Verigy (VRGY) - Description of business

Conduct (including code of ethics provisions that apply to our principal executive officer, principal financial officer, controller and senior financial officers) are available on our website at www.investor.verigy.com under “Documents and Charters”. This information is also available to shareholders by writing to the Company at the address on the cover of this Annual Report on Form 10-K.

Item 1A.                 Risk Factors

A description of the risk factors associated with our business is set forth below. You should carefully consider the risks described below and the other information in this report before investing in our ordinary shares. Our business could be seriously harmed by any of these risks. The trading price of our ordinary shares could decline due to any of these risks, and you may lose all or part of your investment.

Risks Relating to Our Business

We have undertaken a significant restructuring of our operations and continue to incur significant expenses to increase operational efficiencies.

If we are unable to successfully execute our wide-ranging cost saving initiative or if it fails to generate significant cost savings, our business, financial condition and results of operation could be materially adversely affected. We continue to incur significant expenses associate with our cost saving initiative, which affects our operations both domestically and internationally. This initiative involves a number of significant ongoing changes, including:

·        changes to our employee compensation structure, as we recently introduced flexible pay structures which include a significant variable pay component based on overall company performance;

·        consolidation of our operations to a fewer number of facilities;

·        migration of portions of certain activities to Asia;

·        migration to a completely outsourced manufacturing model; and

·        establishing and stabilizing a new, free-standing IT environment in conjunction with our recent separation from Agilent.

This initiative is multi-faceted and complex. Our management will continue to have to respond to a variety of risks related to the execution of this initiative, including the loss of key employees who desire more certain compensation structures or are unwilling or unable to relocate to different locations, the operational and administrative complexity associated with transitioning to new supply chain and manufacturing processes and the inherent intricacy of installing a new IT environment. If we fail to successfully implement these initiatives in full in a timely manner, or if they fail to generate significant cost savings, our business, financial condition, results of operations and cash flows would be materially adversely affected.

Our dependence on contract manufacturers and sole source suppliers and contract manufacturers and our transition to a completely outsourced manufacturing model may prevent us from delivering our products on a timely basis.

Through June 2006, we relied upon two manufacturing models: a hybrid internal and contract manufacturing model for our 93000 Series products and a completely outsourced contract manufacturing model for our Versatest series products. In connection with our separation from Agilent in June 2006, we transitioned the manufacturing processes for the 93000 Series products that we previously conducted internally to Flextronics. As a result of this transition, we now rely entirely on contract manufacturers.

Our current reliance on third-party manufacturers gives us less control over the manufacturing process and exposes us to significant risks, especially inadequate capacity, late delivery, substandard quality and high costs. Moreover, because our products are very complex to manufacture, transitioning manufacturing activities from one location to another, or from one manufacturing partner to another, is complicated. Flextronics commenced production of our Versatest series products in China in July 2006 and assumed our manufacturing activities for the 93000 Series products in Germany in June 2006. The activities currently conducted by Flextronics in Germany are expected to be completely transitioned to China during the first half of calendar 2007. We cannot be certain that existing or future contract manufacturers will be able to manufacture our products on a timely and cost-effective basis, or to our quality and performance specifications. Should our contract manufacturers be unable to meet our manufacturing requirements in a timely manner, whether as a result of transitional issues or otherwise, our ability to ship products and to realize the related revenues when anticipated could be materially impacted.

We rely on sole source suppliers, some of whom are relatively small in size, for many of the components we use in our products, including custom integrated circuits, relays and other electronic components. One sole source supplier recently relocated its manufacturing activities to a new facility and, in connection with this transition, has experienced significant difficulties in meeting our requirements for components. Another sole source supplier has recently substantially extended the order lead times for the components we rely upon, and such components have become difficult to source in the market. While neither of these situations had a material impact on our results for fiscal year 2006, the failure of these or other sole source suppliers to meet our requirements in a timely manner could impair our ability to ship products and to realize the related revenues when anticipated which could adversely affect our business and operating results.

Our quarterly operating results may fluctuate significantly from period to period and this may cause our share price to decline.

In the past, we have experienced, and in the future we expect to continue to experience, fluctuations in revenue and operating results from quarter to quarter for a variety of reasons, including the risk factors described in this report. As a result of these and other risks, as well as our having been previously a wholly owned subsidiary of Agilent, we believe that quarter-to-quarter comparisons of our revenue and operating results may not be meaningful, and that these comparisons may not be an accurate indicator of our future performance. In addition, sales of a relatively limited number of our test systems account for a substantial portion of our net revenue in any particular quarter. In contrast, our costs are relatively fixed in the short-term. Thus, changes in the timing or terms of a small number of transactions could disproportionately affect our operating results in any particular quarter. Moreover, our operating results in one or more future quarters may fail to meet the expectations of securities analysts or investors. If this occurs, we would expect to experience an immediate and significant decline in the trading price of our shares.

Our business and operating results could be harmed by the highly cyclical nature of the semiconductor industry.

Our business and operating results depend in significant part upon capital expenditures of semiconductor designers and manufacturers, which in turn depend upon the current and anticipated market demand for products incorporating semiconductors from these designers and manufacturers. Historically, the semiconductor industry has been highly cyclical with recurring periods of diminished product demand. During these periods, semiconductor designers and manufacturers, facing reduced demand for their products, have significantly reduced their capital and other expenditures, including expenditures for semiconductor test equipment and services such as those we offer. These periods of reduced product and services demand have been characterized by excessive inventory levels, cancellation of customer orders and erosion of selling prices, as well as excessive semiconductor test capacity. As a consequence, during these periods, we have experienced significant reductions in customer orders for new test equipment, fewer upgrades to existing test equipment and less demand for our test services. We have also experienced order cancellations, delays in commitments and delays in collecting accounts receivable. Furthermore, because we have a high proportion of customers that are subcontractors, which during market downturns tend to reduce or cancel orders for new test systems and test services more quickly and dramatically than other customers, any downturn may cause a quicker and more significant adverse impact on our business than on the broader semiconductor industry. In addition, although a decline in orders for semiconductor capital equipment, including test equipment, may accompany or precede the timing of a decline in the semiconductor market as a whole, any recovery in spending for semiconductor capital equipment, including test equipment, may lag any recovery by the semiconductor industry.

We have a limited ability to quickly or significantly reduce our costs, which makes us particularly vulnerable to the highly cyclical nature of the semiconductor industry.

Historically, downturns in the semiconductor industry have affected the test equipment and services market more significantly than the overall semiconductor industry. A significant portion of our overall costs are fixed. In addition, our products require long manufacturing lead times, which require us to make material purchasing commitments from our suppliers well in advance of product sales. Because a high proportion of our costs are fixed, we have a limited ability to reduce expenses and manufacturing inventory purchases quickly in response to decreases in orders and revenues. Moreover, to remain competitive, even during downturns in the semiconductor industry or generally, we are required to maintain significant fixed costs for research and development. As a consequence, in a downturn, we may not be able to reduce our costs quickly, or by a sufficient amount, and our financial performance may suffer.

The market for semiconductor test equipment and services is highly concentrated, and we have limited opportunities to sell our test equipment and services.

The semiconductor industry is highly concentrated in that a small number of semiconductor designers and manufacturers and subcontractors account for a substantial portion of the purchases of semiconductor test equipment and services generally, including our test equipment and services. Consolidation in the semiconductor industry may increase this concentration. Accordingly, we expect that sales of our products will be concentrated with a limited number of large customers for the foreseeable future. We believe that our financial results will depend in significant part on our success in establishing and maintaining relationships with, and effecting substantial sales to, these potential customers. Even if we establish these relationships, our financial results will depend in large part on these customers’ sales and business results.

The loss of, or a significant reduction in the number of sales to, our significant customers could materially harm our business.

For fiscal year 2006, revenue from our top ten customers accounted for approximately 51.6% of our total net revenue, with one customer accounting for 10.1% of our total net revenue. In comparison, for fiscal year 2005, revenue from our top ten customers accounted for approximately 54% of our total net revenue, with no customer accounting for more than 10% of our total net revenue.

Our relationships with our significant customers, who frequently evaluate competitive products prior to placing new orders, could be adversely affected by a number of factors, including:

·        a decision by our customers to purchase test equipment and services from our competitors;

·        a decision by our customers to pursue the development and implementation of self-testing integrated circuits or other strategies that reduce their need for our new or enhanced test equipment;

·        the loss of market share by our customers in the markets in which they operate;

·        the shift by our IDM customers to fabless semiconductor models;

·        our ability to keep pace with changes in semiconductor technology;

·        our ability to maintain quality levels of our equipment and services that meet customer expectations;

·        our ability to produce and deliver sufficient quantities of our test equipment in a timely manner; and

·        our ability to provide quality customer service and support.

Generally, our customers may cancel orders with little or no penalty. Our business and operating results could be materially adversely affected by the loss of, or any reduction in orders by, any of our significant customers, particularly if we are unable to replace that lost revenue with additional orders from new or existing customers.

If we do not maintain and expand existing customer relationships and establish new customer relationships, our ability to generate revenue growth will be adversely affected.

Our ability to increase our sales will depend in large part upon our ability to obtain orders for new test systems, enhancements for existing test systems and services from our existing and new customers. Maintaining and expanding our existing relationships and establishing new ones can require substantial investment without any assurance from customers that they will place significant orders. Moreover, if we are unable to provide new test systems, enhancements for existing test systems and services to our customers in a timely fashion or in sufficient quantities, our business will be harmed. In the past we have experienced, and in our industry it is not unusual to experience, difficulty in delivering new test equipment, as well as product enhancements and upgrades. When we encountered difficulties in the past, our customer relationships and our ability to generate additional revenue from customers were harmed. Our inability to meet the demands of customers would severely damage our reputation, which would make it more difficult for us to sell test equipment, enhancements and services to existing, as well as new, customers and would adversely affect our ability to generate revenue.

In addition, we face significant obstacles in establishing new customer relationships. It is difficult for us to establish relationships with new customers, because such companies may have existing relationships with our competitors, may be unfamiliar with our product and service offerings, may have an installed base of test equipment sufficient for their current needs or may not have the resources necessary to transition to, and train their employees on, our test equipment. Even if we do succeed in establishing new relationships, these new customers may nonetheless continue to favor our competitors, as our competitors may have had longer relationships with these customers or may maintain a larger installed base of their competing test equipment in the facilities of new customers and only purchase limited quantities from us. In addition, we could face difficulties in our efforts to develop new customer relationships abroad as a result of buying practices that may favor local competitors or non-local competitors with a larger presence in local economies than we have. As a result, we may be forced to partner with local companies in order to compete for business and such arrangements, if available, may not be achieved on economically favorable terms, which could negatively affect our financial performance.

Failure to accurately estimate our customers’ demand and plan the production of our new and existing products could adversely affect our inventory levels and our income.

Given the cyclical nature of the semiconductor industry, we cannot reliably forecast the timing and size of our customers’ orders. In order to meet anticipated demand, we must order components and build some inventory before we actually receive purchase orders. Our results could be harmed if we do not accurately estimate our customers’ product demands and are unable to adjust our purchases with market fluctuations, including those caused by the cyclical nature of the semiconductor industry. During a market upturn, our results could be materially and adversely affected if we cannot increase our purchases of components, parts and services quickly enough to meet increasing demand for our products, and during a market downturn, we could have excess inventory that we would not be able to sell, likely resulting in inventory write-offs. Either of these results could have a material adverse effect on our business, financial condition and results of operations.

Further, if we do not successfully manage the introduction of our new products and estimate customer demand for such products, our ability to sell existing inventory may be adversely affected. If demand for our new products exceeds our projections, we might have insufficient quantities of products for sale to our

customers, which could cause us to miss opportunities to increase revenues during market upturns. If our projections exceed demand for our new products or if some of our customers cancel their current orders for our old products in anticipation of our new products, we may have excess inventories of our new products and excess obsolete inventories, which could result in inventory write-offs that would adversely affect our financial performance.

Failure to accurately predict our customers’ varying ordering patterns could adversely affect our inventory levels and our income.

Our customers tend to make large purchases of our products on an inconsistent basis, rather than smaller purchases on a consistent basis, which makes it difficult to predict the timing of customer orders. Failure to accurately predict our customers’ varying ordering patterns may cause us to experience insufficient or excess product inventories. If our competitors are more successful than us at timing new product introductions and inventory levels to customers’ ordering patterns, we may lose important sales opportunities and our business and results of operations may be harmed.

Existing customers may be unwilling to bear expenses associated with transitioning to new and enhanced products.

In order to grow our business, we need to sell enhancements and upgrades for our existing test equipment, in addition to selling new test equipment. Certain customers may be unwilling, or unable, to bear the costs of implementing enhancements and upgrades to our test equipment platforms, particularly during semiconductor industry downturns. As a result, it may be difficult to market and sell enhancements and upgrades to customers. In addition, as we introduce new enhancements and upgrades, we cannot predict with certainty if and when our customers will transition to those enhancements or upgrades. Any delay in or failure of our customers to transition to new enhancements or upgrades could result in excess inventories or our new or enhanced products, which could result in inventory write-offs that would adversely affect our financial performance.

If we do not introduce new test equipment platforms and upgrade existing test equipment platforms in a timely manner, and if we do not offer comprehensive and competitive services for our test equipment platforms, our test equipment and services will become obsolete, we will lose existing customers and our operating results will suffer.

The semiconductor design and manufacturing industry into which we sell our test equipment is characterized by rapid technological changes, frequent new product introductions, including upgrades to existing test equipment, and evolving industry standards. The success of our new or upgraded test equipment offerings will depend on several factors, including our ability to:

·        properly identify customer needs and anticipate technological advances and industry trends, such as the disaggregation of the traditional IDM semiconductor supply chain into fabless design companies, foundries and packaging, assembly and test providers;

·        develop and commercialize new and enhanced technologies and applications that meet our customers’ evolving performance requirements in a timely manner;

·        develop and deliver enhancements and related services for our current test equipment that are capable of satisfying our customers’ specific test requirements; and

·        introduce and promote market acceptance of new test equipment platforms, such as our Versatest V5500 Series system for memory testing.

In many cases, our test equipment and services are used by our customers to develop, test and manufacture their new products. We therefore must anticipate industry trends and develop new test

equipment platforms or upgrade existing test equipment platforms in advance of the commercialization of our customers’ products. In addition, new methods of testing integrated circuits, such as self-testing integrated circuits, may be developed which would render our test equipment uncompetitive or obsolete if we failed to adopt and incorporate these new methods into our new or existing test equipment platforms. Developing new test equipment platforms and upgrading existing test equipment platforms requires a substantial investment before we can determine the commercial viability of the new or upgraded platform.

As our customers’ product requirements are diverse and subject to frequent change, we will also need to ensure that we have an adequate mix of products that meet our customers’ varying requirements. If we fail to adequately predict our customers’ needs and technological advances, we may invest heavily in research and development of test equipment that does not lead to significant revenue, or we may fail to invest in technology necessary to meet changing customer demands. Without the timely introduction of new or upgraded test equipment that reflects technological advances, our test equipment and services will likely become obsolete, we may have difficulty retaining customers and our revenue and operating results would suffer.

Our long and variable sales cycle depends upon factors outside of our control, could cause us to expend significant time and resources prior to our ever earning associated revenues and may therefore cause fluctuations in our operating results.

Sales of our semiconductor test equipment and services depend in significant part upon semiconductor designers and manufacturers upgrading existing manufacturing equipment to accommodate the requirements of new semiconductor devices and expanding existing, and adding new, manufacturing facilities. As a result, our sales are subject to a variety of factors we cannot control, including:

·        the complexity of our customers’ fabrication processes, which impacts the number of our test systems and amount of our product enhancements and upgrades our customers require;

·        the willingness of our customers to adopt new or upgraded test equipment platforms;

·        the internal technical capabilities and sophistication of our customers, which impacts their need for our test services; and

·        the capital expenditures of our customers.

The decision to purchase our equipment and services generally involves a significant commitment of capital. As a result, our test equipment has lengthy and variable sales cycles during which we may expend substantial funds and management effort to secure a sale prior to receiving any commitment from a customer to purchase our test equipment or services. Prior to completing sales to our customers, we are often subject to a number of significant risks, including the risk that our competitors may compete for the sale or that the customer may change its technological requirements. Our business, financial condition and results of operations may be materially adversely affected by our long and variable sales cycle and the uncertainty associated with expending substantial funds and effort with no guarantee that sales will be made.

Test systems that contain defects that harm our customers could damage our reputation and cause us to lose customers and revenue.

Our test equipment is highly complex and employs advanced technologies. The use of complex technology in our test equipment increases the likelihood that we could experience design, performance or manufacturing problems. If any of our products have defects or reliability or quality problems, we may, in some circumstances, be exposed to liability, our reputation could be damaged significantly and customers might be reluctant to buy our products, which could result in a decline in revenues, an increase in product returns and the loss of existing customers and the failure to attract new customers.

We face substantial competition which, among other things, may lead to price pressure and adversely affect our sales and revenue.

We face substantial competition throughout the world in each of our product areas. Our most significant competitors historically have included Advantest Corporation, Credence Systems Corporation, LTX Corporation, Nextest Systems Corporation, Teradyne, Inc. and Yokogawa Electric Corporation. Many of our competitors have substantially greater financial resources, broader product offerings, more extensive engineering, manufacturing, marketing and customer support capabilities or a greater presence in certain countries than we do. We may have less leverage with component vendors than some of our competitors have. Also, some of our competitors have greater resources and may be more willing or able than we are to put capital at risk to win business. Price reductions by our competitors may force us to lower our prices. We also expect our current competitors to continue to improve the performance of their current products and to introduce new products, technologies or services that could adversely affect sales of our current and future test equipment and services. Additionally, current and future competitors may introduce testing technologies, equipment and services, which may in turn reduce the value of our own test equipment and services. Any of these circumstances may limit our opportunities for growth and negatively impact our financial performance.

We may face competition from Agilent in the future.

Pursuant to the intellectual property matters agreement between us and Agilent, except as described below, for a period of three years after the date in which Agilent distributes to its stockholders all of our ordinary shares that it holds, Agilent agreed not to develop, manufacture, distribute, support or service automated semiconductor test systems for providing high-volume functional test of ICs (including memory and high speed memory devices and SOCs) or SIPs, or components for such products. However, during this three-year period, Agilent may compete with us with respect to:

·        products (other than automated semiconductor test systems for high-volume functional test) for providing functional test of ICs or SIPs, whether or not including parametric test (the testing of selected parameters of a device or group of devices to identify errors or flaws), design verification or engineering characterization capabilities;

·        automated semiconductor test development systems (including hardware and software) that are intended to enable development of test programs and protocols for use in high-volume functional test of ICs or SIPs, whether or not such development test systems themselves are capable of providing such high-volume functional test; and

·        products (other than automated semiconductor test systems for high-volume functional test) for providing parametric test, design verification, engineering characterization or functional test of: (i) wireless communications devices, such as cellular telephones or wireless networking products, whether in packaged device or module form, and whether or not implemented as an IC or SIP; (ii) modules (such as RF front-end modules) containing one or more ICs connected with other active or passive devices; and (iii) RF and higher frequency (e.g., microwave and optical) devices and components such as oscillators, mixers, amplifiers and 3-port devices, to the extent that such devices or components are in the form of an IC or SIP.

While none of these areas has provided material revenue to us in the past, nor are they expected to become areas of our focus for the near future, we can provide no assurance that the limitations contained in the intellectual property matters agreement, which was entered into in the context of a parent-subsidiary relationship and may be less favorable to us than if it had been negotiated between unaffiliated third parties, will be effective at protecting us from competition from Agilent.

In addition, the intellectual property matters agreement permits Agilent to fulfill its obligations under contracts in existence as of March 1, 2006, even though fulfilling such obligations would otherwise have been precluded during the non-competition period and even if fulfilling such obligations would result in Agilent competing with us. This exception will allow Agilent to fulfill its obligations to a semiconductor manufacturer pursuant to which Agilent will develop and sell components to the manufacturer for use in the manufacturer’s semiconductor test systems purchased from a competitor of Verigy. While we do not believe that Agilent fulfilling these obligations will have a material effect on our business or prospects, we may in the future be less successful at selling test systems to this semiconductor manufacturer than would have been the case were the manufacturer not able to combine products from Agilent with the test systems of our competitor.

Although under the intellectual property matters agreement Agilent transferred all of the intellectual property rights Agilent held that relate exclusively to our products to us, Agilent retained and only licensed to us the intellectual property rights to underlying technologies used in both our products and the products of Agilent. Under the agreement, Agilent remains free to use the retained underlying technologies without restriction (other than as described above with respect to the three-year non-compete period).

After the three-year non-compete period, Agilent will be free to compete with any portion or all of our business without restriction, and in doing so will be free to use the retained underlying technologies. Agilent will not be permitted to use the intellectual property rights transferred to us, and licensed from us back to Agilent, to compete with us with respect to our core business of developing, manufacturing, selling and supporting automated semiconductor test systems for high-volume functional test of ICs or SIPs. Agilent will, however, be able to use such intellectual property rights to develop and sell components for such systems, including systems developed and sold by us as well as those developed and sold by our competitors. While selling components has not represented a material portion of our business in the past and is not expected to be an area of focus for the near future, our business could be adversely affected if systems offered by our competitors become more competitive as a result of Agilent supplying components for our competitors’ systems or if, by buying components from Agilent, our customers are able to delay or bypass altogether purchasing newer systems from us.

Competition from Agilent during or after the three-year non-compete period described above or other actions taken by Agilent that create real or perceived competition with us, could harm our business and operating results.

Third parties may compete with us by using intellectual property that Agilent licensed to us under the intellectual property matters agreement.

Under the intellectual property matters agreement, Agilent retained and only licensed to us the intellectual property rights to underlying technologies used in both our products and the products of Agilent. Under the agreement, Agilent remains free to license the intellectual property rights to the underlying technologies to any party, including our competitors. Any unaffiliated third party that is licensed to use such retained intellectual property would not be subject to the non-competition provisions of the intellectual property matters agreement and could compete with us at any time using the underlying technologies. The intellectual property that Agilent retained and that can be licensed in this manner does not relate solely or primarily to one or more of our products, or groups of products; rather, the intellectual property that Agilent licensed to us is generally used broadly across our entire product portfolio. Competition by third parties using the underlying technologies retained by Agilent could harm our business and operating results.

Third parties may claim we are infringing their intellectual property, and we could suffer significant litigation or licensing expenses or be prevented from selling our products or services.

Our industry has been and continues to be characterized by uncertain and conflicting intellectual property claims and vigorous protection and pursuit of these rights. As a result, third parties may claim that we are infringing their intellectual property rights, and we may be unaware of intellectual property rights of others that may cover some of our technology, products and services. Any litigation regarding patents or other intellectual property could be costly and time-consuming, and divert our management and key personnel from our business operations. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement might also require us to enter into costly royalty or license agreements. However, we may not be able to obtain royalty or license agreements on terms acceptable to us, or at all. We also may be subject to significant damages or injunctions against development and sale of certain of our products and services.

In addition, there may be third parties who have refrained from asserting intellectual property infringement claims against our products while we were a wholly owned subsidiary of Agilent that elect to pursue such claims against us now that our separation from Agilent is complete because we no longer have the benefit of being able to counterclaim based on Agilent’s patent portfolio, and we are no longer able to provide licenses of Agilent’s patent portfolio in order to resolve such claims.

Third parties may infringe our intellectual property, and we may expend significant resources enforcing our rights or suffer competitive injury.

Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights. If we fail to protect our intellectual property rights, our competitive position could suffer, which could harm our operating results. Our pending patent and trademark registration applications may not be allowed or competitors may challenge the validity or scope of these patent applications or trademark registrations. In addition, our patents may not provide us with a significant competitive advantage.

We may be required to spend significant resources to monitor and protect our intellectual property rights. We may not be able to detect infringement and may lose competitive position in the market before we do so. In addition, competitors may design around our technology or develop competing technologies. Furthermore, the laws of some foreign countries do not offer the same level of protection of our proprietary rights as the laws of the United States, and we may be subject to unauthorized use of our products or technologies in those countries, particularly in Asia, where we expect our business to expand significantly in the foreseeable future.

In addition, our agreements with Agilent, and in particular the intellectual property matters agreement, set forth the terms and provisions under which we received the intellectual property rights necessary to operate our business. Under our agreements with Agilent, we do not have the right to enforce against third parties intellectual property rights we license from Agilent, and Agilent is under no obligation to enforce such rights on our behalf.

Intellectual property rights are difficult to enforce in the certain countries, which may inhibit our ability to protect our intellectual property rights or those of our suppliers and customers in those countries.

Commercial law in certain countries is relatively undeveloped compared to the commercial law in the U.S. Limited protection of intellectual property is available under local law. Consequently, operating in certain countries may subject us to an increased risk that unauthorized parties may attempt to copy or otherwise obtain or use our intellectual property or the intellectual property of our suppliers, customers or

business partners. We cannot assure you that we will be able to protect our intellectual property rights or those of our suppliers and customers or have adequate legal recourse in the event that we encounter difficulties with infringements of intellectual property under local law.

Our brand identity is still relatively new in the marketplace, which could cause our product sales to suffer, and continuing to build our brand identity will require significant amounts of time and resources.

Prior to our separation from Agilent in June 2006, we conducted our business under Agilent’s brand name. Since our separation, we have conducted our business under the “Verigy” brand name. We believe that, historically, sales of our products have benefited from the use of the “Agilent” brand name. Our customers and suppliers, as well as potential employees we are trying to recruit, may not recognize the “Verigy” brand name, which could negatively influence their business decisions concerning us. We need to continue to expend significant time, effort and resources to establish the “Verigy” brand name in the marketplace. We cannot guarantee that this effort will ultimately be successful. If our effort to establish a new brand identity is unsuccessful, our business, financial condition and results of operations may suffer.

Our executive officers and certain key personnel are critical to our business.

Our future operating results will depend substantially upon the performance of our executive officers and key personnel, some of whom are relatively new to our business. Our future operating results also depend in significant part upon our ability to attract and retain qualified management, manufacturing, technical, application engineering, marketing, sales and support personnel. Competition for qualified personnel is intense, and we cannot ensure success in attracting or retaining qualified personnel. Our business is particularly dependent on expertise which only a very limited number of engineers possess and it may be increasingly difficult for us to hire personnel over time. We operate in several geographic locations, including parts of Asia and Silicon Valley, where the labor markets, especially for application engineers, are particularly competitive. Our business, financial condition and results of operations could be materially adversely affected by the loss of any of our key employees, by the failure of any key employee to perform in his or her current position, or by our inability to attract and retain skilled employees, particularly engineers.

We may need additional financing, which could be difficult to obtain on favorable terms or at all.

In the event we need to raise additional funds, we cannot be certain that we will be able to obtain such additional financing on favorable terms, if at all. Our future capital requirements will depend on many factors, including the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancements to existing products, the costs to ensure access to adequate manufacturing capacity, market acceptance of our products and the cyclical and seasonal demand for our products. If we issue additional equity securities, shareholders may experience additional dilution and the new equity securities may have rights, preferences or privileges senior to those of existing holders of our ordinary shares. If we incur debt, we may become subject to restrictions on how we operate our business. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services, take advantage of future opportunities, grow our business or respond to competitive pressures, which could materially adversely affect our business, financial condition and results of operations. In addition, our agreements with Agilent, and in particular the tax sharing agreement, may limit our ability to incur debt or sell equity securities or to obtain additional financing.

We are in the process of implementing the governance and accounting practices and policies required of a company publicly-traded in the United States and incorporated in Singapore. Any delay in implementing such governance and accounting practices and policies could harm our business.

Prior to becoming a stand alone company, we relied on the financial resources and the administrative and operational support systems of Agilent to operate our business. In conjunction with our separation from Agilent, we have separated our assets from those of Agilent and created our own financial, administrative, operational and other support systems or contract with third parties to replace Agilent’s systems. Many of the new systems, including our enterprise resource planning (“ERP”) system, have been in effect only since the separation date. We have experienced, and expect to continue to experience periodic interruptions in our ERP system, and it may take additional time to fully implement and stabilize the ERP system as well as other support systems.

As a publicly-traded company in the United States, we are subject to many rules and regulations, including the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. We are also required to comply with the Sarbanes-Oxley Act of 2002, as amended, and the rules and regulations implemented thereunder. We are required to comply with Section 404 of the Sarbanes-Oxley Act, beginning with our fiscal year ending October 31, 2007. While we are diligently developing the systems, procedures and processes to enable us to fully meet the requirements associated with being publicly traded in the United States, we may encounter problems or delays in completing these activities. Any failure on our part to meet the requirements of operating as a publicly-traded company could jeopardize our ability to produce reliable financial statements, subject us to disciplinary proceedings by the SEC or the Nasdaq Global Select Market, cause investors to lose confidence in the accuracy and reliability of our financial reporting, or otherwise harm our business or results of operations.

Our results could be adversely affected if we do not comply with certain operating conditions agreed to with the Singapore authorities. In addition, our new legal structure could cause our effective tax rate to vary significantly from period to period, and we could owe significant taxes even during periods when we experience low operating profit or operating losses.

We have negotiated tax incentives with the Singapore Economic Development Board, an agency of the Government of Singapore, which have been approved by Singapore’s Ministry of Finance and Ministry of Trade and Industry. Under the incentives, a portion of the income we earn in Singapore during 10- to 15-year incentive periods is subject to reduced rates of Singapore income tax. The Singapore corporate income tax rate that would apply, absent the incentives, is 20%. In order to receive the benefit of the incentives, we must develop and maintain in Singapore certain functions such as procurement, financial services, order management, credit and collections, spare parts depot and distribution center, a refurbishment center and regional activities like an application development center. In addition to these qualifying activities, we must hire specified numbers of employees and maintain minimum levels of investment in Singapore. We have from 2- to 9-years to phase-in the qualifying activities and to hire the specified numbers of employees. If we do not fulfill these conditions for any reason, our incentive could lapse, our income in Singapore would be subject to taxation at higher rates, and our overall effective tax rate could be between five and ten percentage points higher than would have been the case had we maintained the benefit of the incentives.

In addition, our effective tax rate may vary significantly from period to period because, for example, we may owe significant taxes in jurisdictions other than Singapore during periods when we are profitable in those jurisdictions even though we may be experiencing low operating profit or operating losses on a consolidated basis. Our effective tax rate will vary based on a variety of factors, including overall profitability, the geographical mix of income before taxes and the related tax rates in the jurisdictions where we operate, as well as discrete events, such as settlements of future audits. Certain combinations of these factors could cause us to owe significant taxes even during periods when we experience low income before taxes or loss before taxes.

We sell our products and services worldwide, and our business is subject to risks inherent in conducting business activities in geographies outside of the United States.

Since we sell our products and services worldwide, our business is subject to risks associated with doing business internationally. Revenue from customers in Japan accounted for approximately 10.2%, 20.6% and 15.8% of total net revenue for fiscal years 2006, 2005 and 2004, respectively. Revenue from customers in Singapore accounted for approximately 48.3%, 39.5% and 42.7% for fiscal years 2006, 2005 and 2004, respectively, and revenue from customers in other countries in Asia accounted for approximately 3.7%, 3.3% and 2.8% of total net revenue for fiscal years 2006, 2005 and 2004, respectively. The economies of Asia have been highly volatile and recessionary in the past, resulting in significant fluctuations in local currencies. Our exposure to the business risks presented by the economies of Asia will increase to the extent that we continue to expand our operations in that region, including establishing our headquarters in Singapore and transitioning our contract manufacturing processes to Flextronics in China.

Our international activities subjects us to a number of risks associated with conducting operations internationally, including:

·        difficulties in managing geographically disparate operations;

·        potential greater difficulty and longer time in collecting accounts receivable from customers located abroad;

·        difficulties in enforcing agreements through non-U.S. legal systems;

·        unexpected changes in regulatory requirements that may limit our ability to export our software or sell into particular jurisdictions or impose multiple conflicting tax laws and regulations;

·        political and economic instability, civil unrest or war;

·        terrorist activities and health risks such as ‘bird flu’ and SARS that impact international commerce and travel;

·        difficulties in protecting our intellectual property rights, particularly in countries where the laws and practices do not protect proprietary rights to as great an extent as do the laws and practices of the United States;

·        changing laws and policies affecting economic liberalization, foreign investment, currency convertibility or exchange rates, taxation or employment; and

·        nationalization of foreign owned assets, including intellectual property.

In addition, we are exposed to foreign currency exchange movements versus the U.S. dollar, particularly in the Japanese Yen. With respect to revenue, our primary exposure exists during the period between execution of a purchase order denominated in a foreign currency and collection of the related receivable. During this period, changes in the exchange rates of the foreign currency to the U.S. Dollar will affect our revenue, cost of sales and operating margins and could result in exchange gains or losses. While a significant portion of our purchase orders to date have been denominated in U.S. Dollars, competitive conditions may require us to enter into an increasing number of purchase orders denominated in foreign currencies. We incur a variety of costs in foreign currencies, including some of our manufacturing costs, component costs and sales costs. Therefore, as we expand our operations in Asia, we may become more exposed to a strengthening of currencies in the region against the U.S. dollar. We cannot assure you that any hedging transactions we may enter into will be effective or will not result in foreign exchange hedging gains or losses. As a result, we are exposed to greater risks in currency fluctuations.

We may incur a variety of costs to engage in future acquisitions of companies, products or technologies, and the anticipated benefits of any acquisitions we may make may never be realized.

We may acquire, or make significant or minority investments in, complementary businesses, products or technologies. Any future acquisitions or investments could be accompanied by risks such as:

·        difficulties in assimilating the operations and personnel of acquired companies;

·        diversion of our management’s attention from ongoing business concerns;

·        our potential inability to maximize our financial and strategic position through the successful incorporation of acquired technology and rights into our products and services;

·        additional expense associated with amortization of acquired assets;

·        difficulty in maintaining uniform standards, controls, procedures and policies;

·        impairment of existing relationships with employees, suppliers and customers as a result of the integration of new management personnel;

·        dilution to our shareholders in the event we issue shares as consideration to finance an acquisition;

·        difficulty integrating and implementing the accounting controls necessary to comply with regulatory requirements such as Section 404 of the Sarbanes-Oxley Act; and

·        increased leverage, if we incur debt to finance an acquisition.

We cannot guarantee that we will realize any benefit from the integration of any business, products or technologies that we might acquire in the future, and our failure to do so could harm our business.

If our facilities or the facilities of our contract manufacturers were to experience catastrophic loss due to natural disasters, our operations would be seriously harmed.

Our facilities and the facilities of our contract manufacturers could be subject to a catastrophic loss caused by natural disasters, including fires and earthquakes. We and our contract manufacturers have significant facilities in areas with above average seismic activity, such as California, Japan and Taiwan. If any of these facilities were to experience a catastrophic loss, it could disrupt our operations, delay production and shipments, reduce revenue and result in large expenses to repair or replace the facility. We do not carry catastrophic insurance policies that cover potential losses caused by earthquakes.

Risks Related to Our Separation from Agilent

Our historical financial information as a business segment of Agilent may not be representative of our results as an independent public company.

The historical financial statements prior to June 1, 2006, have been derived from the combined and consolidated financial statements of Agilent and do not necessarily reflect what our financial position, results of operations or cash flows would have been had we been an independent entity during the historical periods presented. The historical costs and expenses reflected in our combined and consolidated financial statements include an allocation for certain corporate functions historically provided by Agilent, including centralized legal, accounting, tax, treasury, information technology and other corporate services and infrastructure costs, which we believe are reasonable reflections of the historical utilization levels of these services in support of our business. The historical financial information is not necessarily indicative of our future results of operations, financial position, cash flows or costs and expenses. We did not make adjustments to periods prior to our separation from Agilent to reflect many significant changes that will occur in our cost structure, funding and operations as a result of our separation from Agilent, including changes in our employee base, changes in our legal structure, potential increased costs associated with reduced economies of scale, increased marketing expenses related to establishing a new brand identity and increased costs associated with being an independent publicly traded company.

Our tax sharing agreement with Agilent may require us to indemnify Agilent for certain tax liabilities, including liabilities that may arise in connection with a distribution of our ordinary shares by Agilent, and may limit our ability to obtain additional financing or participate in future acquisitions.

Under our tax sharing agreement with Agilent, we and Agilent agreed to indemnify one another for certain taxes and similar obligations that the other party could incur under certain circumstances. In general, under the tax sharing agreement we are responsible for taxes relating to our business that arise after our separation from Agilent.

Agilent’s distribution of our ordinary shares to its stockholders was intended by Agilent to qualify as a distribution subject to Section 355 of the Internal Revenue Code of 1986, as amended. Under our tax sharing agreement with Agilent, we are obligated to indemnify Agilent for any taxes imposed on Agilent under Section 355(e) of the Code arising as a result of our actions. If we are required to indemnify Agilent for additional taxes imposed on Agilent with respect to the distribution of our ordinary shares to its stockholders, our results of operations may be materially impaired.

We are subject to certain covenants that restrict our ability to obtain additional financing or to engage in acquisition or disposition transactions for a period of two years after the distribution.

Our ability to obtain additional financing or to engage in transactions that would result in a change in control of Verigy is limited by the intellectual property matters agreement and the tax sharing agreement that we entered into with Agilent as part of our separation. Specifically, under the intellectual property matters agreement, Agilent’s consent is required for us to transfer intellectual property rights we have licensed from Agilent, which may act as a deterrent to an acquisition of us by a third party. Under our tax sharing agreement with Agilent, for two years following the distribution, we are subject to certain covenants that are intended to ensure that the distribution of our ordinary shares by Agilent is not fully taxable to Agilent. Those covenants require us to obtain the consent of Agilent (which cannot be unreasonably withheld) before we can:

·        sell assets outside the ordinary course of business for consideration in excess of $50 million (including assumption of liabilities related to such assets);

·        merge or liquidate our parent company or its subsidiaries that operate our business into another company; or

·        enter into any other corporate transaction that would cause us to undergo a greater than 35% change in our share ownership.

The restrictive covenants in our tax sharing agreement with Agilent restrict our ability to obtain additional financing or to engage in acquisition or disposition transactions for a period of two years after the distribution, even if the financing or transaction might be in the best interest of our shareholders. If we breach those covenants, we may incur substantial additional liabilities and may be exposed to costly and time-consuming litigation.

Any disputes that arise between us and Agilent with respect to our past and ongoing relationships could harm our business operations.

Disputes may arise between Agilent and us in a number of areas relating to our past and ongoing relationships, including:

·        intellectual property and technology matters, including related non-compete provisions applicable to Agilent and us;

·        labor, tax, employee benefit, indemnification and other matters arising from our separation from Agilent;

·        employee retention and recruiting;

·        business combinations involving us;

·        sales or distributions by Agilent of all or any portion of its ownership interest in us;

·        the nature, quality and pricing of transitional services Agilent has agreed to provide us; and

·        business opportunities that may be attractive to both Agilent and us.

We may not be able to resolve any potential conflicts, and even if we do, the resolution may be less favorable than if we were dealing with an unaffiliated party.

Some of our directors and executive officers may have conflicts of interest because of their ownership of Agilent common stock, options to acquire Agilent common stock and positions with Agilent.

Some of our executive officers own Agilent common stock and options to purchase Agilent common stock. In addition, one of our directors is an executive officer of Agilent and owns Agilent common stock and options to purchase Agilent common stock. Ownership of Agilent common stock and some of our officers, ownership of Agilent common stock and options to purchase Agilent common stock by one of our directors and the presence of an executive officer of Agilent on our board of directors could create, or appear to create, potential conflicts of interest and other issues with respect to their fiduciary duties to us when our directors and officers are faced with decisions that could have different implications for Agilent than for us.

Risks Related to the Securities Markets and Ownership of Our Ordinary Shares

Our securities have a limited trading history, and the price of our ordinary shares may fluctuate significantly.

There has been a public market for our ordinary shares for a short period of time. An active public market for our ordinary shares may not develop or be sustained, which would adversely impact the liquidity and market price of our ordinary shares. The market price of our ordinary shares may fluctuate significantly. Among the factors that could affect the market price of our ordinary shares are the risk factors described in this section and other factors including:

·        changes in expectations as to our future financial performance, including financial estimates or publication of research reports by securities analysts;

·        strategic moves by us or our competitors, such as acquisitions or restructurings;

·        announcements of new products or technical innovations by us or our competitors;

·        actions by institutional shareholders; and

·        speculation in the press or investment community.

We may become involved in securities litigation that could divert management’s attention and harm our business.

The stock market in general, and The Nasdaq Global Select Market and the securities of semiconductor capital equipment companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of the affected companies. Further, the market prices of securities of semiconductor test system companies have been particularly volatile. These market and industry factors may materially harm the market price of our ordinary shares, regardless of our operating performance. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought

against that company. We may become involved in this type of litigation in the future. Such litigation, whether or not meritorious, could result in the expenditure of substantial funds, divert management’s attention and resources, and harm our reputation in the industry and the securities markets, which would reduce our profitability and harm our business.

It may be difficult for investors to affect service of process within the United States on us or to enforce civil liabilities under the federal securities laws of the United States against us.

We are incorporated in Singapore under the Companies Act, Chapter 50 of Singapore, or Singapore Companies Act. Some of our officers and directors reside outside the United States. A substantial portion of our assets is located outside the United States. As a result, it may not be possible for investors to effect service of process within the United States upon us. Similarly, investors may be unable to enforce judgments obtained in U.S. courts predicated upon the civil liability provisions of the federal securities laws of the United States against us in U.S. courts. Judgments of U.S. courts based upon the civil liability provisions of the federal securities laws of the United States are not directly enforceable in Singapore courts and are not given the same effect in Singapore as judgments of a Singapore court. Accordingly, there can be no assurance as to whether Singapore courts will enter judgments in actions brought in Singapore courts based upon the civil liability provisions of the federal securities laws of the United States.

In addition to our tax sharing and intellectual property matters agreements with Agilent, Singapore corporate law may impede a takeover of our company by a third party, which could adversely affect the value of our ordinary shares.

Under the Singapore Code on Take-overs and Mergers, generally when a person (or a group of persons acting together) acquires shares having 30% or more of the voting rights of a company or holds at least 30% but not more than 50% of the voting rights of a company and thereafter acquires in any period of six months additional shares carrying more than 1% of the voting rights, then such person is required by law to make an offer to acquire the remaining voting shares of the company.

For a limited period of time, our board of directors has general authority to issue new shares on terms and conditions and with any preferences, rights or restrictions as may be determined by our board of directors in its sole discretion.

Under Singapore law, new shares may be issued only with the prior approval of our shareholders in a general meeting. As our sole shareholder prior to our initial public offering, Agilent provided general authority to issue new shares until the earlier to occur of the conclusion of our 2007 annual general meeting or the expiration of the period within which the next annual general meeting is required to be held. Subject to the shareholder approval, the provisions of the Singapore Companies Act and our amended and restated memorandum and articles of association, our board of directors may allot and issue new shares on terms and conditions and with the rights and restrictions as they may think fit to impose. Any additional issuances of new shares by our board of directors may adversely impact the market price of our ordinary shares.

Our public shareholders may have more difficulty protecting their interests than they would as shareholders of a U.S. corporation.

Our corporate affairs are governed by our amended and restated memorandum and articles of association and by the laws governing corporations incorporated in Singapore. The rights of our shareholders and the responsibilities of the members of our board of directors under Singapore law are different from those applicable to a corporation incorporated in the United States. Therefore, our public shareholders may have more difficulty in protecting their interests in connection with actions taken by our management, members of our board of directors or our controlling shareholder than they would as

shareholders of a corporation incorporated in the United States. For example, controlling shareholders in U.S. corporations are subject to fiduciary duties while controlling shareholders in Singapore corporations are not subject to such duties.

Item 1B.                Unresolved Staff Comments

None.