Cabot Microelectronics 10-K 9-30-2006


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K

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

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2006
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________

COMMISSION FILE NUMBER 000-30205

CABOT MICROELECTRONICS CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE
36-4324765
(State of Incorporation)
(I.R.S. Employer Identification No.)

870 NORTH COMMONS DRIVE
60504
AURORA, ILLINOIS
(Zip Code)
(Address of principal executive offices)
 
Registrant's telephone number, including area code: (630) 375-6631

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchange on which registered
Common Stock, $0.001 par value
The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes x No o
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.      Yes o No x

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): 
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o

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

The aggregate market value of the registrant’s Common Stock held beneficially or of record by stockholders who are not affiliates of the registrant, based upon the closing price of the Common Stock on March 31, 2006, as reported by the NASDAQ Global Select Market, was approximately $897,990,000. For the purposes hereof, "affiliates" include all executive officers and directors of the registrant.

As of October 31, 2006, the Company had 23,957,552 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on March 6, 2007, are incorporated by reference in Part III of this Form 10-K to the extent stated herein.

This Form 10-K includes statements that constitute “forward-looking statements” within the meaning of federal securities regulations. For more detail regarding “forward-looking statements” see Item 7 of Part II of this Form 10-K.
 


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CABOT MICROELECTRONICS CORPORATION
FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2006

PART I.
     
Page
         
 
Item 1.
 
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Item 1A.
 
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Item 1B.
 
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Item 2.
 
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Item 3.
 
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Item 4.
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PART II.
       
         
 
Item 5.
 
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Item 6.
 
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Item 7.
 
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Item 7A.
 
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Item 8.
 
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Item 9.
 
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Item 9A.
 
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Item 9B.
 
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PART III.
       
         
 
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Item 11.
 
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Item 12.
 
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Item 13.
 
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Item 14.
 
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PART IV.
       
         
 
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PART I

ITEM 1. BUSINESS

OUR COMPANY

Cabot Microelectronics Corporation ("Cabot Microelectronics'', "the Company'', "us'', "we'', or "our''), which was incorporated in the state of Delaware in 2000, is the leading supplier of high-performance polishing slurries used in the manufacture of advanced integrated circuit (IC) devices within the semiconductor industry, in a process called chemical mechanical planarization (CMP). CMP is a process that polishes surfaces at an atomic level, thereby enabling IC device manufacturers to produce smaller, faster and more complex IC devices with fewer defects. 

We operate predominantly in one industry segment - the development, manufacture and sale of CMP slurries. Our CMP products are used for a number of applications, such as polishing insulating dielectric layers, tungsten that is used to connect the multiple wiring layers of IC devices through these insulating layers, and copper wiring, including the associated barrier film. In addition, we are developing and commercializing CMP polishing pads, which are used in conjunction with slurries in the CMP process.

In addition to expanding our core business in the semiconductor industry, we also are beginning to grow our business through our engineered surface finishes (ESF) initiative. We believe we can leverage our expertise in CMP slurry formulation, materials and polishing techniques and apply it to demanding surface modification and fine finish polishing applications in other industries where shaping, enabling and enhancing performance is critical to success. For example, we develop, manufacture and sell CMP slurries for polishing certain components in the hard disk drive industry, specifically rigid disk substrates and magnetic heads, and we believe we are one of the leading suppliers in this area. In addition to growing internally, we also are expanding through acquisitions such as our July 2006 acquisition of substantially all of the assets and assumption of certain liabilities of QED Technologies, Inc. (QED), a privately-held company that specializes in unique, patented polishing and metrology systems for fabricating high precision optics. Metrology systems measure surface finish, shape and performance of the optic. Further, in October 2005 we acquired substantially all of the assets and assumed certain liabilities of Surface Finishes Co., Inc. (“Surface Finishes”), a privately-held company that specializes in precision machining techniques at the sub-nanometer level on prototype or production components such as mirrors for optical imaging and scanning, air bearings, optical disc molds, large area reference surfaces and custom gauging.
 

IC DEVICE MANUFACTURING
 
An advanced IC device is composed of millions of transistors and other electronic components connected by miles of wiring. The wiring, composed primarily of either aluminum or copper, carries electrical signals through the multiple layers of the IC device. Insulating material is used throughout the IC device to electrically isolate the electronic components and the wiring. To enhance performance, IC device manufacturers have progressively increased the number and density of transistors and other electronic components in each IC device. Consequently, the number of wires and the number of discrete layers have also increased.

The multi-step manufacturing process for IC devices typically begins with a circular wafer of pure silicon. A large number of identical IC devices, or dies, are manufactured on each wafer at the same time. The first step in the manufacturing process builds transistors and other electronic components on the silicon wafer. These are isolated from each other using a layer of insulating material, most often silicon dioxide, to prevent electrical signals from bridging from one transistor to another. These components are then wired together using either aluminum or copper in a particular sequence to produce a functional IC device with specific characteristics. When the wiring on one layer of the IC device is completed, another layer of insulating material is added. The process of alternating insulating and wiring layers is repeated until the desired wiring within the IC device is finished. At the end of the process, the wafer is cut into the individual dies, which are then packaged to form individual chips.

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The percentage of IC devices that utilize CMP in the manufacturing process has increased steadily over time as semiconductor technology has advanced and performance requirements of IC devices have increased. We believe that CMP is used in just over half of all IC devices made today, and we expect that CMP will be used more extensively in the future as manufacturers continue to shrink the size of devices.

IC devices can generally be segmented into either logic or memory devices. Logic devices include chips such as microprocessors, digital signal processors, microcomponents and microcontrollers. These are normally computing-intensive devices that need to perform large numbers of processing steps every second. Advanced logic chips use copper wiring to provide increased processing speed because copper wiring has lower electrical resistance than aluminum wiring; aluminum wiring is generally used in chips that do not require this speed, such as logic devices of older technology, because it is more cost-effective than using copper wiring. Memory devices, which include flash, DRAM and SRAM chips, function by reading, storing and writing data. Traditionally this segment has been highly cost sensitive and processing speed is not as critical as in logic devices. Therefore, memory devices tend to use aluminum wiring.

CMP PROCESS AND BENEFITS

CMP is a polishing process used by IC device manufacturers to planarize or flatten many of the multiple layers of material that are built upon silicon wafers in the production of advanced IC devices. In this polishing process, CMP slurries and pads are used to level, smooth and remove excess material from the surfaces of these layers via a combination of chemical reactions and mechanical abrasion, while leaving minimal residue or defects on the surface and leaving only the material necessary for circuit integrity. CMP slurries are liquid solutions generally composed of high-purity deionized water, proprietary chemical additives and engineered abrasives that chemically and mechanically interact with the surface material of the IC device at an atomic level. CMP pads are engineered polymeric materials designed to distribute and transport the slurry to the surface of the wafer and distribute it evenly across the wafer. During the CMP process the wafer is typically held on a rotating carrier, which is pressed down against a rotating polishing table and spun in a circular motion. The portion of the table that comes in contact with the wafer is covered by a textured polishing pad. A CMP slurry is continuously applied to the polishing pad to facilitate and enhance the polishing process. Hard disk drive manufacturers use a process similar to this IC CMP process to smooth the surface of substrate disks before depositing magnetic media.

The characteristics that are important for an effective CMP process include:

 
§
High polishing rates, which increase productivity and throughput;
 
§
Selectivity, which is the ability to enhance the polishing of specific materials while at the same time inhibiting the polishing of other materials;
 
§
Uniform planarity, which minimizes unevenness as different layers are built on the wafer;
 
§
Uniformity of polishing, which means that different surface materials can be polished to the same degree at the same time across the wafer, leading to uniformity of all dies on the wafer;
 
§
Low defectivity, which means that the devices have fewer imperfections and therefore produce higher yield; and
 
§
Cost, because it is important for users to minimize their cost of manufacturing.

These attributes may be achieved through technical optimization of the CMP slurry and pad in conjunction with an appropriately designed CMP process. Prior to introducing new or different CMP slurries into its manufacturing process, an IC device manufacturer generally requires the product to be qualified in its processes through an extensive series of tests and evaluations. These qualifications are intended to ensure that the product will function properly in the manufacturing process, as well as to optimize its application. These tests may require changes to the CMP process or the CMP slurry. While this qualification process varies depending on numerous factors, it is generally quite costly and may take six or more months to complete. IC device manufacturers usually take the cost, time delay and impact on production into account when they consider implementing or switching to a new CMP slurry or supplier.

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CMP enables IC device manufacturers to produce smaller, faster and more complex IC devices with fewer defects and a greater density of transistors and other electronic components than was previously possible. CMP provides the near perfectly smooth and flat surface required to create the associated intricate wiring patterns. By enabling IC device manufacturers to make smaller IC devices, CMP also allows them to increase the number of IC devices that fit on a wafer. This increase in the number of IC devices per wafer in turn increases the throughput, or the number of IC devices that can be manufactured in a given time period, and reduces the cost per chip. CMP also helps reduce the number of defective or substandard IC devices produced, which increases the device yield. Improvements in throughput and yield reduce an IC device manufacturer's unit production costs, and reducing costs is one of the highest priorities of a semiconductor manufacturer because return on its significant investment in manufacturing capacity can be enhanced by lower unit costs. More broadly, sustained growth in the semiconductor industry traditionally has been fueled by lower unit costs that have made IC devices more affordable in an expanding range of applications.


PRECISION POLISHING PROCESSES AND BENEFITS

Through our ESF initiative, we are applying our technical expertise in CMP slurry formulation, materials and polishing techniques to demanding surface modification and fine finish polishing applications in other industries where shaping, enabling and enhancing performance of surfaces is critical to success. We believe we can deliver improvements in production economics, figure precision and surface finish (smoothness and texture) for a variety of difficult-to-polish materials, potentially enabling the use of these materials in higher-value applications.

In addition, many of the production processes currently used in precision machining and polishing have been based on traditional, labor-intensive techniques, which are being replaced by computer-controlled, deterministic processes. Our CMP technology may help to accelerate this transition to automated processes in several areas by providing consistent, rapid results.
 

OUR PRODUCTS

CMP SLURRIES AND POLISHING PADS FOR IC DEVICES
 
We develop and produce CMP slurries of various formulations for a wide range of polishing applications including tungsten and dielectric materials, which currently represent the most common use of CMP in IC device manufacturing. Slurries for polishing tungsten and dielectrics are used primarily in memory devices and older generation logic devices. Dielectric slurries are used in inter layer dielectric (ILD) applications, which represent the more mature and cost-sensitive part of the CMP business, as well as in advanced dielectric applications, which require higher performing solutions such as those used for pre-metal dielectric and direct shallow trench isolation applications.

We also develop and manufacture slurry products for polishing copper, which is used primarily in the wiring of advanced IC logic devices to provide increased processing speed because copper wiring has lower electrical resistance than aluminum wiring. These products include different slurries for polishing the copper film, as well as for the thin barrier metal layer used to separate copper from the adjacent insulating material. We have multiple products to enable different integration schemes depending on specific customer needs and for a range of technology nodes.

We are currently developing and commercializing CMP polishing pads utilizing our own and licensed technology. CMP polishing pads are consumable materials used in the CMP process that work in conjunction with CMP slurries to facilitate the polishing process, as described above. We believe that CMP polishing pads represent a natural adjacency to our CMP slurry business, and that there is value in co-developing slurries and pads to achieve technically optimized CMP solutions.
 
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CMP SLURRIES FOR THE DATA STORAGE INDUSTRY

We develop and produce CMP slurries for polishing the coating on rigid disks as well as magnetic heads in hard disk drives, which represents an extension of our core CMP slurry technology and manufacturing capabilities established for the semiconductor industry. We believe CMP significantly improves the surface finish of these coatings, resulting in greater storage capacity of the substrates, and also improves the production efficiency of manufacturers of hard disk drives by helping them increase their throughput and yield.


PRECISION OPTICS PRODUCTS AND SERVICES

Through our wholly-owned subsidiary, QED, we design and produce precision polishing equipment for advanced optics applications that allows customers to attain near-perfect shape (figure) and surface (finish) on a range of optical devices such as mirrors, lenses and prisms. Historically, advanced optics have been produced using labor-intensive processes so variability is common. QED has created an automated polishing system that enables rapid, deterministic and repeatable surface correction to the most demanding levels of precision and surface finish in dramatically less time than with traditional means. The machine uses Magneto-Rheological Finishing, QED’s proprietary surface figuring and finishing technology, which employs magnetic fluids and sophisticated computer technology to polish a variety of shapes.

Fabrication of high quality, advanced optics is often hampered by the lack of accurate and affordable metrology. For example, interferometers, which measure the surface of an optic, traditionally are limited by the size and precision of the reference optic used. QED has developed a Subaperture Stitching Interferometry (SSI) workstation that enables the automatic capture of precise metrology data for large and/or strongly curved optical parts and gives the user a complete map of the optical surface. The SSI workstation measures portions of large optical parts, and digitally “stitches” these portions together into a single complete surface map. This map is needed to produce high precision optics to exacting tolerances.


INDUSTRY TRENDS

The semiconductor industry has experienced rapid growth over the past three decades, but it has also been cyclical. In our early history as an independent entity, our revenue grew despite the protracted semiconductor industry downturn from 2001 to 2003, primarily because CMP was used in only the most advanced IC devices and the most advanced technology continued to grow even though the overall semiconductor industry contracted. Since CMP has become more broadly used within the IC industry, the semiconductor industry downturn in fiscal 2005 affected us, and we believe this downturn contributed to our revenue decline in that year. The semiconductor industry recovered moderately in fiscal 2006.

As we enter fiscal 2007, and semiconductor technology continues to advance, we believe that CMP technical solutions are becoming more complex, and leading-edge technologies now often require some customization by customer, tool set and process integration approach. Leading-edge device designs are introducing more materials and processes into next generation chips. Further, as CMP technology has matured, we believe that semiconductor manufacturers’ processes have become highly sensitive to CMP slurries, and customers now demand a high level of consistency and quality in CMP slurry products. Also, as CMP technology advances, customers are selecting suppliers much earlier in their development processes.

On a geographic basis, the Asia Pacific region continues to be the fastest growing region for IC manufacturing, as well as for our business, and we expect this trend to continue. We anticipate the worldwide market for CMP consumables used by IC device manufacturers will grow in the future as a result of expected increases in the number of IC devices produced, the percentage of IC devices produced that require CMP, the number of CMP polishing steps used to produce these devices and new materials used in semiconductor devices. We believe that the increased emphasis on memory technology and the incorporation of advanced logic and memory products into digital consumer devices will continue to be a key growth driver in the industry over the long term and will parallel the industry’s traditional emphasis on microprocessors for computing applications.

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We expect this anticipated growth will be somewhat mitigated by increased efficiencies in CMP slurry usage, driven by pressure on IC manufacturers to reduce costs, including the costs of the CMP process. For example, historically the semiconductor industry has migrated to increasingly larger wafers to manufacture chips. The predominant wafer size used for volume production today is 200 mm, or eight-inch, wafers, but a substantial number of new semiconductor manufacturing facilities (“fabs”) being built use 300 mm, or 12-inch, wafers to gain the economic advantages of a larger surface area. IC manufacturers use more CMP slurry on a 300 mm wafer, but use less slurry per device produced. However, we believe that the lower cost of the devices due to the economies of 300 mm manufacturing will spur additional growth of these devices due to greater affordability, consistent with past industry transitions to larger wafer sizes.

Our recent QED acquisition introduces us to the precision optics industry. We believe precision optics are pervasive, have new application growth potential and serve several existing large and growing markets such as semiconductor equipment, aerospace, defense, security and telecommunications. The precision optics industry appears to be transitioning from labor-intensive, artisan production methods for optical components to computer-controlled, deterministic production of high precision optics. The industry is also characterized by the need for higher precision in surface figure and finish, as well as a historical lack of significant advancements in state-of-the-art polishing methods.


STRATEGY
 
We believe our core competencies lie in our ability to shape, enable and enhance the performance of surfaces at an atomic level, as well as our ability to consistently and reliably deliver and support products around the world that meet our customers’ specifications. We intend to utilize these capabilities to strengthen and grow our core CMP business within the semiconductor and hard disk drive industries, and also to leverage our expertise in CMP process and slurry formulation into other technically demanding polishing applications that are synergistic to our core CMP slurry and pads businesses.

As we strengthen and grow our business, we intend to continue to implement the following strategic initiatives:

TECHNOLOGY LEADERSHIP

We believe that technology is vital to success in our CMP consumables and ESF businesses and we plan to continue to devote significant resources to research and development. We need to keep pace with the rapid technological advances in the semiconductor industry so we can continue to deliver a full line of CMP slurry products, over a range of technologies, that meet or exceed our customers' evolving needs. In October 2005 we opened our Asia Pacific technology center in Geino, Japan, which includes a clean room and provides polishing, metrology and product development capability to support our customers in the Asia Pacific region. Also, we built a technical service center in Taiwan with slurry formulation capability to provide expertise to our customers there; this technical service center acts as an extension of our Asia Pacific technology center. In addition, we moved our data storage laboratory to Singapore.

OPERATIONS EXCELLENCE
 
Our customers demand increasing performance of our products in terms of product quality and consistency and expect a highly reliable supply source. We believe the capacity and the location of our production facilities in the United States, Asia and Europe give us a competitive advantage in providing a dependable and predictable supply chain to meet our customers' CMP slurry and pad requirements in a consistent and timely manner. We believe that this ability to support a number of leading-edge customers with assurance of supply for business continuity is unique. We intend to continue to advance our strict quality systems in order to improve the uniformity and consistency of performance of our CMP products. To support our operations excellence initiative, we have adopted the concepts of Six Sigma across our Company; Six Sigma is a systematic, data-driven approach and methodology for improving quality by reducing variability in processes. We have made productivity and efficiency gains through this program in fiscal 2005 and 2006, and expect more in fiscal 2007. We also have extended our Six Sigma initiative to include joint projects with customers.

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CONNECTING WITH CUSTOMERS

We believe that building close relationships with our customers is another cornerstone for long-term success in our business. We work closely with our customers to identify and develop new and better CMP consumables, to integrate our products into their manufacturing processes, and to assist them with supply, warehousing and inventory management. We have devoted significant resources to enhancing our close customer relationships and we are committed to continuing this effort. We believe that we are unique in our ability to support a number of leading-edge customers through business scale in CMP consumables.

We also believe in locating our employees in the same geographies as our customers. As more of our business shifts to the Asia Pacific region, we have reinforced our customer commitment with our Asia Pacific technology center in Geino, Japan, which we believe enhances our ability to provide optimized CMP solutions to our customers in this region. We built a technical service center in Taiwan for slurry formulation capability for our customers there. In April 2006 we began selling directly to customers in Taiwan, rather than through a distributor, in order to better serve them. In addition, we moved the portion of our business that serves the hard disk drive market to Singapore, because Southeast Asia is an important manufacturing region for a number of participants in this industry. By next year, we plan to add additional pad manufacturing capability in Taiwan and are exploring alternatives to add slurry manufacturing capabilities there as well. All of these initiatives represent our belief that by working closely with customers at a local level we can leverage our global knowledge to their benefit.

ENGINEERED SURFACE FINISHES INITIATIVE

In addition to strengthening and growing our core CMP business, we also are leveraging our CMP experience and technology developed for the semiconductor industry to explore new applications and products to diversify and grow our business in other demanding applications in which we believe our technical ability to shape, enable and enhance the performance of surfaces at an atomic level may provide improved productivity or previously unseen surface performance. Our slurries for data storage polishing applications represent one example, and we are also pursuing opportunities in optics, optoelectronics, flat panel displays and metal finishing.

In pursuit of this initiative, we are supplementing our internal development efforts with some externally acquired technologies and businesses. For example, in October 2005 we acquired substantially all of the assets and assumed certain current liabilities of Surface Finishes, which was a privately-held company established in 1949 that specializes in precision machining techniques at the sub-nanometer level. This acquisition provides us with commercial finishing capabilities that we expect will present opportunities to facilitate the introduction of our internally developed technology to customers beyond the semiconductor industry, and afford access to a variety of markets that benefit from precision surface finish, but that we do not currently serve.

In July 2006 we acquired substantially all of the assets, including certain associated proprietary technology and intellectual property, and assumed certain current liabilities of QED. QED was a privately-held company that specializes in unique, patented polishing and metrology systems for shaping and polishing high precision optics. The optics industry shares a number of attributes with the semiconductor market: the value of precise surface finish; employing some of the same materials like silicon and aluminum; and some overlap in customer base because photolithography equipment and optical inspection equipment for semiconductor and flat panel displays rely on the kind of precision optics enabled by QED’s technology.
 
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CUSTOMERS, SALES AND MARKETING

Within the semiconductor industry, our customers are primarily producers of logic IC devices, producers of memory IC devices and IC foundries. Often, logic and memory companies outsource all or a portion of the production of physical devices to foundries, which provide contract manufacturing services, in order to avoid the high cost of constructing and operating a fab or in cases where they need additional capacity.

Our sales process begins long before the actual sale of our products and occurs on a number of levels. Due to the long lead times from research and development to product commercialization and sales, we have fundamental research teams who collaborate with customers on emerging applications years before the products are required by the market. We also have development teams who coordinate with our customers, using our research and development facilities and capabilities to design CMP products tailored to their precise needs. Next, our applications support teams work with customers to integrate our products into their manufacturing processes. Finally, as part of our sales process, our logistics and sales personnel provide supply, warehousing and inventory management to our customers. Through our interactive approach, we are able to build close relationships with our customers in a variety of areas.

We market our products primarily through direct sales to our customers. In the past, we also have relied to varying degrees on distributors. However, over the last few years we have reduced the number of resellers that distribute our products in situations where we have had sufficient business scale to support direct sales and where we have seen strategic benefit. For example, in April 2006 we began selling our products directly to customers in Taiwan rather than through Marketech, an independent distributor, although we still use Marketech to distribute our products in China. We believe this strategy is one way we can achieve our goal of staying connected with our customers.

In response to significant growth in the IC device manufacturing industry in Asia, we have implemented the following initiatives:

 
·
Increased the number of sales and marketing, technical and customer support personnel in the Asia Pacific region;
 
·
Transitioned to selling directly to customers in Taiwan, rather than through a distributor, as discussed above;
 
·
Opened our Asia Pacific technology center, which includes a clean room and provides polishing, metrology and product development capability to support our customers in this region;
 
·
Built a technical service center in Taiwan for slurry formulation capability for our customers there, as an extension of our Asia Pacific technology center; and
 
·
Relocated the portion of our business that serves the hard disk drive market to Singapore, because Southeast Asia is an important manufacturing region for a number of participants in this industry.  

Our QED subsidiary supports customers in the semiconductor equipment, aerospace, defense, security and telecommunications markets, and counts among its worldwide customers leading precision optics manufacturers and the United States government. QED has strived to maintain a sustainable and loyal customer base.  

In fiscal 2006, our five largest customers accounted for approximately 44% of our revenue, with Marketech and Taiwan Semiconductor Manufacturing Company (TSMC) accounting for approximately 19% and 10% of our revenue, respectively. Effective April 2006, with our transition to direct sales in Taiwan, we began selling directly to TSMC, our largest end customer, and other customers in Taiwan rather than through Marketech. For additional information on concentration of customers, refer to Note 2 of “Notes to the Consolidated Financial Statements” included in Item 8 of Part II of this Form 10-K. 
 
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COMPETITION
 
We compete in the CMP consumables industry, which is characterized by rapid advances in technology and demanding product quality and consistency requirements. We face competition from other CMP consumables suppliers, and we also may face competition in the future from significant changes in technology or emerging technologies.

We believe that customers make supplier decisions based on three factors, in this order of priority: first, product performance; second, supply assurance, including the ability to reliably deliver a high level of consistency and quality in CMP slurry products; and third, product price. We believe that rapid incorporation of CMP technology and growth of the CMP industry, combined with our customers’ desires to gain purchasing leverage and lower their cost of ownership, have led to greater competitive activity among, and pricing pressure on, CMP slurry suppliers.

Our competitors range from small companies that compete with a single product and/or in a single geographic region to divisions of global companies with multiple lines of IC manufacturing products. However, we believe we have more CMP slurry business than each of our competitors. In our view, we are the only CMP slurry supplier today that serves a broad range of customers by offering and supporting a full line of CMP slurry products for all major applications over a range of technologies, and that has a proven track record of supplying these products globally in high volumes with the attendant required high level of technical support services. We intend to continue to invest in our extensive manufacturing and technological infrastructures, which we believe give us a competitive advantage and allow us to deliver the supply assurance that is important to our customers.

Our QED subsidiary operates in the precision optics industry. There are few direct competitors for QED’s technologies because they are relatively new and unique. We believe the main alternative to QED’s technology is non-adoption and continued reliance on traditional artisan-based methods of surface finishing.


RAW MATERIALS SUPPLY

Fumed metal oxides, such as fumed silica and fumed alumina, are significant raw materials we use in many of our CMP slurries. In an effort to mitigate our raw materials supply risks, we have entered into multi-year supply agreements with a number of suppliers for the purchase of raw materials, including agreements with Cabot Corporation for the purchase of certain amounts and types of fumed silica and fumed alumina. For additional information regarding these agreements, refer to “Tabular Disclosure of Contractual Obligations”, included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, in Item 7 of Part II of this Form 10-K. In the interest of supply assurance, our strategy is to secure multiple sources of raw materials and qualify those sources as necessary to ensure our supply of raw materials remains uninterrupted.


RESEARCH, DEVELOPMENT AND TECHNICAL SUPPORT
 
We believe that technology is vital to success in the CMP business as well as in our other initiatives, and we plan to continue to devote significant resources to research and development, and balance our efforts between the shorter-term market needs and the longer-term investments required of us as the technology leader.

Our technology efforts are currently focused on four main areas:

 
·
Research related to fundamental CMP technology;
 
·
Development and formulation of new and enhanced CMP slurry and pad products;
 
·
Process development to support rapid and effective commercialization of new products; and
 
·
Evaluation of new polishing applications outside of the semiconductor industry.

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We invest in fundamental CMP technology and materials research, in order to be prepared to meet the dynamic needs of advanced technology, investing well in advance of the market need because there are long lead times from research and development to commercialization and sales. We focus on such areas as: engineered polymer and particles; advanced metrology; and mechanistic understanding and emerging applications. As a result of our investment in research and development, we have a fundamental understanding of the CMP process, chemistry, and mechanics that we believe allows us to quickly and efficiently tailor our applications to meet the needs of our leading-edge customers.
 
We also develop and formulate new and enhanced CMP consumables and new CMP processes. We believe our leadership in this area depends in part on our ability to develop CMP applications tailored to our customers' needs, so we have assembled dedicated development teams that work closely with customers to identify their specific technology and manufacturing challenges and to translate these challenges into viable CMP process solutions. We also remain focused on supporting our customers in the use of our products in their processes, so we have technical teams dedicated to problem-solving and working with our customers daily at their facilities.

Beyond CMP for the semiconductor and data storage industries, we are also increasing internal research and development efforts related to our ESF initiative. We are leveraging our technical expertise in CMP formulation, materials and polishing techniques and applying it to demanding surface modification and fine finish polishing applications in other industries where shaping, enabling and enhancing performance is critical to success. We believe that a number of application areas we are currently developing represent natural adjacencies to our core CMP business and technology, and include uses in fields such as optics, optoelectronics, flat panel displays and metal finishing.

We believe competitive advantage lies in technology leadership, and that our investments in research and development provide us with leading-edge polishing and metrology capabilities to support the most advanced and challenging customer technology requirements on a global basis. In fiscal 2006, 2005 and 2004 we incurred approximately $48.1 million, $43.0 million and $44.0 million, respectively, in research and development expenses. Investments in research and development property, plant and equipment are capitalized and depreciated over their useful lives. We operate a research and development facility in Aurora, Illinois, which is staffed by a team that includes experts from the semiconductor industry and scientists from key disciplines required for the development of high-performance CMP products. This facility features a state-of-the-art Class 1 clean room and advanced equipment for product development. We also have invested in 300 mm polishing and metrology capabilities to remain aligned with our leading-edge customers and to provide us with the ability to replicate their CMP activities in our clean room. In addition, we operate a technology center in Japan that we believe enhances our ability to provide optimized CMP solutions to our customers in the Asia Pacific region, and underscores our commitment both to continuing to invest in our technology infrastructure to maintain our technology leadership, and to becoming even more responsive to the needs of our customers. Other examples of this commitment include our technical service center in Taiwan and our data storage laboratory in Singapore that provide additional slurry formulation capability.


INTELLECTUAL PROPERTY

Our intellectual property is important to our success and ability to compete. As of October 31, 2006, we had 137 active U.S. patents and 103 pending U.S. patent applications. In most cases we file counterpart foreign patent applications. Many of these patents are important to our continued development of new and innovative products for CMP and related processes, as well as for new business initiatives, such as ESF. Our patents have a range of duration and we do not expect to lose any material patent through expiration in the next five years. We attempt to protect our intellectual property rights through a combination of patent, trademark, copyright and trade secret laws, as well as employee and third party nondisclosure and assignment agreements. We vigorously and proactively pursue any parties that attempt to compromise our investments in research and development by infringing our intellectual property. For example, we recently were successful in an action we brought before the United States International Trade Commission (ITC) concerning Cheil Industries, Inc. and its importation and sale within the United States of certain CMP slurries that infringe certain of our patents. The ITC’s actions served to grant our request to prevent this competitor from, among other things, importing any infringing products into the U.S.

11


We also may acquire intellectual property from others to enhance our intellectual property portfolio. For example, in June 2006 we entered into a patent assignment agreement with the International Business Machines Corporation (IBM). Under the terms of the agreement, we acquired a number of patents and associated rights relating to CMP slurry technology from IBM, including various applications such as copper, copper barrier, tungsten, and dielectrics, among others. We believe these technology rights will enhance our competitive advantage by providing us with future product development opportunities and expanding our already substantial intellectual property portfolio. Furthermore, with our QED and Surface Finishes acquisitions we acquired certain associated proprietary technology and intellectual property.


ENVIRONMENTAL MATTERS

Our facilities are subject to various environmental laws and regulations, including those relating to air emissions, wastewater discharges, the handling and disposal of solid and hazardous wastes, and occupational safety and health. We believe that our facilities are in substantial compliance with applicable environmental laws and regulations. We have incurred, and will continue to incur, capital and operating expenditures and other costs in complying with these laws and regulations in both the United States and abroad. However, we currently do not anticipate that the future costs of environmental compliance will have a material adverse effect on our business, financial condition or results of operations.


EMPLOYEES

We believe we have a world-class team of scientists, technologists, engineers and other human resources who make our Company successful. As of October 31, 2006, we employed 742 individuals, including 357 in operations, 208 in research and development, 85 in sales and marketing and 92 in administration. None of our employees are covered by collective bargaining agreements. We have not experienced any work stoppages and in general consider our relations with our employees to be good. 


FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS

We sell our products worldwide. Our geographic coverage allows us to draw on business and technical expertise from a worldwide workforce, provides stability to our operations and revenue streams to offset geography-specific economic trends, and offers us an opportunity to take advantage of new markets for products.

For more financial information about geographic areas, see Note 17 of “Notes to the Consolidated Financial Statements” included in Item 8 of Part II of this Form 10-K.


AVAILABLE INFORMATION

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, definitive proxy statements on Form 14a, current reports on Form 8-K, and any amendments to those reports are made available free of charge on our Company website, www.cabotcmp.com, as soon as reasonably practicable after such reports are filed with the Securities and Exchange Commission (SEC). Statements of changes in beneficial ownership of our securities on Form 4 by our executive officers and directors are made available on our Company website by the end of the business day following the submission to the SEC of such filings. In addition, the SEC’s website, www.sec.gov, contains reports, proxy statements, and other information regarding reports that we file electronically with the SEC.
 
12


ITEM 1A. RISK FACTORS

We do not believe there have been any material changes in our risk factors since the filing of our Annual Report on Form 10-K for the fiscal year ended September 30, 2005. However, we may update our risk factors in our SEC filings from time to time for clarification purposes or to include additional information, at management's discretion, even when there have been no material changes.


RISKS RELATING TO OUR BUSINESS

WE HAVE A NARROW PRODUCT RANGE AND OUR PRODUCTS MAY BECOME OBSOLETE, OR TECHNOLOGICAL CHANGES MAY REDUCE OR LIMIT INCREASES IN CMP CONSUMPTION

Our business is substantially dependent on a single class of products, CMP slurries, which historically has accounted for almost all of our revenue. Our business would suffer if these products became obsolete or if consumption of these products decreased. Our success depends on our ability to keep pace with technological changes and advances in the semiconductor industry and to adapt, improve and customize our products for advanced IC applications in response to evolving customer needs and industry trends. Since its inception, the semiconductor industry has experienced rapid technological changes and advances in the design, manufacture, performance and application of IC devices, and our customers continually pursue lower cost of ownership of materials consumed in their manufacturing processes, including CMP slurries. We expect these technological changes and advances, and this drive toward lower costs, to continue in the future. Emerging technologies in the semiconductor industry, as well as our customers’ efforts to reduce consumption of CMP slurries, could render our products less important to the IC device manufacturing process.


A SIGNIFICANT AMOUNT OF OUR BUSINESS COMES FROM A LIMITED NUMBER OF LARGE CUSTOMERS AND OUR REVENUE AND PROFITS COULD DECREASE SIGNIFICANTLY IF WE LOST ONE OR MORE OF THEM AS CUSTOMERS
 
Our customer base is concentrated among a limited number of large customers. One or more of these principal customers may stop buying CMP slurries from us or may substantially reduce the quantity of CMP slurries they purchase from us. Our principal customers also hold considerable purchasing power, which can impact the pricing and terms of sale of our products. Any deferral or significant reduction in CMP slurries sold to these principal customers, or a significant number of smaller customers, could seriously harm our business, financial condition and results of operations.
 
In fiscal 2006, our five largest customers accounted for approximately 44% of our revenue, with Marketech, a distributor, and TSMC accounting for approximately 19% and 10% of our revenue, respectively. Effective April 2006, with our transition to direct sales in Taiwan, we began selling directly to TSMC, our largest end customer, and our other customers in Taiwan rather than through Marketech. In fiscal 2005, our five largest customers accounted for approximately 53% of our revenue, with Marketech accounting for approximately 35% of our revenue.
 
13


OUR BUSINESS COULD BE SERIOUSLY HARMED IF OUR EXISTING OR FUTURE COMPETITORS DEVELOP SUPERIOR SLURRY PRODUCTS, OFFER BETTER PRICING TERMS OR SERVICE, OR OBTAIN CERTAIN INTELLECTUAL PROPERTY RIGHTS

Competition from current CMP slurry manufacturers or new entrants to the CMP slurry market could seriously harm our business and results of operations. Competition from other existing providers of CMP slurries could continue to increase, and opportunities exist for other companies with sufficient financial or technological resources to emerge as potential competitors by developing their own CMP slurry products. Increased competition has and may continue to impact the prices we are able to charge for our slurry products as well as our overall business. In addition, our competitors could have or obtain intellectual property rights which could restrict our ability to market our existing products and/or to innovate and develop new products.


ANY PROBLEM OR INTERRUPTION IN SUPPLY OF OUR MOST IMPORTANT RAW MATERIALS, INCLUDING FUMED METAL OXIDES, COULD DELAY OUR SLURRY PRODUCTION AND ADVERSELY AFFECT OUR SALES

Our business would suffer from any problem or interruption in our supply of the key raw materials we use in our CMP slurries, including fumed alumina and fumed silica. For example, Cabot Corporation continues to be our primary supplier of particular amounts and types of fumed alumina and fumed silica. We believe it would be difficult to promptly secure alternative sources of key raw materials, including fumed metal oxides, in the event one of our suppliers becomes unable to supply us with sufficient quantities of raw materials that meet the quality and technical specifications required by our customers. In addition, contractual amendments to the existing agreements with, or non-performance by, our suppliers could adversely affect us.

Also, if we change the supplier or type of key raw materials, such as fumed metal oxides, we use to make our CMP slurries, or are required to purchase them from a different manufacturer or manufacturing facility or otherwise modify our products, in certain circumstances our customers might have to requalify our CMP slurries for their manufacturing processes and products. The requalification process could take a significant amount of time and expense to complete and could motivate our customers to consider purchasing products from our competitors, possibly interrupting or reducing our sales of CMP slurries to these customers.


WE ARE SUBJECT TO RISKS ASSOCIATED WITH OUR FOREIGN OPERATIONS

We currently have operations and a large customer base outside of the United States. Approximately 79% and 78% of our revenue was generated by sales to customers outside of the United States for fiscal 2006 and 2005, respectively. We encounter risks in doing business in certain foreign countries, including, but not limited to, adverse changes in economic and political conditions, as well as difficulty in enforcing business and customer contracts and agreements, including protection of intellectual property rights.


BECAUSE WE HAVE LIMITED EXPERIENCE IN BUSINESS AREAS OUTSIDE OF CMP SLURRIES, EXPANSION OF OUR BUSINESS INTO NEW PRODUCTS AND APPLICATIONS MAY NOT BE SUCCESSFUL

An element of our strategy has been to leverage our current customer relationships and technological expertise to expand our CMP business from CMP slurries into other areas, such as polishing pads. Additionally, under our engineered surface finishes initiative we are actively pursuing a variety of surface modification applications, such as high precision optics. Expanding our business into new product areas could involve technologies, production processes and business models in which we have limited experience, and we may not be able to develop and produce products or provide services that satisfy customers’ needs or we may be unable to keep pace with technological or other developments. Also, our competitors may have or obtain intellectual property rights which could restrict our ability to market our existing products and/or to innovate and develop new products.

14


BECAUSE WE RELY HEAVILY ON OUR INTELLECTUAL PROPERTY, OUR FAILURE TO ADEQUATELY OBTAIN OR PROTECT IT COULD SERIOUSLY HARM OUR BUSINESS

Protection of intellectual property is particularly important in our industry because CMP slurry and pad manufacturers develop complex technical formulas for CMP products which are proprietary in nature and differentiate their products from those of competitors. Our intellectual property is important to our success and ability to compete. We attempt to protect our intellectual property rights through a combination of patent, trademark, copyright and trade secret laws, as well as employee and third-party nondisclosure and assignment agreements. Due to our international operations, we pursue protection in different jurisdictions, which may require varying degrees of protection, and we cannot provide assurance that we can obtain adequate protection in each such jurisdiction. Our failure to obtain or maintain adequate protection of our intellectual property rights for any reason could seriously harm our business.


WE MAY PURSUE ACQUISITIONS OF, INVESTMENTS IN, AND STRATEGIC ALLIANCES WITH OTHER ENTITIES, WHICH COULD DISRUPT OUR OPERATIONS AND HARM OUR OPERATING RESULTS IF THEY ARE UNSUCCESSFUL

We expect to continue to make investments in companies, either through acquisitions, investments or alliances, in order to supplement our internal growth and development efforts. Acquisitions and investments involve numerous risks, including the following: difficulties in integrating the operations, technologies, products and personnel of acquired companies; diversion of management’s attention from normal daily operations of the business; potential difficulties in entering markets in which we have limited or no direct prior experience and where competitors in such markets have stronger market positions; potential difficulties in operating new businesses with different business models; potential difficulties with regulatory or contract compliance in areas in which we have limited experience; initial dependence on unfamiliar supply chains or relatively small supply partners; insufficient revenues to offset increased expenses associated with acquisitions; potential loss of key employees of the acquired companies; or inability to effectively cooperate and collaborate with our alliance partners.

Further, we may never realize the perceived or anticipated benefits of a business combination or investments in other entities. Acquisitions by us could have negative effects on our results of operations, such as contingent liabilities, gross profit margins, amortization charges related to intangible assets and other effects of accounting for the purchases of other business entities. Investments and acquisitions of technology and development stage companies are inherently risky because these businesses may never develop, and we may incur losses related to these investments. In addition, we may be required to write down the carrying value of these investments to reflect other than temporary declines in their value, which could harm our business and results of operations.


DEMAND FOR OUR PRODUCTS AND OUR BUSINESS MAY BE ADVERSELY AFFECTED BY WORLDWIDE ECONOMIC AND INDUSTRY CONDITIONS

Our business is affected by economic and industry conditions and it is extremely difficult to predict sales of our products given uncertainties in these factors. There are several factors that make it difficult for us to predict future revenue trends for our business, including: the cyclical nature of the semiconductor industry; short order to delivery time for our products and the associated lack of visibility to future customer orders; and quarter to quarter changes in our revenue regardless of industry strength. Some factors that affect demand for our products are driven by variables such as our customer’s production of logic versus memory devices, customer integration schemes, share gains and losses and pricing changes by us and our competitors.
 
15


OUR INABILITY TO ATTRACT AND RETAIN KEY PERSONNEL COULD CAUSE OUR BUSINESS TO SUFFER

If we fail to attract and retain the necessary managerial, technical and customer support personnel, our business and our ability to maintain existing and obtain new customers, develop new products and provide acceptable levels of customer service could suffer. Competition for qualified personnel, particularly those with significant experience in the CMP and IC device industries, is intense. The loss of services of key employees could harm our business and results of operations.


RISKS RELATING TO THE MARKET FOR OUR COMMON STOCK

THE MARKET PRICE MAY FLUCTUATE SIGNIFICANTLY AND RAPIDLY

The market price of our common stock has fluctuated and could continue to fluctuate significantly as a result of factors such as: economic and stock market conditions generally and specifically as they may impact participants in the semiconductor and related industries; changes in financial estimates and recommendations by securities analysts who follow our stock; earnings and other announcements by, and changes in market evaluations of, us or participants in the semiconductor and related industries; changes in business or regulatory conditions affecting us or participants in the semiconductor and related industries; announcements or implementation by us, our competitors, or our customers of technological innovations, new products or different business strategies; and trading volume of our common stock.


ANTI-TAKEOVER PROVISIONS UNDER OUR CERTIFICATE OF INCORPORATION AND BYLAWS AND OUR RIGHTS PLAN MAY DISCOURAGE THIRD PARTIES FROM MAKING AN UNSOLICITED BID FOR OUR COMPANY

Our certificate of incorporation, our bylaws, our rights plan and various provisions of the Delaware General Corporation Law may make it more difficult to effect a change in control of our Company. For example, our amended and restated certificate of incorporation authorizes our Board of Directors to issue up to 20 million shares of blank check preferred stock and to attach special rights and preferences to this preferred stock. Also our amended and restated certificate of incorporation provides for the division of our Board of Directors into three classes as nearly equal in size as possible with staggered three-year terms. In addition, the rights issued to our stockholders under our rights plan may make it more difficult or expensive for another person or entity to acquire control of us without the consent of our Board of Directors.

We have adopted change in control arrangements covering our executive officers and other key employees. These arrangements provide for a cash severance payment, continued medical benefits and other ancillary payments and benefits upon termination of service of a covered employee’s employment following a change in control.


ITEM 1B. UNRESOLVED STAFF COMMENTS

None

16


ITEM 2. PROPERTIES 

Our principal U.S. facilities that we own consist of:

 
§
a global headquarters and research and development facility in Aurora, Illinois, comprising approximately 200,000 square feet;
 
§
a commercial dispersion plant and distribution center in Aurora, Illinois, comprising approximately 175,000 square feet;
 
§
a commercial manufacturing plant in Aurora, Illinois, comprising approximately 48,000 square feet;
 
§
an additional 13.2 acres of vacant land in Aurora, Illinois, to accommodate the possibility of future growth; and
 
§
a facility in Addison, Illinois, comprising approximately 15,000 square feet.

In addition, we lease a facility in Rochester, New York, comprising approximately 21,000 square feet.

Our principal foreign facilities that we own consist of:

 
§
a commercial dispersion plant and distribution center in Geino, Japan, comprising approximately 113,000 square feet;
 
§
a research and development facility in Geino, Japan, comprising approximately 20,000 square feet.

Our principal foreign facilities that we lease consist of:

 
§
a commercial manufacturing plant, research and development facility and business office in Singapore, comprising approximately 24,000 square feet;
 
§
a commercial dispersion plant in Barry, Wales, comprising approximately 22,000 square feet; and
 
§
an office, laboratory and pilot plant in Hsin-Chu, Taiwan, comprising approximately 20,000 square feet.

We believe that our current facilities are suitable and adequate for their intended purpose and provide us with sufficient capacity and capacity expansion opportunities and technological capability to meet our current and expected demand in the foreseeable future.


ITEM 3. LEGAL PROCEEDINGS

We are not currently involved in any material legal proceedings.


ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

17


EXECUTIVE OFFICERS OF THE REGISTRANT

Set forth below is information concerning our executive officers and their ages as of October 31, 2006.

NAME
 
AGE
 
POSITION
         
William P. Noglows
 
48
 
Chairman of the Board, President and Chief Executive Officer
H. Carol Bernstein
 
46
 
Vice President, Secretary and General Counsel
Jean Pol Delrue
 
59
 
Vice President of Global Sales
William S. Johnson
 
49
 
Vice President and Chief Financial Officer
Daniel J. Pike
 
43
 
Vice President of Corporate Development
Stephen R. Smith
 
47
 
Vice President of Marketing
Clifford L. Spiro
 
52
 
Vice President of Research and Development
Adam F. Weisman
 
44
 
Vice President of Business Operations
Daniel S. Wobby
 
43
 
Vice President of Asia Pacific Region
Thomas S. Roman
 
45
 
Principal Accounting Officer and Corporate Controller

WILLIAM P. NOGLOWS has served as our Chairman, President and Chief Executive Officer since November 2003. Mr. Noglows had previously served as a director of our Company from January 2000 until April 2002. Prior to joining us, Mr. Noglows served as an Executive Vice President of Cabot Corporation from 1998 to June 2003. Prior to that, Mr. Noglows held various management positions at Cabot Corporation including General Manager of Cabot Corporation’s Cab-O-Sil Division, where he was one of the primary founders of Cabot Microelectronics when its business was a division of Cabot Corporation, and was responsible for identifying and encouraging the development of the CMP application. Mr. Noglows received his B.S. in Chemical Engineering from the Georgia Institute of Technology.

H. CAROL BERNSTEIN has served as our Vice President, Secretary and General Counsel since August 2000. From January 1998 until joining us, Ms. Bernstein served as the General Counsel and Director of Industrial Technology Development of Argonne National Laboratory, which is operated by the University of Chicago for the United States Department of Energy. From May 1985 until December 1997, she served in various positions with the IBM Corporation, culminating in serving as an Associate General Counsel, and was the Vice President, Secretary and General Counsel of Advantis Corporation, an IBM joint venture. Ms. Bernstein received her B.A. from Colgate University and her J.D. from Northwestern University; she is a member of the Bar of the states of Illinois and New York.

JEAN POL DELRUE has served as our Vice President of Global Sales since April 2005. Previously, he was our Vice President of European Business Region since July 2004. He also served as our European Business Manager from June 2001 to July 2004. Prior to joining us, Dr. Delrue worked for Ebara Precision Machinery Europe from January 1995 to June 2001, culminating in serving as the Vice President of CMP Europe. Prior to that, he served as the Business and Technical Development Director and Member of the Management Board at Riber Instruments SA. Dr. Delrue holds an Executive M.B.A. from the Centre de Perfectionnement des Affaires in Paris, France, a Ph.D. in Physical Chemistry from Belgium's University of Mons, and has performed post doctorate work in chemical engineering at Stanford University.

WILLIAM S. JOHNSON has served as our Vice President and Chief Financial Officer since April 2003. Prior to joining us, Mr. Johnson served as Executive Vice President and Chief Financial Officer for Budget Group, Inc. from August 2000 to March 2003. Before that, Mr. Johnson spent 16 years at BP Amoco in various senior finance and management positions, the most recent of which was President of Amoco Fabrics and Fibers Company. Mr. Johnson received his B.S. in Mechanical Engineering from the University of Oklahoma and his M.B.A. from the Harvard Business School.

DANIEL J. PIKE has served as our Vice President of Corporate Development since January 2004 and prior to that was our Vice President of Operations from December 1999. Mr. Pike served as Cabot Corporation’s Director of Global Operations from 1996 to 1999. Prior to that, Mr. Pike worked for FMC Corporation. Mr. Pike received his B.S. in Chemical Engineering from the University of Buffalo and his M.B.A. from the Wharton School of Business of the University of Pennsylvania.

18


STEPHEN R. SMITH has served as our Vice President of Marketing since September 2006, and previously was our Vice President of Marketing and Business Management since April 2005 and our Vice President of Marketing and Sales from October 2001. Prior to joining us, Mr. Smith served as Vice President, Sales & Business Development for Buildpoint Corporation from 2000 to October 2001. Prior to that, Mr. Smith spent 17 years at Tyco Electronics Group, formerly known as AMP Incorporated, in various management positions. Mr. Smith earned a B.S. in Industrial Engineering from Grove City College and an M.B.A. from Wake Forest University.

CLIFFORD L. SPIRO has served as Vice President of Research and Development since December 2003. Prior to joining us, Dr. Spiro served as Vice President of Research and Development at Ondeo-Nalco from 2001 through November 2003. Prior to that, Dr. Spiro held research and development management and senior technology positions at the General Electric Company from 1980 through 2001, the most recent of which was Global Manager - Technology for Business Development. Dr. Spiro received his B.S. in Chemistry from Stanford University and his Ph.D. in Chemistry from the California Institute of Technology.

ADAM F. WEISMAN has served as our Vice President of Business Operations since September 2006, and prior to that was our Vice President of Operations. Before joining us, Mr. Weisman held various engineering and senior operations management positions with the General Electric Company from 1988 through 2004, including having served as the General Manager of Manufacturing for GE Plastics - Superabrasives, and culminating in serving as the Executive Vice President of Operations for GE Railcar Services. Prior to joining GE, he worked as an engineering team leader and pilot plant manager for E.I. Du Pont de Nemours & Company. Mr. Weisman holds a B.S. in Ceramic Engineering from Alfred University.

DANIEL S. WOBBY has served as our Vice President of Asia Pacific Region since September 2005. Prior to that, Mr. Wobby served as Vice President of Greater China and Southeast Asia starting in February 2004. Mr. Wobby previously was our Corporate Controller and Principal Accounting Officer from 2000 to 2004. From 1989 to 2000, Mr. Wobby held various accounting and operations positions with Cabot Corporation culminating in serving as Director of Finance. Mr. Wobby earned a B.S. in Accounting from St. Michael’s College and an M.B.A. from the University of Chicago’s Graduate School of Business.

THOMAS S. ROMAN has served as our Corporate Controller and Principal Accounting Officer since February 2004 and previously served as our North American Controller. Prior to joining us in April 2000, Mr. Roman was employed by FMC Corporation in various financial reporting, tax and audit positions. Before that, Mr. Roman worked for Gould Electronics and Arthur Andersen LLP. Mr. Roman is a C.P.A. and earned a B.S. in Accounting from the University of Illinois and an M.B.A. from DePaul University’s Kellstadt Graduate School of Business.
 
19


PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock has traded publicly on the NASDAQ Global Select Market (formerly the NASDAQ National Market) under the symbol "CCMP" since our initial public offering in April 2000. The following table sets forth the range of quarterly high and low closing sales prices for our common stock on the NASDAQ Global Select Market.

   
HIGH
 
LOW
Fiscal 2005
     
 
First Quarter
40.80
 
30.58
 
Second Quarter
38.37
 
30.43
 
Third Quarter
31.77
 
27.39
 
Fourth Quarter
33.10
 
27.74
Fiscal 2006
     
 
First Quarter
32.33
 
28.26
 
Second Quarter
37.14
 
28.82
 
Third Quarter
38.25
 
25.84
 
Fourth Quarter
32.34
 
26.21
Fiscal 2007 First Quarter (through October 31, 2006)
31.25
 
28.36
 
As of October 31, 2006, there were approximately 1,025 holders of record of our common stock. No dividends were declared or paid in either fiscal 2006 or fiscal 2005 and we have no current plans to pay cash dividends in the future.


ISSUER PURCHASES OF EQUITY SECURITIES

Period
 
Total Number
of Shares
Purchased
 
Average
Price Paid
Per Share
 
Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
 
Approximate Dollar Value
of Shares that May Yet Be
Purchased Under the
Plans or Programs
(in thousands)
 
July 1 through
July 31, 2006
   
   
   
 
$
32,005
 
Aug. 1 through
Aug. 31, 2006
   
269,363
 
$
29.70
   
269,363
   
24,004
 
Sept. 1 through
Sept. 30, 2006
   
   
   
   
24,004
 
 
Total
   
269,363
 
$
29.70
   
269,363
 
$
24,004
 
 
In the fourth quarter of fiscal 2005, we completed our initial $25.0 million share repurchase program, which was authorized in July 2004. On October 27, 2005, we announced that our Board of Directors had authorized a new share repurchase program for up to $40.0 million of our outstanding common stock. Shares are repurchased from time to time, depending on market conditions, in open market transactions, at management’s discretion. We fund share repurchases from our existing cash balance. The program, which became effective on the authorization date, may be suspended or terminated at any time, at the Company’s discretion. We view the program as an effective means to return cash to shareholders.

20

 
ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data for each year of the five-year period ended September 30, 2006, has been derived from the audited consolidated financial statements. Certain reclassifications of prior fiscal year amounts have been made to conform to the current period presentation.

The information set forth below is not necessarily indicative of results of future operations and should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes to those statements included in Items 7 and 8 of Part II of this Form 10-K, as well as Risk Factors included in Item 1A of Part I of this Form 10-K.
 
21


CABOT MICROELECTRONICS CORPORATION
SELECTED FINANCIAL DATA - FIVE YEAR SUMMARY
(Amounts in thousands, except per share amounts)

   
Year Ended September 30,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
Consolidated Statement of Income Data:
                     
Revenue
 
$
320,795
 
$
270,484
 
$
309,433
 
$
251,665
 
$
235,165
 
Cost of goods sold
   
171,758
   
141,282
   
156,805
   
124,269
   
113,067
 
Gross profit
   
149,037
   
129,202
   
152,628
   
127,396
   
122,098
 
                                 
Operating expenses:
                               
Research, development and technical
   
48,070
   
43,010
   
44,003
   
41,516
   
33,668
 
Selling and marketing
   
21,115
   
16,989
   
16,225
   
11,221
   
9,667
 
General and administrative
   
34,319
   
25,427
   
22,691
   
18,565
   
17,803
 
Litigation settlement
   
-
   
-
   
-
   
-
   
1,000
 
Purchased in-process research and development
   
1,120
   
-
   
-
   
-
   
-
 
Total operating expenses
   
104,624
   
85,426
   
82,919
   
71,302
   
62,138
 
Operating income
   
44,413
   
43,776
   
69,709
   
56,094
   
59,960
 
 
                               
Other income (expense), net
   
4,111
   
2,747
   
139
   
(27
)
 
763
 
Income before income taxes
   
48,524
   
46,523
   
69,848
   
56,067
   
60,723
 
Provision for income taxes
   
15,576
   
14,050
   
23,120
   
18,334
   
20,038
 
Net income
 
$
32,948
 
$
32,473
 
$
46,728
 
$
37,733
 
$
40,685
 
 
                               
Basic earnings per share
 
$
1.36
 
$
1.32
 
$
1.89
 
$
1.55
 
$
1.68
 
 
                               
Weighted average basic shares outstanding
   
24,228
   
24,563
   
24,750
   
24,401
   
24,160
 
 
                               
Diluted earnings per share
 
$
1.36
 
$
1.32
 
$
1.88
 
$
1.53
 
$
1.66
 
 
                               
Weighted average diluted shares outstanding
   
24,228
   
24,612
   
24,882
   
24,665
   
24,565
 
 
                               
Cash dividends per share
 
$
-
 
$
-
 
$
-
 
$
-
 
$
-
 
 
                               
 
 
 As of September 30,
 
 
 
2006
 
2005
 
2004
 
2003
 
2002
 
Consolidated Balance Sheet Data:
                               
Current assets
 
$
261,505
 
$
245,807
 
$
229,681
 
$
179,112
 
$
123,283
 
Property, plant and equipment, net
   
130,176
   
135,784
   
127,794
   
133,695
   
132,264
 
Other assets
   
20,452
   
5,172
   
5,816
   
2,810
   
2,838
 
Total assets
 
$
412,133
 
$
386,763
 
$
363,291
 
$
315,617
 
$
258,385
 
 
                               
Current liabilities
 
$
38,833
 
$
35,622
 
$
32,375
 
$
28,916
 
$
30,571
 
Long-term debt
   
-
   
-
   
-
   
-
   
3,500
 
Other long-term liabilities
   
5,529
   
12,057
   
15,294
   
14,928
   
10,808
 
Total liabilities
   
44,362
   
47,679
   
47,669
   
43,844
   
44,879
 
Stockholders' equity
   
367,771
   
339,084
   
315,622
   
271,773
   
213,506
 
Total liabilities and stockholders' equity
 
$
412,133
 
$
386,763
 
$
363,291
 
$
315,617
 
$
258,385
 

22


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following “Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as disclosures included elsewhere in this Form 10-K, include "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a safe harbor for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact we make in this Form 10-K are forward-looking. In particular, the statements herein regarding future sales and operating results; Company and industry growth and trends; growth of the markets in which the Company participates; international events; product performance; the generation, protection and acquisition of intellectual property; new product introductions; development of new products, technologies and markets; the acquisition of or investment in other entities; the construction of new or refurbishment of existing facilities by the Company; and statements preceded by, followed by or that include the words "intends", "estimates", "plans", "believes", "expects", "anticipates", "should", "could" or similar expressions, are forward-looking statements. Forward-looking statements reflect our current expectations and are inherently uncertain. Our actual results may differ significantly from our expectations. We assume no obligation to update this forward-looking information. The section entitled "Risk Factors" describes some, but not all, of the factors that could cause these differences.

The following discussion and analysis should be read in conjunction with our historical financial statements and the notes to those financial statements which are included in Item 8 of Part II of this Form 10-K.


OVERVIEW

Cabot Microelectronics Corporation ("Cabot Microelectronics'', "the Company'', "us'', "we'', or "our'') is the leading supplier of high-performance polishing slurries used in the manufacture of advanced integrated circuit (IC) devices within the semiconductor industry, in a process called chemical mechanical planarization (CMP). CMP is a process that polishes surfaces at an atomic level, thereby enabling IC device manufacturers to produce smaller, faster and more complex IC devices with fewer defects. We believe that demand for our products is primarily based on the number of wafers, or “wafer starts”, of advanced devices produced by semiconductor manufacturers.
 
We operate predominantly in one industry segment - the development, manufacture and sale of CMP slurries. Our CMP products are used for a number of applications, such as polishing insulating dielectric layers, tungsten that is used to connect the multiple wiring layers of IC devices through these insulating layers, and copper wiring, including the associated barrier film. We also develop, manufacture and sell CMP slurries for polishing certain components in hard disk drives, specifically rigid disk substrates and magnetic heads, and we believe we are one of the leading suppliers in this area. In addition, we are developing and commercializing CMP polishing pads, which are used in conjunction with slurries in the CMP process.

In addition to strengthening and growing our core CMP business, through our Engineered Surface Finishes (ESF) initiative we are exploring a variety of surface modification applications where we believe our technical ability to shape, enable and enhance the performance of surfaces at an atomic level may provide improved productivity or previously unseen surface performance. By supplementing our internal development efforts with some externally acquired technologies and businesses, we seek to leverage our expertise in CMP slurry formulation, materials and polishing techniques for the semiconductor industry to address other demanding market applications requiring nanoscale control of surface shape and finish, and gain access to a variety of markets that we do not currently serve.

23


In pursuit of our ESF initiative, we completed two acquisitions in fiscal 2006. In October 2005, we acquired substantially all of the assets and assumed certain current liabilities of Surface Finishes Co., Inc., a privately-held company that specializes in precision machining techniques at the sub-nanometer level, as well as associated real property from a related trust. The total purchase price, was approximately $2.3 million. In July 2006 we acquired substantially all of the assets and assumed certain current liabilities of QED Technologies, Inc. (QED), a privately-held company that specializes in unique, patented polishing and metrology systems for shaping and polishing of high precision optics. The purchase price was approximately $19 million, which we paid in cash from our available balance and we may pay up to an additional $4.5 million depending upon the performance of the QED business over the two years following the purchase.

On a geographic basis, the Asia Pacific region continues to be the fastest growing region for IC manufacturing as well as for our business, and we expect this trend to continue in the future. In furtherance of our strategic initiatives to advance our technology leadership and to stay connected with our customers, we opened our Asia Pacific technology center, located adjacent to our existing manufacturing facility in Geino, Japan, which includes a clean room and provides polishing, metrology and product development capability to support our customers in the region. In addition, we moved the portion of our business that serves the rigid disk market to Singapore, since a number of important industry participants are located in Southeast Asia. Another example of our commitment to staying connected with customers is our transition to direct sales in Taiwan. In August 2005 we announced plans to sell our products directly to customers in Taiwan, rather than through Marketech, an independent distributor, effective April 2006. We executed this orderly transition in our second fiscal quarter of 2006. Our distributor sold its remaining inventory of our products to our customers and we built inventory required to service these customers directly; this caused a short-term adverse effect to our normal sales pattern of approximately $10 million to $11 million during our second fiscal quarter. However, following the transition period, our sales volumes rebounded and our revenue increased slightly to the extent we were able to gain a portion of our distributor’s markup.

This year, we added to our portfolio of intellectual property for CMP slurries by acquiring from International Business Machines Corporation (IBM) a number of patents and associated rights relating to CMP slurry technology for $5.0 million. These patents and associated rights cover a wide range of CMP slurry applications, and we believe they represent a valuable complement to our existing technology and build on the overall strength of our intellectual property. Additionally, we were successful in an action we brought before the United States International Trade Commission (ITC) concerning Cheil Industries, Inc. and its importation and sale within the United States of certain CMP slurries that infringe certain of our patents. The ITC’s actions served to grant our request to prevent this competitor from, among other things, importing any infringing products into the U.S.

In October 2005 we announced that our Board of Directors authorized a new share repurchase program for up to $40.0 million of our outstanding common stock. Shares were repurchased from time to time, depending on market conditions, in open market transactions, at management’s discretion. We intend to continue funding share repurchases from our existing cash balance. We view the program as an effective means to return cash to shareholders. The program, which became effective on the authorization date, may be suspended or terminated at any time, at the Company’s discretion. In fiscal 2006 we repurchased 523,147 shares of stock for a total price of $16.0 million, leaving $24.0 million remaining under the program at the beginning of fiscal 2007.

Revenue for fiscal 2006 was $320.8 million, which was an increase of 18.6% from the $270.5 million reported for fiscal 2005, due largely to an increase in sales volume. This increase in revenue reflects a modest semiconductor industry recovery in 2006 following a downturn in 2005. Our long-term goal is to grow our revenue by 15% per year, which would allow us to achieve annual revenue of approximately $500 million in three years. However, there are many factors that make it difficult for us to predict future revenue trends for our business, including the cyclical nature of the semiconductor industry; timing of our potential future acquisitions; short order to delivery time for our products and the associated lack of visibility to future customer orders; and quarter to quarter changes in our revenue regardless of industry strength.

24


Gross profit expressed as a percentage of revenue for fiscal 2006 was 46.5%, which represents a decrease from the 47.8% reported for fiscal 2005. The decrease was primarily driven by selected price reductions and higher costs including those associated with commercializing our pad product line and the transition of our data storage business to Singapore. These adverse effects were partially offset by higher utilization of our manufacturing capacity due to the higher level of sales. We expect to be able to maintain our gross profit as a percentage of revenue in the range of 46% to 48% for fiscal year 2007. This guidance applies to our full fiscal year results rather than specific quarterly results; we may experience quarterly gross profit above or below this range due to fluctuations in our product mix or other factors.

Operating expenses, which include research, development, technical, selling, marketing, general and administrative expenses, increased 22.5%, or $19.2 million, from the $85.4 million reported for fiscal 2005. One of the primary reasons for this increase is the adoption of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R) effective October 2005. Share-based compensation expense is now recognized in our income statement rather than just disclosed in our footnotes, which was previously allowed. Pre-tax share-based compensation expense for fiscal 2006 was $10.7 million, of which $10.0 million was classified in operating expenses. Another reason for the increase in operating expenses was higher staffing costs, including costs to support our initiatives in the Asia Pacific region. Operating expenses also increased due to our acquisitions described above, including for the expensing of purchased in-process research and development (IPR&D) associated with our QED acquisition. In fiscal 2007, we expect our operating expenses to be in the range of approximately $27 million to $30 million per quarter, trending up slightly within this range during the year.


CRITICAL ACCOUNTING POLICIES AND ESTIMATES

This "Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as disclosures included elsewhere in this Form 10-K, are based upon our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingencies. On an ongoing basis, we evaluate the estimates used, including those related to bad debt expense, warranty obligations, inventory valuation, impairment of long-lived assets and investments, business combinations, goodwill, other intangible assets, share-based compensation, income taxes and contingencies. We base our estimates on historical experience, current conditions and on various other assumptions that we believe 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, as well as identifying and assessing our accounting treatment with respect to commitments and contingencies. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies involve significant judgments and estimates used in the preparation of our consolidated financial statements.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

We maintain an allowance for doubtful accounts for estimated losses resulting from the potential inability of our customers to make required payments. Our allowance for doubtful accounts is based on historical collection experience, adjusted for any specific known conditions or circumstances. While historical experience may provide a reasonable estimate of uncollectible accounts, actual results may differ from what was recorded. As of September 30, 2006, our allowance for doubtful accounts represented 1.1% of gross accounts receivable. If we had increased our estimate of bad debts by 1.0%, to 2.1% of gross accounts receivable, our general and administrative expense would have increased by $0.5 million.
 
 
25


WARRANTY RESERVE

We maintain a warranty reserve that reflects management’s best estimate of the cost to replace product that does not meet customers’ specifications and performance requirements, and costs related to such replacement. The warranty reserve is based upon a historical product replacement rate, adjusted for any specific known conditions or circumstances. Should actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability may be required. As of September 30, 2006, our warranty reserve represented 1.1% of the current quarter revenue. If we had increased our warranty reserve estimate by 1.0%, to 2.1% of the current quarter revenue, our cost of goods sold would have increased by $0.9 million.

INVENTORY VALUATION

We value inventory at the lower of cost or market and write down the value of inventory for estimated obsolescence or if inventory is deemed unmarketable. An inventory reserve is maintained based upon a historical percentage of actual inventory written off applied against inventory at the end of the period, adjusted for known conditions and circumstances. We exercise judgment in estimating the amount of inventory that is obsolete. Should actual product marketability and raw material fitness for use be affected by conditions that are different from those projected by management, revisions to the estimated inventory reserve may be required.

IMPAIRMENT OF LONG-LIVED ASSETS AND INVESTMENTS

SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), requires us to assess the recoverability of the carrying value of long-lived assets whenever events or changes in circumstances indicate that the assets may be impaired. We must exercise judgment in assessing whether an event of impairment has occurred. For purposes of recognition and measurement of an impairment loss, long-lived assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. We must exercise judgment in this grouping. SFAS 144 requires that if the sum of the undiscounted future cash flows expected to result from the identified asset group is less than the carrying value of the asset group, then an impairment must be recognized in the financial statements. The amount of the impairment to be recognized is calculated by subtracting the fair value of the asset group from the reported value of the asset group. Determining future cash flows and estimating fair values requires significant judgments and is highly susceptible to change from period to period because it requires management to make assumptions about future sales and cost of sales generally over a long-term period.

We evaluate the estimated fair value of investments annually or more frequently if indicators of potential impairment exist, to determine if an other-than-temporary impairment in the value of the investment has taken place.

BUSINESS COMBINATIONS

In accordance with SFAS No. 141, “Business Combinations”, we allocate the purchase price of acquired entities to the tangible and intangible assets acquired, liabilities assumed, as well as IPR&D based on their estimated fair values. We engage independent third-party appraisal firms to assist us in determining the fair values of assets and liabilities acquired. This valuation requires management to make significant estimates and assumptions, especially with respect to long-lived and intangible assets.

Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows related to acquired developed technologies and patents and assumptions about the period of time the technologies will continue to be used in the combined Company’s product portfolio; expected costs to develop the IPR&D into commercially viable products and estimating cash flows from the projects when completed; and discount rates. Management’s estimates of value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

26


GOODWILL AND OTHER INTANGIBLE ASSETS

Purchased intangible assets with finite lives are amortized over their estimated useful lives. Goodwill and other intangible assets are tested annually or more frequently if indicators of potential impairment exist, using a fair-value-based approach. We determined that goodwill and other intangible assets were not impaired as of September 30, 2006.

SHARE-BASED COMPENSATION

Effective October 1, 2005, we adopted SFAS 123R, which requires all share-based payments, including stock option grants, restricted stock and employee stock purchases, to be recognized in the income statement based on their fair values. SFAS 123R supersedes our previous accounting for share-based compensation under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations, as allowed under SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (SFAS 148). Under SFAS 123R, the pro forma disclosure alternative permitted under SFAS 123 and SFAS 148 is no longer allowable. We adopted SFAS 123R using the modified prospective transition method as permitted by SFAS 123R; therefore, we have not restated our financial results for prior periods. Under SFAS 123R, we continue to attribute share-based compensation expense using the straight-line approach based on awards ultimately expected to vest, which requires the use of an estimated forfeiture rate. Forfeitures were estimated based on historical experience. In addition, we continue to use the Black-Scholes option-pricing model (“Black-Scholes model”) to estimate grant date fair value, which requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. A small change in the underlying assumptions can have a relatively large effect on the estimated valuation. Under SFAS 123R, we estimate expected volatility based on a combination of our stock’s historical volatility and the implied volatilities from actively-traded options on our stock. Prior to the adoption of SFAS 123R, we estimated expected volatility based only on our stock’s historical volatility in accordance with SFAS 123 for purposes of our pro forma disclosure. We believe that implied volatility is more reflective of market conditions; however, due to the shorter length in term of the actively-traded options, we believe it to be appropriate to use a blended assumption. In addition, we have updated our expected term assumption by adopting the simplified method as defined under Staff Accounting Bulletin (SAB) No. 107, “Share-Based Payments” (SAB 107), due to our limited amount of historical option exercise data. This method uses an average of the vesting and contractual terms.
 
Through an amendment made and effective as of September 27, 2004, the vesting of approximately 1.3 million options, that had option prices greater than $34.65 on the amendment date, was accelerated to September 1, 2005. The acceleration enabled us to eliminate the recognition of share-based compensation expense associated with these "out-of-the-money" options in our consolidated financial statements upon the adoption of SFAS 123R in October 2005. Because expected share-based compensation expense for fiscal 2006 would have been higher if the vesting of these “out-of-the-money” stock options had not been accelerated, it may not be representative of share-based compensation expense for future years. In addition, factors that may impact share-based compensation expense in future years include, but are not limited to, changes to our historical approaches to long-term incentives, such as the timing and number of additional grants of stock option awards, the vesting period and contractual term of stock option awards and types of equity awards granted. Further, share-based compensation may be impacted by changes in the fair value of future awards through variables such as fluctuations in and volatility of our stock price, as well as changes in employee exercise behavior and forfeiture rates. As of September 30, 2006, there was $23.9 million of total unrecognized share-based compensation expense related to nonvested stock options granted under the Plan. That cost is expected to be recognized over a weighted-average period of 2.6 years.

Our historical approach to long-term incentives has been primarily through the issuance of stock options. However, beginning in fiscal 2007, we anticipate moving to a blend of equity grants, under which a combination of stock option awards and restricted stock or restricted stock units are anticipated being granted. We anticipate that both the stock options and the restricted stock or restricted stock units will vest equally over a four-year period, with first vesting on the anniversary of the grant date, and with stock options continuing to have a ten-year contractual term.
 
27


ACCOUNTING FOR INCOME TAXES

We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” (SFAS 109), which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. We have determined that it is more likely than not that our future taxable income will be sufficient to realize our deferred tax assets.

COMMITMENTS AND CONTINGENCIES

We have entered into unconditional purchase obligations, which include noncancelable purchase commitments and take-or-pay arrangements with suppliers. We review our agreements and make an assessment of the likelihood of a shortfall in purchases and determine if it is necessary to record a liability. In addition, we are subject to the possibility of various loss contingencies arising in the ordinary course of business such as a legal proceeding or claim. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required.


EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for fiscal years ending after November 15, 2007. We do not expect the adoption of SAB 108 to have a material impact on our consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (SFAS 157). SFAS 157 establishes a common definition for fair value in generally accepted accounting principles, establishes a framework for measuring fair value and expands disclosure about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting SFAS 157 on our consolidated financial position, results of operations and cash flows.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS 158). SFAS 158 requires an employer that sponsors one or more single-employer defined benefit plans to: a) recognize the overfunded or underfunded status of a benefit plan in its statement of financial position; b) recognize as a component of other comprehensive income, net of tax, any remaining unamortized transition obligation upon adoption as well as the gains or losses and prior service costs or credits that have not yet been recognized as components of net periodic benefit cost pursuant to SFAS No. 87, “Employers’ Accounting for Pensions”, or SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”; c) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end; and d) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits and transition asset or obligation. This statement is effective for fiscal years ending after December 15, 2006. We are currently evaluating the impact of adopting SFAS 158 on our consolidated financial position, results of operations and cash flows.

28


In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement 109” (FIN 48), which clarifies the accounting for uncertainty in tax positions. This interpretation sets forth a recognition threshold and measurement element for the recognition and measurement of a tax position taken or expected to be taken on a tax return. This interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial position, results of operations and cash flows.

In June 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force (EITF) in Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (EITF 06-3). The scope of this issue includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing activity between a seller and a customer and may include, but is not limited to, sales, use, value-added, and some excise taxes. EITF 06-3 indicates that the income statement presentation of these taxes on a gross or net basis is an accounting policy decision that should be disclosed in a company’s financial statements. EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006. We do not expect the adoption of EITF 06-3 to have an impact on our consolidated financial position, results of operations or cash flows.

In November 2005, the FASB issued FASB Staff Position (FSP) Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (FSP FAS 115-1 and 124-1). This FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. It also includes accounting considerations subsequent to the recognition of other-than-temporary impairments. The FSP applies to reporting periods beginning after December 15, 2005. The adoption of FSP FAS 115-1 and 124-1 did not impact our consolidated financial position, results of operations or cash flows.

In September 2005, the FASB issued EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (EITF 04-13). The EITF concludes that two or more legally separate exchange transactions with the same counterparty should be combined and considered as a single arrangement for purposes of applying Accounting Principles Board (APB) Opinion No. 29, “Accounting for Nonmonetary Transactions”, when the transactions are entered into in contemplation of one another. Furthermore, when two transactions are considered a single arrangement, the assets exchanged should be accounted for at fair value. The EITF is effective for transactions completed in reporting periods beginning after March 15, 2006. The adoption of EITF 04-13 did not impact our consolidated financial position, results of operations or cash flows.
 
29


RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, the percentage of revenue of certain line items included in our historical statements of income:

   
Year Ended September 30,
 
   
2006
 
2005
 
2004
 
               
Revenue
   
100.0
%
 
100.0
%
 
100.0
%
Cost of goods sold
   
53.5
   
52.2
   
50.7
 
Gross profit
   
46.5
   
47.8
   
49.3
 
                     
Research, development and technical
   
15.0
   
15.9
   
14.2
 
Selling and marketing
   
6.6
   
6.3
   
5.2
 
General and administrative
   
10.7
   
9.4
   
7.3
 
Purchased in-process research and development
   
0.3
   
-
   
-
 
                     
Operating income
   
13.8
   
16.2
   
22.6
 
Other income, net
   
1.3
   
1.0
   
-
 
Income before income taxes
   
15.1
   
17.2
   
22.6
 
Provision for income taxes
   
4.9
   
5.2
   
7.5
 
                     
Net income
   
10.3
%
 
12.0
%
 
15.1
%


YEAR ENDED SEPTEMBER 30, 2006, VERSUS YEAR ENDED SEPTEMBER 30, 2005

REVENUE

Revenue was $320.8 million in 2006, which represented an 18.6%, or $50.3 million, increase from 2005. Of this increase, $48.7 million was due to an increase in sales volume and $5.1 million was related to our July 2006 acquisition of QED; these increases were partially offset by a net $3.5 million decrease due to the change in weighted average selling price. The decrease in weighted average selling price primarily resulted from selected price reductions largely offset by a higher-priced product mix. Selling prices are also affected by changes in foreign currency exchange rates. Revenue for fiscal 2006 would have been $3.7 million higher had the average exchange rates for the Japanese Yen and Euro during the year held constant with the prior year’s average rates.

Revenue increased in fiscal 2006 despite our transition to selling directly to our customers in Taiwan rather than through a distributor, which caused a short-term interruption in our normal sales pattern during our second quarter of fiscal 2006 of approximately $10 million to $11 million. However, after this transition period, we believe we were able to gain a portion of the markup that our distributor previously charged its end customers, which partially offset the adverse revenue impact from the transition.  

Our long-term goal is to grow our revenue by 15% per year, which would allow us to achieve annual revenue of approximately $500 million in three years. However, there are several factors that make it difficult for us to predict future revenue trends, as discussed in the “Overview” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
 
30


COST OF GOODS SOLD

Total cost of goods sold was $171.8 million in 2006, which represented an increase of 21.6%, or $30.5 million, from 2005. Of this increase, $25.4 million was due to higher sales volume, $3.5 million was related to our acquisition of QED and $1.5 million was due to higher average costs per gallon. The average cost per gallon increased primarily due to a higher-cost product mix, higher fixed costs, including amortization of our CMP technology patents from IBM, and greater logistics costs as a result of our transition to direct sales in Taiwan. These costs were partially offset by higher utilization of our manufacturing capacity due to the higher level of sales.

Fumed metal oxides, such as fumed silica and fumed alumina, are significant raw materials that we use in many of our CMP slurries. In an effort to mitigate our risk to rising raw material costs and to increase supply assurance and quality performance requirements, we have entered into multi-year supply agreements with a number of suppliers. For more financial information about our supply contracts, see “Tabular Disclosure of Contractual Obligations” included in Item 7 of Part II of this Form 10-K.

Our need for additional quantities or different kinds of key raw materials in the future has required, and will continue to require, that we enter into new supply arrangements with third parties. Future arrangements may result in costs which are different from those in the existing agreements. In addition, rising energy costs may also impact the cost of raw materials, packaging and freight costs. We also expect to continue to invest in our operations excellence initiative to improve product quality, reduce variability and improve product yields in our manufacturing process.


GROSS PROFIT

Our gross profit as a percentage of revenue was 46.5% in 2006 as compared to 47.8% in 2005. The 1.3 percentage point decrease in gross profit margin resulted primarily from selected price reductions and higher costs including those associated with commercializing our pad product line and the transition of our data storage business to Singapore. These adverse effects were partially offset by higher utilization of our manufacturing capacity due to the higher level of sales. We expect to be able to maintain our gross profit as a percentage of revenue in the range of 46% to 48% for full fiscal year 2007. Quarterly gross profit may be above or below this range due to fluctuations in our product mix or other factors.


RESEARCH, DEVELOPMENT AND TECHNICAL

Total research, development and technical expenses were $48.1 million in 2006, which represented an increase of 11.8% or $5.1 million, from 2005. The increase was primarily related to $3.5 million in increased staffing costs, $1.5 million in increased depreciation and $0.7 million in impairment expense. The increased staffing costs included $1.2 million in higher expenses for our annual incentive program related to our research, development and technical staff as well as $1.0 million in share-based compensation expense. The increased depreciation expense was primarily related to the October 2005 opening of our Asia Pacific technology center in Geino, Japan. The impairment expense was attributable to the decision to no longer use the portion of a building in Aurora, Illinois, that was previously used for research and development activities. These increases were partially offset by $0.8 million in decreased costs for clean room materials and laboratory supplies.

Our research, development and technical efforts are focused on the following main areas:

 
·
Research related to fundamental CMP technology;
 
·
Development and formulation of new and enhanced CMP slurry and pad products;
 
·
Process development to support rapid and effective commercialization of new products;
 
·
Evaluation of new polishing applications outside of the semiconductor industry; and
 
·
Applications support.
 
31


SELLING AND MARKETING

Selling and marketing expenses were $21.1 million in 2006, which represented an increase of 24.3%, or $4.1 million, over 2005. The increase resulted primarily from higher staffing costs of $3.0 million, including $1.0 million in share-based compensation expense and $0.4 million in higher expense for our annual incentive program related to our sales and marketing staff. Another $0.4 million of the increase was due to increased travel to the Asia Pacific region as we implemented a number of projects in support of our strategic initiative to stay connected with our customers, such as transitioning to direct sales in Taiwan and moving our data storage business to Singapore. Selling and marketing expenses also increased $0.2 million due to higher office rental fees and $0.2 million related to increased product sample costs.


GENERAL AND ADMINISTRATIVE

General and administrative expenses were $34.3 million in 2006, which represented an increase of 35.0%, or $8.9 million, from 2005.  The increase resulted primarily from $9.5 million in higher staffing costs, including $8.0 million in share-based compensation expense and $0.9 million in higher expense for our annual incentive program.


PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

Purchased IPR&D expense was $1.1 million in 2006, resulting from the acquisition of substantially all of the assets and assumption of certain liabilities of QED. We may make future acquisitions and may record additional expenses for IPR&D in connection with those acquisitions.
 

OTHER INCOME, NET

Other income was $4.1 million in 2006, compared to $2.7 million in 2005. The increase in other income was primarily due to $2.0 million greater interest income from higher interest rates and our larger average balance of cash and short-term investments, partially offset by $0.6 million of expense associated with our investment in NanoProducts Corporation.


PROVISION FOR INCOME TAXES

Our effective income tax rate was 32.1% in 2006 and 30.2% in 2005. The increase in the effective tax rate was primarily due to reduced research and experimentation tax credits due to the expiration of the credit effective December 31, 2005. In addition, we recognized reduced extraterritorial income tax deductions related to export sales of our products from North America due to the phase-out of this tax benefit. We expect our effective tax rate in fiscal 2007 to be between 32 and 33 percent.


NET INCOME

Net income was $32.9 million in 2006, which represented an increase of 1.5%, or $0.5 million, from 2005 as a result of the factors discussed above.
 
32


YEAR ENDED SEPTEMBER 30, 2005, VERSUS YEAR ENDED SEPTEMBER 30, 2004

REVENUE

Revenue was $270.5 million in 2005, which represented a 12.6%, or $38.9 million, decrease from 2004. Of this decrease, $23.3 million was due to a decrease in sales volume and $15.7 million was due to a decrease in weighted average selling price, primarily resulting from selected price reductions partially offset by a higher valued product mix. Revenue for fiscal 2005 would have been $0.7 million lower had the average exchange rates for the Japanese Yen and Euro during the period held constant with the prior year’s average rates.

Following a period of strong semiconductor demand in the second half of fiscal 2004, our revenue during the first three quarters of fiscal 2005 was adversely impacted in part by a downturn in the semiconductor industry, which we believe was partially driven by a reduction in wafer starts by some semiconductor manufacturers to reduce excess inventories of certain semiconductor devices. Another factor that adversely affected our fiscal 2005 revenue was the remaining impact of one large customer transitioning to another supplier of CMP slurry for polishing copper interconnects at 130 nanometer technology.


COST OF GOODS SOLD

Total cost of goods sold was $141.3 million in 2005, which represented a decrease of 9.9%, or $15.5 million, from 2004. Of this decrease, $11.8 million was due to lower sales volume and $3.7 million was due to lower average costs per gallon, primarily due to improved manufacturing yields partially offset by higher fixed costs.


GROSS PROFIT

Our gross profit as a percentage of revenue was 47.8% in 2005 as compared to 49.3% in 2004. The 1.5 percentage point decrease in gross profit margin resulted primarily from selected price reductions and lower utilization of our manufacturing capacity due to the lower level of sales, partially offset by a higher valued product mix.


RESEARCH, DEVELOPMENT AND TECHNICAL

Total research, development and technical expenses were $43.0 million in 2005, which represented a decrease of 2.3% or $1.0 million, from 2004. The decrease is primarily related to $1.1 million in lower expenses for clean room materials and laboratory supplies, $0.8 million in lower technical service and analysis fees and $0.5 million in lower facilities costs. These decreases were partially offset by $0.6 million in higher depreciation expense related to equipment purchased in 2004 for our CMP polishing and metrology clean room in Aurora, Illinois, and $0.4 million in higher staffing costs.


SELLING AND MARKETING

Selling and marketing expenses were $17.0 million in 2005, which represented an increase of 4.7%, or $0.8 million, over 2004. The increase resulted primarily from higher staffing costs of $0.9 million and higher facility costs of $0.5 million. These increases were partially offset by decreased consulting fees of $0.4 million and lower product sample costs of $0.4 million.
 
33


GENERAL AND ADMINISTRATIVE

General and administrative expenses were $25.4 million in 2005, which represented an increase of 12.1%, or $2.7 million, from 2004.  The increase resulted primarily from $1.7 million in higher staffing costs and $1.0 million of increased professional fees primarily related to meeting the requirements of Sarbanes-Oxley Section 404.

 
OTHER INCOME, NET

Other income was $2.7 million in 2005, compared to $0.1 million in 2004. The increase in other income was primarily due to $2.0 million greater interest income from higher interest rates and our larger average balance of cash and short-term investments, as well as a $0.7 million increase in foreign exchange gains.


PROVISION FOR INCOME TAXES

Our effective income tax rate was 30.2% in 2005 and 33.1% in 2004. The decrease in the effective tax rate was primarily due to higher tax-exempt interest income and the increased effect of extraterritorial income tax credits related to export sales from North America.


NET INCOME

Net income was $32.5 million in 2005, which represented a decrease of 30.5%, or $14.3 million, from 2004 as a result of the factors discussed above.


LIQUIDITY AND CAPITAL RESOURCES

We had cash flows from operating activities of $58.7 million in fiscal 2006, $48.0 million in fiscal 2005 and $64.2 million in fiscal 2004. Our cash provided by operating activities in fiscal 2006 originated from net income from operations of $32.9 million and noncash items of $31.4 million, which were partially offset by a net increase in working capital of $5.7 million.

In fiscal 2006 cash flows used in investing activities were $32.4 million. Purchases of property, plant and equipment, primarily for the construction of our Asia Pacific technology center and for projects in our manufacturing operations, were made with $22.2 million in cash and $1.0 million in accrued liabilities and accounts payable. We also completed two acquisitions during the fiscal year for a total of $20.9 million, net of cash acquired. In addition, we used $5.0 million to acquire patents and associated rights relating to CMP slurry technology. Finally, $15.7 million was provided by net sales of short-term auction rate securities. Fiscal 2005 cash flows used in investing activities were $35.7 million. Purchases of property, plant and equipment, primarily for the construction of our Asia Pacific technology center and other manufacturing projects, were made with $21.1 million in cash and $8.2 million in accrued liabilities. In addition, $12.6 million was used for net purchases of short-term auction rate securities in fiscal 2005 and $1.9 million was used for the final payment for our acquisition of a minority ownership interest in NanoProducts Corporation. In fiscal 2004 cash flows used in investing activities were $126.8 million, of which $114.0 million was used for net purchases of auction rate securities. Also in that year, $11.0 million was used for purchases of property, plant and equipment, including purchases of land in Geino, Japan, manufacturing equipment and research and development equipment. Finally, we invested $1.8 million as partial payment for a minority ownership interest in NanoProducts Corporation in fiscal 2004. We estimate that our total capital expenditures in fiscal 2007 will be approximately $17.0 million; however, we are exploring options for providing CMP slurry manufacturing capability in Taiwan, and depending on how we fulfill this initiative, our capital spending could be much higher.
 
34

   
    In fiscal 2006 cash flows used in financing activities were $15.6 million, primarily as a result of $16.0 million in repurchases of common stock under our share repurchase program and $0.9 million in principal payments under capital lease obligations. These outflows were partially offset by the issuance of common stock of $1.4 million primarily from purchases under our employee stock purchase plan. In fiscal 2005 cash flows used in financing activities were $10.9 million, primarily as a result of $17.0 million in repurchases of common stock under our share repurchase program and $0.9 million in principal payments under capital lease obligations. These outflows were partially offset by the issuance of common stock of $7.0 million from the exercise of stock options under our equity incentive plan and purchases under our employee stock purchase plan. In fiscal 2004 cash flows used in financing activities of $5.4 million were largely a result of repurchasing $8.0 million of common stock under our share repurchase program and paying $0.8 million in principal payments under capital lease obligations. These outflows were partially offset by the issuance of common stock of $3.4 million from the exercise of stock options under our equity incentive plan and purchases under our employee stock purchase plan. 

In the fourth quarter of fiscal 2005, we completed our initial $25.0 million share repurchase program, which was authorized in July 2004. In October 2005, our Board of Directors authorized a new share repurchase program for up to $40.0 million of our outstanding common stock. Shares are repurchased from time to time, depending on market conditions, in open market transactions, at management’s discretion. We fund share repurchases from our existing cash balance. We view the program as an effective means to return cash to stockholders. The program became effective on the authorization date and may be suspended or terminated at any time, at the Company’s discretion.

We have an unsecured revolving credit facility of $50.0 million with an option to increase the facility up to $80.0 million. This agreement runs through November 2008. Interest accrues on any outstanding balance at either the institution’s base rate or the Eurodollar rate plus an applicable margin. We also pay a non-use fee. Loans under this facility are anticipated to be used primarily for general corporate purposes, including working capital and capital expenditures. The credit agreement also contains various covenants. No amounts are currently outstanding under this credit facility and we believe we are currently in compliance with the covenants.

We believe that cash generated by our operations and available borrowings under our revolving credit facility will be sufficient to fund our operations, expected capital expenditures, including merger and acquisition activities, and share repurchases for the foreseeable future. However, we plan to expand our business and continue to improve our technology, and to do so may require us to raise additional funds in the future through public or private equity or debt financing, strategic relationships or other arrangements.


OFF-BALANCE SHEET ARRANGEMENTS

At September 30, 2006 and 2005, we did not have any unconsolidated entities or financial partnerships, which might have been established for the purpose of facilitating off-balance sheet arrangements, such as entities often referred to as structured finance or special purpose entities.

35


TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

     The following summarizes our contractual obligations at September 30, 2006, and the effect such obligations are expected to have on our liquidity and cash flow in future periods.


CONTRACTUAL OBLIGATIONS
(In millions)
 
Total
 
Less Than
1 Year
 
1-3
Years
 
3-5
Years
 
After 5
Years
 
                       
Capital lease obligations
 
$
5.7
 
$
1.3
 
$
2.2
 
$
2.2
 
$
-
 
Operating leases
   
2.6
   
1.3
   
1.2
   
0.1
   
-
 
Purchase obligations
   
42.5
   
32.0
   
7.3
   
2.9
   
0.3
 
Other long-term liabilities 
   
1.1
   
-
   
-
   
-
   
1.1
 
Total contractual obligations
 
$
51.9
 
$
34.6
 
$
10.7
 
$
5.2
 
$
1.4
 


CAPITAL LEASE OBLIGATIONS

In December 2001, we entered into a fumed alumina supply agreement with Cabot Corporation under which we agreed to pay Cabot Corporation for the expansion of a fumed alumina manufacturing facility in Tuscola, Illinois. The payments for the facility have been treated as a capital lease for accounting purposes and the present value of the minimum quarterly payments resulted in an initial $9.8 million lease obligation and related leased asset. The agreement’s first term runs through December 2006 and it has been renewed for another five-year term ending in December 2011.

OPERATING LEASES

We lease certain vehicles, warehouse facilities, office space, machinery and equipment under cancelable and noncancelable operating leases, most of which expire within ten years of their respective commencement dates and may be renewed by us.

PURCHASE OBLIGATIONS

We have entered into multi-year supply agreements with Cabot Corporation for the purchase of fumed metal oxides. We purchase fumed silica primarily under a fumed silica supply agreement with Cabot Corporation that became effective in January 2004, and was amended in September 2006. The agreement has an initial six-year term that runs through December 2009 and will automatically renew unless either party gives certain notice of non-renewal. We are obligated to purchase fumed silica for at least 90% of our six-month volume forecast for certain of our slurry products, to purchase certain non-material minimum quantities every six months, and to pay for the shortfall if we purchase less than these amounts. We currently anticipate meeting minimum forecasted purchase volume requirements. Since December 2001, we have purchased fumed alumina primarily under a fumed alumina supply agreement with Cabot Corporation that has an original term ending in December 2006 and has been renewed for another five-year term ending in December 2011. Prices charged for fumed alumina from Cabot Corporation are pursuant to the terms of the supply agreement and may fluctuate based upon the actual costs incurred by Cabot Corporation in the manufacture of fumed alumina. Under these agreements, Cabot Corporation continues to be the exclusive supplier of certain quantities and types of fumed silica and fumed alumina for products we produced as of the effective dates of these agreements. Subject to certain terms, these agreements prohibit Cabot Corporation from selling fumed silica and fumed alumina to third parties for use in CMP applications, as well as engaging itself in CMP applications. If Cabot Corporation fails to supply us with our requirements for any reason, including if we require product specification changes that Cabot Corporation cannot meet, we have the right to purchase products meeting those specifications from other suppliers. We also may purchase raw materials from other suppliers for products we have produced since the effective date of these agreements. Purchase obligations include an aggregate amount of $22.0 million of contractual commitments related to our Cabot Corporation agreements for fumed silica and fumed alumina.

36


We paid $19.0 million in cash related to our July 2006 QED acquisition, and we are obligated to pay up to an additional $4.5 million depending upon the performance of the QED business over the two years following the purchase. Contractual obligations at September 30, 2006, include $4.5 million in contingent payments related to this agreement.


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

EFFECT OF CURRENCY EXCHANGE RATES AND EXCHANGE RATE RISK MANAGEMENT

We conduct business operations outside of the United States through our foreign operations. Some of our foreign operations maintain their accounting records in their local currencies. Consequently, period to period comparability of results of operations is affected by fluctuations in exchange rates. The primary currencies to which we have exposure are the Japanese Yen and, to a lesser extent, the British Pound and the Euro. From time to time we enter into forward contracts in an effort to manage foreign currency exchange exposure. However, we may be unable to hedge these exposures completely. Approximately 14% of our revenue is transacted in currencies other than the U.S. dollar. We do not currently enter into forward exchange contracts or other derivative instruments for speculative or trading purposes.

MARKET RISK AND SENSITIVITY ANALYSIS RELATED TO FOREIGN EXCHANGE RATE RISK

We have performed a sensitivity analysis assuming a hypothetical 10% adverse movement in foreign exchange rates. As of September 30, 2006, the analysis demonstrated that such market movements would not have a material adverse effect on our consolidated financial position, results of operations or cash flows over a one-year period. Actual gains and losses in the future may differ materially from this analysis based on changes in the timing and amount of foreign currency rate movements and our actual exposures.

37


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
 

   
Page
Consolidated Financial Statements:
 
 
Report of Independent Registered Public Accounting Firm
39
 
Consolidated Statements of Income for the years ended September 30, 2006, 2005 and 2004
41
 
Consolidated Balance Sheets at September 30, 2006 and 2005
42
 
Consolidated Statements of Cash Flows for the years ended September 30, 2006, 2005 and 2004
43
 
Consolidated Statements of Changes in Stockholders’ Equity for the years ended September 30, 2006, 2005 and 2004
44
 
Notes to the Consolidated Financial Statements
45
 
Selected Quarterly Operating Results
65
 
 
Financial Statement Schedule:
 
 
Schedule II - Valuation and Qualifying Accounts
67

All other schedules are omitted, because they are not required, are not applicable, or the information is included in the consolidated financial statements and notes thereto.

38


Report of Independent Registered Public Accounting Firm

To the Stockholders and Board of Directors of
Cabot Microelectronics Corporation:

We have completed integrated audits of Cabot Microelectronics Corporation’s 2006 and 2005 consolidated financial statements and of its internal control over financial reporting as of September 30, 2006, and an audit of its 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Cabot Microelectronics Corporation and its subsidiaries at September 30, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Notes 2 and 10 to the consolidated financial statements, the Company began recording share-based compensation expense in accordance with Statement of Financial Accounting Standards No. 123(R) “Share-Based Payment” on October 1, 2005.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of September 30, 2006 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

39


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.
 

PricewaterhouseCoopers LLP
Chicago, IL
November 28, 2006

40


CABOT MICROELECTRONICS CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
 
   
Year Ended September 30,
 
   
2006
 
2005
 
2004
 
               
Revenue
 
$
320,795
 
$
270,484
 
$
309,433
 
                     
Cost of goods sold *
   
171,758
   
141,282
   
156,805
 
                     
Gross profit
   
149,037
   
129,202
   
152,628
 
                     
Operating expenses:
                   
Research, development and technical *
   
48,070
   
43,010
   
44,003
 
Selling and marketing *
   
21,115
   
16,989
   
16,225
 
General and administrative *
   
34,319
   
25,427
   
22,691
 
Purchased in-process research and development
   
1,120
   
-
   
-
 
Total operating expenses
   
104,624
   
85,426
   
82,919
 
                     
Operating income
   
44,413
   
43,776
   
69,709
 
                     
Other income, net
   
4,111
   
2,747
   
139
 
Income before income taxes
   
48,524
   
46,523
   
69,848
 
Provision for income taxes *
   
15,576
   
14,050
   
23,120
 
                     
Net income
 
$
32,948
 
$
32,473
 
$
46,728
 
                     
Basic earnings per share
 
$
1.36
 
$
1.32
 
$
1.89
 
                     
Weighted average basic shares outstanding
   
24,228
   
24,563
   
24,750
 
                     
Diluted earnings per share
 
$
1.36
 
$
1.32
 
$
1.88
 
                     
Weighted average diluted shares outstanding
   
24,228
   
24,612
   
24,882
 
* Includes the following amounts related to share-based compensation expense:
                   
Cost of goods sold
 
$
648
 
$
-
 
$
-
 
Research, development and technical
   
959
   
-
   
-
 
Selling and marketing
   
1,037
   
-
   
-
 
General and administrative
   
8,020
   
-
   
-
 
Tax benefit
   
(3,809
)
 
-
   
-
 
Total share-based compensation expense, net of tax
 
$
6,855
 
$
-
 
$
-
 

The accompanying notes are an integral part of these consolidated financial statements.
 
41


CABOT MICROELECTRONICS CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
 
   
September 30,
 
   
2006
 
2005
 
ASSETS
         
Current assets:
         
Cash and cash equivalents
 
$
54,965
 
$
44,436
 
Short-term investments
   
110,965
   
126,605
 
Accounts receivable, less allowance for doubtful accounts of $551 at September 30, 2006, and $470 at September 30, 2005
   
48,028
   
36,759
 
Inventories
   
40,326
   
28,797
 
Prepaid expenses and other current assets
   
4,785
   
5,970
 
Deferred income taxes
   
2,436
   
3,240
 
Total current assets
   
261,505
   
245,807
 
               
Property, plant and equipment, net
   
130,176
   
135,784
 
Goodwill
   
4,565
   
1,373
 
Other intangible assets, net
   
11,447
   
-
 
Other long-term assets
   
4,440
   
3,799
 
Total assets
 
$
412,133
 
$
386,763
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
             
Current liabilities:
             
Accounts payable
 
$
15,104
 
$
10,236
 
Capital lease obligations
   
1,254
   
1,170
 
Accrued expenses, income taxes payable and other current liabilities
   
22,475
   
24,216
 
Total current liabilities
   
38,833
   
35,622
 
               
Capital lease obligations
   
4,420
   
5,436
 
Deferred income taxes
   
-
   
4,967
 
Other long-term liabilities
   
1,109
   
1,654
 
Total liabilities
   
44,362
   
47,679
 
               
Commitments and contingencies (Note 15)
             
               
Stockholders’ equity:
             
               
Common stock:
             
Authorized: 200,000,000 shares, $0.001 par value
             
Issued: 25,254,719 shares at September 30, 2006, and 25,198,809 shares at September 30, 2005
   
24
   
24
 
Capital in excess of par value of common stock
   
157,463
   
145,011
 
Retained earnings
   
251,007
   
218,059
 
Accumulated other comprehensive income
   
272
   
1,160
 
Unearned compensation
   
-
   
(171
)
Treasury stock at cost, 1,297,167 shares at September 30, 2006, and 774,020 shares at September 30, 2005
   
(40,995
)
 
(24,999
)
Total stockholders’ equity
   
367,771
   
339,084
 
               
Total liabilities and stockholders’ equity
 
$
412,133
 
$
386,763
 

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

42


CABOT MICROELECTRONICS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

   
Year Ended September 30,
 
   
2006
 
2005
 
2004
 
Cash flows from operating activities:
             
Net income
 
$
32,948
 
$
32,473
 
$
46,728
 
Adjustments to reconcile net income to net cash provided by operating activities:
                   
Depreciation and amortization
   
21,174
   
19,072
   
17,611
 
Purchased in-process research and development
   
1,120
   
-
   
-
 
Loss on equity investment
   
566
   
330
   
73
 
Share-based compensation expense
   
10,664
   
312
   
67
 
Income tax benefit on exercises of stock options
   
-
   
1,288
   
967
 
Deferred income tax expense (benefit)
   
(5,571
)
 
(2,417
)
 
1,119
 
Non-cash foreign exchange (gain)/loss
   
2,606
   
1,079
   
(3
)
Loss on disposal of property, plant and equipment
   
1,109
   
363
   
58
 
Impairment of property, plant and equipment
   
790
   
657
   
-
 
Other
   
(1,081
)
 
299
   
(471
)
Changes in operating assets and liabilities:
                   
Accounts receivable
   
(8,492
)
 
3,902
   
(3,166
)
Inventories
   
(5,635
)
 
(4,760
)
 
(326
)
Prepaid expenses and other assets
   
1,726
   
(2,824
)
 
(308
)
Accounts payable, accrued liabilities and other current liabilities
   
7,166
   
(2,847
)
 
567
 
Income taxes payable, deferred compensation and other noncurrent liabilities
   
(422
)
 
1,035
   
1,294
 
Net cash provided by operating activities
   
58,668
   
47,962
   
64,210
 
                     
Cash flows from investing activities:
                   
Additions to property, plant and equipment
   
(22,230
)
 
(21,137
)
 
(10,968
)
Proceeds from the sale of property, plant and equipment
   
19
   
6
   
15
 
Acquisitions of businesses, net of cash acquired
   
(20,919
)
 
-
   
-
 
Purchase of patents
   
(5,000
)
 
-
   
-
 
Purchases of equity investments
   
-
   
(1,930
)
 
(1,820
)
Purchases of short-term investments
   
(185,655
)
 
(141,570
)
 
(184,040
)
Proceeds from the sale of short-term investments
   
201,392
   
128,975
   
70,030
 
Net cash used in investing activities
   
(32,393
)
 
(35,656
)
 
(126,783
)
                     
Cash flows from financing activities:
                   
Repurchases of common stock
   
(15,996
)
 
(16,999
)
 
(8,000
)
Net proceeds from issuance of stock
   
1,359
   
6,983
   
3,385
 
Principal payments under capital lease obligations
   
(933
)
 
(869
)
 
(815
)
Net cash used in financing activities
   
(15,570
)
 
(10,885
)
 
(5,430
)
                     
Effect of exchange rate changes on cash
   
(176
)
 
(293
)
 
(7
)
Increase (decrease) in cash
   
10,529
   
1,128
   
(68,010
)
Cash and cash equivalents at beginning of year
   
44,436
   
43,308
   
111,318
 
Cash and cash equivalents at end of year
 
$
54,965
 
$
44,436
 
$
43,308
 
 
Supplemental disclosure of cash flow information:
                   
Cash paid for income taxes
 
$
21,745
 
$
14,014
 
$
19,554
 
Cash paid for interest
 
$
658
 
$
596
 
$
688
 
                     
Supplemental disclosure of noncash investing and financing activities:
                   
Purchases of property, plant and equipment in accrued liabilities and accounts payable at the end of period
 
$
968
 
$
8,204
 
$
-
 
Issuance of restricted stock
 
$
63
 
$
125
 
$
25
 

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

43


CABOT MICROELECTRONICS CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(In thousands)

   
 Common
Stock
 
Capital
In Excess
Of Par
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Comprehensive
Income
 
Unearned
Compensation
 
Treasury
Stock
 
Total
 
Balance at September 30, 2003
   $
25
   $
131,913
   $
138,858
   $
1,187
         $
(210
)
 $
-
   $
271,773
 
                                                   
Exercise of stock options
         
2,232
                                 
2,232
 
Tax benefit on stock options exercised
         
967
                                 
967
 
Amortization of unearned compensation on restricted stock
                                 
76
         
76
 
Issuance of Cabot Microelectronics restricted stock under deposit share plan
         
75
                     
(25
)
       
50
 
Forfeiture of Cabot Microelectronics restricted stock
         
(15
)
                   
15
         
-
 
Reverse amortization related to restricted stock forfeited
                                 
(9
)
       
(9
)
Issuance of Cabot Microelectronics stock under Employee Stock Purchase Plan
         
1,087
                                 
1,087
 
Purchase of treasury stock, at cost
                                       
(8,000
)
 
(8,000
)
Net income
               
46,728
       
$
46,728
                   
Net unrealized loss on derivative intruments
                     
(10
)
 
(10
)
                 
Foreign currency translation adjustment
                     
728
   
728
                   
Total comprehensive income
                         
$
47,446
               
47,446
 
                                                   
Balance at September 30, 2004
 
$
25
 
$
136,259
 
$
185,586
 
$
1,905
       
$
(153
)
$
(8,000
)
$
315,622
 
                                                   
Exercise of stock options
         
5,655
                                 
5,655
 
Tax benefit on stock options exercised
         
1,288
                                 
1,288
 
Amortization of unearned compensation on restricted stock
                                 
106
         
106
 
Issuance of Cabot Microelectronics restricted stock under deposit share plan
         
376
                     
(125
)
       
251
 
Forfeiture of Cabot Microelectronics restricted stock
         
(5
)
                   
5
         
-
 
Reverse amortization related to restricted stock forfeited
                                 
(4
)
       
(4
)
Issuance of Cabot Microelectronics stock under directors' deferred compensation plan
         
374
                                 
374
 
Issuance of Cabot Microelectronics stock under Employee Stock Purchase Plan
          1,064                                   1,064  
Purchase of treasury stock, at cost
   
(1
)
                               
(16,999
)
 
(17,000
)
Net income
               
32,473
       
$
32,473
                   
Net unrealized gain on derivative intruments
                     
35
   
35
                   
Foreign currency translation adjustment
                     
(780
)
 
(780
)
                 
Total comprehensive income
                         
$
31,728
               
31,728
 
                                                   
Balance at September 30, 2005
 
$
24
 
$
145,011
 
$
218,059
 
$
1,160
       
$
(171
)
$
(24,999
)
$
339,084
 
                                                   
                                                   
Reclassification of unearned compensation upon adoption of SFAS 123R
         
(171
)
                   
171
         
-
 
Reclassification of directors' deferred compensation upon adoption of SFAS 123R
         
600
                                 
600
 
Issuance of Cabot Microelectronics restricted stock under deposit share plan
         
137
                                 
137
 
Issuance of Cabot Microelectronics stock under Employee Stock Purchase Plan
         
1,222
                                 
1,222
 
Share-based compensation expense