 2006, Varian Semiconductor’s retirement benefit expense was $7.6 million, $8.6 million and $7.2 million, respectively. These expenses consist of Varian Semiconductor’s defined contribution retirement plan, defined benefit pension plans and amounts paid to VMS in reimbursement of shared retirement costs.
Varian Semiconductor adopted SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans-an Amendment of FASB Statements No. 87, 88, 106, and 132(R),” effective September 28, 2007. SFAS No. 158 requires an employer to recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year, and recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes are reported in accumulated other comprehensive loss. The following table summarizes the incremental effects of the initial adoption of SFAS No. 158 on Varian Semiconductor’s Consolidated Balance Sheet at September 28, 2007:
During fiscal year 2008, the balance in accumulated other comprehensive income increased by $0.6 million, net of $0.4 million tax provision.
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Note 20. Lease Commitments
Varian Semiconductor leases various types of warehouse and office facilities and equipment, furniture and fixtures under noncancelable lease agreements that expire at various dates. Future minimum lease payments under operating leases are as follows:
Rental expense for fiscal years 2008, 2007 and 2006, was $3.1 million, $2.4 million and $2.3 million, respectively.
Note 21. Commitments, Contingencies and Guarantees
From time to time, Varian Semiconductor may be named a defendant in legal actions and could incur an uninsured liability in one or more of them. In the opinion of management, there are presently no legal actions where the outcome would have a material adverse effect on the consolidated financial position, results of operations or cash flows of Varian Semiconductor.
As permitted under Delaware law, Varian Semiconductor has agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was, serving in such capacity at the request of Varian Semiconductor. The term of the indemnification period is the later of (i) ten (10) years after the officer’s or director’s relationship with Varian Semiconductor has ceased, or (ii) the termination of all pending or threatened actions, suits, proceedings or investigations. The maximum potential amount of future payments Varian Semiconductor could be required to make under these indemnification agreements is unlimited; however, Varian Semiconductor has a Director and Officer insurance policy that limits its exposure and enables Varian Semiconductor to recover a portion of any future amounts paid. As a result of Varian Semiconductor’s insurance policy coverage, management believes the estimated fair value of these indemnification agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of October 3, 2008.
Varian Semiconductor enters into indemnification agreements in the normal course of business. Pursuant to these agreements, Varian Semiconductor indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally Varian Semiconductor customers, in connection with any patent, or any copyright or other intellectual property infringement claim by any third party with respect to Varian Semiconductor products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments Varian Semiconductor could be required to make under these indemnification agreements is unlimited. Management believes the estimated fair value of these agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of October 3, 2008.
Varian Semiconductor also indemnifies certain customers with respect to damages, losses and liabilities they may suffer or incur relating to personal injury, personal property damage, product liability, and environmental
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claims relating to the use of Varian Semiconductor’s products and services or resulting from the acts or omissions of Varian Semiconductor, its employees, officers, authorized agents or subcontractors. Varian Semiconductor has general and umbrella insurance policies that limit its exposure under these indemnification obligations and guarantees. As a result of Varian Semiconductor’s insurance policy coverage, Varian Semiconductor believes the estimated fair value of these indemnification agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of October 3, 2008.
Prior to the spin-off of Varian Semiconductor from VAI, Varian Semiconductor’s business was operated as the Semiconductor Equipment Business (“SEB”) of VAI. On April 2, 1999, VAI contributed its SEB to Varian Semiconductor, its Instruments Business (“IB”) to Varian, Inc. (“VI”), and changed its name to VMS. In connection with the spin-off from VAI, Varian Semiconductor, VMS and VI entered into certain agreements which include a Distribution Agreement, an Employee Benefits Allocation Agreement, an Intellectual Property Agreement, a Tax Sharing Agreement, and a Transition Services Agreement (collectively, the “Distribution Related Agreements”) whereby Varian Semiconductor agreed to indemnify VMS and VI for any costs, liabilities or expenses relating to Varian Semiconductor’s legal proceedings. Under the Distribution Related Agreements, Varian Semiconductor has agreed to reimburse VMS for one-third of the costs, liabilities, and expenses, adjusted for any related tax benefits recognized or realized by VMS, with respect to certain legal proceedings relating to discontinued operations of VAI. Varian Semiconductor believes the estimated fair value of the indemnification agreements is minimal, except as already recorded on the financial statements.
Varian Semiconductor’s operations are subject to various foreign, federal, state and/or local laws relating to the protection of the environment. These include laws regarding discharges into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. In addition, several countries are reviewing proposed regulations that would require manufacturers to dispose of their products at the end of a product’s useful life. These laws have the effect of increasing costs and potential liabilities associated with the conduct of certain operations.
Varian Semiconductor also enters into purchase order commitments in the normal course of business. As of October 3, 2008, Varian Semiconductor had approximately $38.0 million of purchase order commitments with various suppliers.
Environmental Remediation
VAI has been named by the United States Environmental Protection Agency or third parties as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act of 1980, at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also involved in various stages of environmental investigation and/or remediation under the direction of, or in consultation with, foreign, federal, state and/or local agencies at certain current or former VAI facilities (including facilities disposed of in connection with VAI’s sale of its Electron Devices business during fiscal year 1995, and the sale of its Thin Film Systems business during fiscal year 1997). The Distribution Related Agreements provide that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.
For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued $1.1 million in estimated environmental investigation and remediation costs for these sites and facilities as of October 3, 2008, and $1.2 million as of September 28, 2007. As to other sites
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and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has accrued $4.0 million as of October 3, 2008 and $4.1 million as of September 28, 2007, which represents future costs discounted at 7%, net of inflation, to cover Varian Semiconductor’s portion of these costs. This reserve is in addition to the $1.1 million as of October 3, 2008 and $1.2 million as of September 28, 2007 previously described.
As of October 3, 2008, Varian Semiconductor’s environmental liability, based upon future environmental-related costs estimated by VMS as of that date and included in current and long-term accrued expenses, is calculated as follows:
The current portion of the reserve is $0.7 million. The long-term portion of the reserve is $4.6 million, which is included in long-term accrued expenses.
The amounts set forth in the foregoing table are only estimates of anticipated future environmental-related costs and the amounts actually spent in the years indicated may be greater or less than such estimates. The aggregate range of cost estimates reflects various uncertainties inherent in many environmental investigation and remediation activities and the large number of sites where VMS is undertaking such investigation and remediation activities. VMS believes that most of these cost ranges will narrow as investigation and remediation activities progress. Varian Semiconductor believes that its reserves are adequate, but as the scope of the obligations becomes more clearly defined, these reserves may be modified and related charges against income may be made.
Although any ultimate liability arising from environmental-related matters described herein could result in significant expenditures that, if aggregated and assumed to occur within a single fiscal year, would be material to Varian Semiconductor’s financial statements, the likelihood of such occurrence is considered remote. Based on information currently available to management and its best assessment of the ultimate amount and timing of environmental-related events, Varian Semiconductor’s management believes that the costs of these environmental-related matters are not reasonably likely to have a material adverse effect on the consolidated financial statements of Varian Semiconductor.
Varian Semiconductor evaluates its liability for environmental-related investigation and remediation in light of the liability and financial wherewithal of potentially responsible parties and insurance companies where Varian Semiconductor believes that it has rights to contribution, indemnity and/or reimbursement. Claims for recovery of environmental investigation and remediation costs already incurred, and to be incurred in the future, have been
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asserted against various insurance companies and other third parties. In 1992, VAI filed a lawsuit against 36 insurance companies with respect to most of the above-referenced sites and facilities. VAI received certain cash settlements with respect to these lawsuits in prior years. VMS has also reached an agreement with an insurance company under which the insurance company agreed to pay a portion of Varian Semiconductor’s past and future environmental-related expenditures. Although VMS intends to aggressively pursue additional insurance recoveries, Varian Semiconductor has not reduced any liability in anticipation of recovery with respect to claims made against third parties.
Legal Proceedings
Varian Semiconductor is currently a party to legal disputes. While Varian Semiconductor believes it has meritorious claims and/or defenses with respect to each dispute, it cannot predict the outcome of each such dispute. Management believes that the ultimate outcome of these disputes, individually and in the aggregate, will not have a material adverse effect on the financial condition or results of operations of Varian Semiconductor.
From time to time, Varian Semiconductor may become involved in legal actions and could incur an uninsured liability. While the ultimate outcome of legal matters is difficult to predict, litigation, and in particular intellectual property litigation, can be expensive and the costs incurred can be substantial, regardless of outcome.
Note 22. Settlements and License Agreements
Pursuant to a settlement agreement dated March 7, 2006 between Varian Semiconductor and Nissin Ion Equipment Co., Ltd., a patent infringement litigation asserted by Varian Semiconductor against Nissin Ion was settled in the Western District of Texas without any admission of infringement or payment by Nissin Ion. This case was closed by the Court on March 20, 2006.
Pursuant to the dispute resolution provisions of an Agreement dated January 1, 1992 (“the Agreement”) between Varian Semiconductor and Applied Materials, in September 2002 Varian Semiconductor filed an arbitration demand with the American Arbitration Association asserting that Applied Materials breached the Agreement by failing to pay royalties on products Varian Semiconductor believed were covered by the Agreement’s patent license to Applied Materials. In its arbitration demand, Varian Semiconductor sought to recover back royalties, interest and attorneys’ fees. On May 2, 2003, the arbitration panel issued its decision that certain of Applied Materials’ products were subject to royalty obligations under the Agreement, and on September 1, 2004 the arbitration panel ruled that the patents at issue in the arbitration were valid and enforceable. Applied Materials made an initial payment of $22.0 million for back royalties and interest on October 4, 2004 and a final payment of $2.6 million for back interest and royalties on November 8, 2004. Applied Materials also was required to pay quarterly unit-based royalty payments to Varian Semiconductor on future sales of certain products found to be within the scope of the Agreement through expiration of the Agreement on March 20, 2007.
The royalty-bearing license agreements produced revenue of $0.1 million in fiscal year 2008, $7.5 million in fiscal year 2007 and $9.5 million in fiscal year 2006. The last of the principal patents covered by these licenses expired on March 20, 2007.
Note 23. Other Transactions with Affiliates
Varian Semiconductor, VMS and VI entered into the Distribution Related Agreements for purposes of providing an orderly transition and to define certain ongoing relationships between and among Varian Semiconductor, VMS and VI after the spin-off.
VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Distribution Related Agreements provide that, from and after the spin-off, VMS, VI and Varian Semiconductor indemnify each other and their respective subsidiaries, directors, officers, employees and agents against all losses arising in connection with shared liabilities, including certain environmental and legal liabilities. All shared liabilities are managed and administered by VMS and expenses and losses, net of proceeds and other receivables, are borne one-third each by VMS, VI and Varian Semiconductor. The Distribution Related Agreements also provide that Varian Semiconductor shall assume all of its liabilities, other than shared liabilities, including accounts payable, accrued payroll and pension liabilities, in accordance with their terms. During fiscal years 2008, 2007 and 2006, Varian Semiconductor was charged $1.0 million, $0.9 million and $1.4 million, respectively, by VMS in settlement of these obligations. Varian Semiconductor’s accounts payable balance due to VMS at October 3, 2008 was $0.1 million. Varian Semiconductor’s accounts payable balance due to VMS at September 28, 2007 was $0.1 million.
Note 24. Operating Segments and Geographic Information
Varian Semiconductor has determined that it operates in one business segment: the manufacturing, marketing and servicing of semiconductor processing equipment for ion implantation systems. Since Varian Semiconductor operates in one segment, all financial segment information required by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” can be found in the consolidated financial statements.
Revenue from Varian Semiconductor’s ten largest customers, in fiscal years 2008, 2007 and 2006, accounted for approximately 74%, 72% and 63% of total revenue, respectively. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. In fiscal year 2008, revenue from two customers accounted for 16% and 13% of Varian Semiconductor’s total revenue. In fiscal year 2007, revenue from one customer accounted for 17% of Varian Semiconductor’s total revenue. In fiscal year 2006, revenue from three customers accounted for 11%, 10% and 10%, respectively, of Varian Semiconductor’s total revenue.
Sales to Asia Pacific accounted for 70%, 71% and 67% of revenues in fiscal years 2008, 2007 and 2006, respectively. Varian Semiconductor’s North American sales accounted for 22% of total revenues in fiscal years 2008, 2007 and 2006. European sales accounted for 7%, 7% and 11% of Varian Semiconductor’s total revenues in fiscal years 2008, 2007 and 2006, respectively.
The following table summarizes revenue based on final destination and long-lived assets by geography:
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
For the fiscal years ended 2008, 2007, and
(Amounts in thousands)
S-1