##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549


Form 10-K

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended December 31,
    2003                                             
|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-

Novellus Systems, Inc.

(Exact name of Registrant as specified in its
charter)


|                                                                   |  |                                            
|------------------------------------------------------------------ |  | -------------------------------------------
|California                                                         |  | 77-0024666                                 
|(State or other jurisdiction of
    incorporation of organization) |  | (I.R.S. Employer
    Identification Number)
|4000 North First Street, San Jose, California
    95134           
|(Address of principal executive offices
    including Zip code)   

(408) 943-9700

(Registrants telephone number, including
area code)


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

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

Common Stock, no par value

(Title of Class)


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

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K 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.     þ

Indicate by check mark whether the Registrant is
an accelerated filer (as defined in Exchange Act
Rule 12b-2.     Yes þ          No o

As of June 27, 2003 the aggregate market
value of voting and non-voting stock held by non-affiliates of
the Registrant was $5,417,810,884, based on the average of the
high and low prices of the Common Stock as reported on the
NASDAQ National Market on such date. Shares of Common Stock held
by officers, directors and holders of more than 5% of the
outstanding Common Stock have been excluded from this
calculation because such persons may be deemed to be affiliates.
This determination of affiliate status is not necessarily a
conclusive determination for other purposes.

The number of shares of the Registrants
Common Stock outstanding on March 5, 2004 was 153,331,661.

Documents Incorporated by
Reference:Part III of this
Form 10-K incorporates information by reference from the
Registrants Proxy Statement for its 2004 Annual Meeting of
Shareholders. Except as expressly incorporated by reference, the
Registrants Proxy Statement shall not be deemed to be a
part of this Form 10-K.



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NOVELLUS SYSTEMS, INC.

2003 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

|              |  |                                                                                           |  |      |    | 
|------------- |  | ----------------------------------------------------------------------------------------- |  | ---- | -- | 
|              |  |                                                                                           |  | Page
|              |  |                                                                                           |  |     
|PART I       
|Item 1:       |  | Business                                                                                  |  |      | 2  | 
|Item 2:       |  | Properties                                                                                |  |      | 11 | 
|Item 3:       |  | Legal Proceedings                                                                         |  |      | 11 | 
|Item 4:       |  | Submission of Matters to a
    Vote of Security Holders                                   |  |      | 14 | 
|PART II      
|Item 5:       |  | Market for Registrants
    Common Equity and Related Shareholder Matters                 |  |      | 14 | 
|Item 6:       |  | Selected Financial Data                                                                   |  |      | 14 | 
|Item 7:       |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations |  |      | 16 | 
|Item 7A:      |  | Quantitative and Qualitative
    Disclosures about Market Risk                            |  |      | 35 | 
|Item 8:       |  | Financial Statements and
    Supplementary Data                                           |  |      | 38 | 
|Item 9:       |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure  |  |      | 68 | 
|Item 9a:      |  | Controls and Procedures                                                                   |  |      | 68 | 
|PART III     
|Item 10:      |  | Directors and Executive
    Officers of the Registrant                                    |  |      | 69 | 
|Item 11:      |  | Executive Compensation                                                                    |  |      | 70 | 
|Item 12:      |  | Security Ownership of
    Certain Beneficial Owners and Management                        |  |      | 70 | 
|Item 13:      |  | Certain Relationships and
    Related Transactions                                        |  |      | 70 | 
|Item 14:      |  | Principal Accountant Fees
    and Services                                                |  |      | 70 | 
|PART IV      
|Item 15:      |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                       |  |      | 70 | 
|Signatures    |  |                                                                                           |  |      | 75 | 
|EXHIBIT 3.2  
|EXHIBIT 10.37
|EXHIBIT 10.38
|EXHIBIT 10.39
|EXHIBIT 10.40
|EXHIBIT 10.41
|EXHIBIT 10.42
|EXHIBIT 10.43
|EXHIBIT 21.1 
|EXHIBIT 23.1 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 



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This Annual Report on Form 10-K and certain
information incorporated herein by reference contain
forward-looking statements within the safe harbor
provisions of the Private Securities Litigation Reform Act of
1995. All statements included or incorporated by reference in
this Annual Report on Form 10-K, other than statements that
are purely historical, are forward-looking statements.
Forward-looking statements may be identified by use of words
such as anticipates, expects,
intends, may, plans,
believes, seeks, estimates,
will and similar expressions also identify
forward-looking statements. Forward-looking statements are not
guarantees of future performance and are subject to risks and
uncertainties that could cause actual results to differ
materially from the results contemplated by the forward-looking
statements.

The forward-looking statements in this Annual
Report on Form 10-K are subject to additional risks and
uncertainties further discussed under Item 7.
Managements Discussion and Analysis of Financial Condition
and Results of Operations  Forward-Looking Statements
and Risk Factors, and are based on information available
to us on the date hereof. We assume no obligation to update any
forward-looking statements. Readers are cautioned not to place
undue reliance on forward-looking statements, which speak only
as of the date of this Annual Report on Form 10-K. Readers
should also consult the forward-looking statements and risk
factors listed from time to time in our Reports on
Forms 10-Q, 8-K, 10-K and in our Annual Reports to
Shareholders.




PART I

The following information should be read in
conjunction with the Consolidated Financial Statements and notes
thereto included in this Annual Report.






|        |         
|------- | --------
|Item 1. | Business

Novellus Systems, Inc., a California corporation
organized in 1984, develops, manufactures, sells and supports
systems used in the fabrication of integrated circuits. The
customers for these products are manufacturers of semiconductor
integrated circuits, or chips, who either incorporate the chips
they manufacture in their own products or sell them to other
companies for use in electronic products.

Integrated circuits are generally built on a
silicon wafer base and include a large number of different
components, such as transistors, capacitors and other electronic
devices that are connected by multiple layers of wiring, or
interconnects. To build an integrated circuit, transistors are
first created on the surface of the silicon wafer. The wiring
and insulating structures are then added as multiple thin-film
layers through a series of manufacturing process steps.
Typically, a first layer of dielectric
(insulating) material is deposited on top of the formed
transistors. Subsequent layers of metal (historically, aluminum)
are formed on top of this base layer, etched to create the
conductive lines that carry the electricity, and then filled
with dielectric material to create the necessary insulators
between the lines, in a manufacturing process called subtractive
aluminum. When copper wires are being constructed, the
manufacturing process, called copper damascene, is a mirror
image of that described above: the insulator (dielectric) is
etched, and the copper wiring is created in the etched insulator
via a high-technology electroplating process called
electrochemical deposition. Building either copper or aluminum
wiring requires these manufacturing steps to be repeated many
times; advanced chip designs may require as many as 500 process
steps.

Novellus has historically focused on a single
segment of the chipmaking process, the deposition of conducting
and insulating material films. Novellus advanced
deposition systems use chemical vapor deposition (CVD), physical
vapor deposition (PVD), and electrochemical deposition (ECD)
processes to form the interconnects in the device structure. Our
High-Density Plasma CVD (HDP) and Plasma-Enhanced CVD (PECVD)
systems employ a chemical plasma to deposit all of the
dielectric or insulating layers and some of the metal or
conductive layers on the surface of a semiconductor wafer. Our
PVD systems use direct-current power to deposit conductive metal
layers by sputtering metallic atoms from the surface of a target
source. Our Electrofill (ECD) systems are used for depositing
conductive layers of copper on wafers in a damascene
manufacturing process.

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In 2001, Novellus expanded beyond deposition
technologies into the area of wafer surface preparation when we
acquired GaSonics International Corporation, a manufacturer of
systems used to clean and prepare a wafer surface after the
manufacturing steps that precede deposition. We also acquired
SpeedFam-IPEC, Inc., a manufacturer of chemical mechanical
planarization (CMP) products in 2002. As the semiconductor
industry migrates to the use of copper and low-k
(low-capacitance) dielectrics in semiconductors, the
manufacturing steps for surface preparation and CMP are becoming
increasingly important.

Our headquarters are located at 4000 North
First Street, San Jose, California 95134 and our telephone
number is (408) 943-9700.

Additional information about Novellus is
available on our web site at www.novellus.com. We make
available free of charge on our web site our Annual Reports on
Form 10-K, our Quarterly Reports on Form 10-Q, and our
Current Reports on Form 8-K, as well as amendments to those
Reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended. These
reports are available as soon as reasonably practicable after we
electronically file them with  or furnish them
to  the Securities and Exchange Commission, or the
SEC. Information contained on our web site is not part of this
Annual Report on Form 10-K or of our other filings with the
SEC.

Industry Background

Over the past twenty years, the semiconductor
industry has grown rapidly as a result of increasing demand for
personal computers, the expansion of the Internet and the
telecommunications industry, and the emergence of new
applications in consumer electronics. More recently, growth has
slowed, and there are signs that the industry may be beginning
to mature. While unit demand for semiconductor devices continues
to rise, the average selling prices of chips continue to
decline. There is growing pressure on chipmakers to reduce
manufacturing costs while simultaneously increasing the value of
their products. The semiconductor industry has also been
historically cyclical, with periods of rapid expansion followed
by periods of over-capacity.

Several technological trends characterize
semiconductor manufacturing. Perhaps the most prominent of these
trends is increasing density. Moores Law, first postulated
in the mid-1960s and still substantially accurate almost
40 years later, states that the density of circuitry on an
individual semiconductor chip doubles every 18 months.
Todays advanced devices are being manufactured with line
widths as small as 0.09 microns, or 90 nanometers, and with up
to ten layers of interconnect circuitry. By increasing circuit
density, manufacturers can pack more electronic components on a
chip and thereby provide higher performance and value.

Another trend worth noting is the transition to
copper wiring from aluminum wiring as the primary conductive
material in semiconductor devices. Copper has a lower electrical
resistance value than aluminum, and this provides a number of
performance advantages. Because of the superior properties of
copper, a chip made with copper may need only half as many metal
layers as one made with aluminum, providing considerable
reduction in manufacturing cost. In addition, copper wiring
produces a substantial improvement in device performance and a
significant reduction in power requirements compared to aluminum.

A similar transition is underway from traditional
silicon oxide films to dielectric insulators with a low
dielectric constant, or low-k. Low-k dielectrics are better at
limiting the capacitance between metal lines in a device, which
improves the speed and performance of the chip. However, low-k
materials are also less stable than silicon oxide, and this
poses a host of new challenges to the semiconductor industry in
pursuing its goals of increased circuit density and, at the same
time, lower manufacturing costs and elevated product performance
and value.

Another important trend is the move to larger
wafer sizes. Chipmakers are now migrating to larger, 300mm
wafers because of the potential manufacturing cost advantages of
these larger wafers compared to 200mm. The 300mm wafers provide
up to 2.25 times the number of chips per wafer, and hence may
provide significant economies of scale in the manufacturing
process.

These trends shape the equipment and process
demands of our customers. Our customers generally measure the
cost and performance of their production equipment in terms of
cost per wafer, a ratio

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determined by factoring in the costs for
acquisition and installation of a system, operating costs, and
net throughput rate. A system with higher net throughput allows
a manufacturer to recover the purchase price over a greater
number of wafers, thereby reducing the cost of ownership of the
system on a per-wafer basis. Yield and film qualities are also
significant factors in selecting processing equipment. The
increased cost of larger and more complex semiconductor wafers
have made high yields extremely important to our customers. To
achieve elevated yields and better film quality, systems must be
able to repeat a process consistently and reliably. This
characteristic, known as repeatability, is critical in achieving
commercially acceptable yields. Systems that operate at desired
throughput rates without approaching critical tolerance limits
can achieve repeatability more easily.


Strategy

Our business objective is to use our core
expertise to increase our market share in interconnect
manufacturing, and strengthen our position as a leading supplier
of semiconductor processing equipment. The following are the key
elements of our strategy:

Emphasize High-Productivity
Systems We established our
current position in the industry by emphasizing high
productivity as the principal benefit that our products and
technologies deliver to customers. Our unique multi-chamber
system for continuous PECVD processing illustrates our
commitment to productivity. This multi-chamber design enables
our PECVD systems to attain very high levels of wafer
throughput, yield and film quality. The simple architecture of
our systems also takes up less space in the fabrication facility
(fab) and requires less downtime than other system designs. We
intend to retain our historical focus on productivity by
applying our multi-chamber and continuous processing
architecture in product enhancements and new product offerings.

Focus on Reducing Customer
Costs Cost is an important
component when measuring overall productivity. To that end, we
strive to provide products and technologies that reduce our
customers overall cost of ownership by offering chipmakers
a number of process improvements and process differentiators, as
well as by providing highly reliable systems that require less
servicing than competing alternatives in the market.

Differentiate our Service
Philosophy Our philosophy
is to develop reliable products that require less servicing than
competing alternatives. We strive to provide support that
minimizes the downtime and service costs that our customers
experience.

Lead in our Target
Markets Our goal is to
command a leadership position in each of our target market
areas. We aim to be a leading provider in each of the subsets
that comprise the served available market for our deposition
products: HDP, CVD, PECVD, PVD and ECD. As a result of our 2001
acquisition of GaSonics and subsequent internal product
development efforts, we are one of the leading providers of
surface preparation products. Our 2002 acquisition of
SpeedFam-IPEC has enabled us to enter a new market segment, CMP,
and we are aggressively pursuing a leadership position in this
market segment as well.

Broaden our Interconnect
Offerings As semiconductor
manufacturing technology becomes more complex, the interconnect
structures on a chip take on greater importance in the
manufacturing process. We believe that by expanding beyond our
historical focus on deposition products, we can add value in
related interconnect manufacturing process steps. The
acquisitions of GaSonics and SpeedFam-IPEC are examples of this
strategy in action.

Focus on Major Semiconductor
Manufacturers In 2003, we
sold systems to each of the worlds top 20 semiconductor
manufacturing equipment capital spenders. Our sales objective is
to work closely with our customers as they expand existing
facilities, retrofit older manufacturing plants with new
equipment, and build new fabs. We strive to build customer
loyalty and achieve a high level of repeat business by offering
high-reliability products, comprehensive field support, and a
responsive parts replacement and service program.

Expand Market Presence in
Asia While we derive a
significant percentage of net sales from Asia, we believe that
substantial additional growth potential exists in the region
over the long term. Japan, Taiwan and Korea continue to
represent a significant portion of the worlds capacity for
semiconductor manufacturing, and

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China is rapidly becoming a major manufacturing
region for the industry. Our local presence in Asia includes
sales and support offices throughout Japan. In addition, we
maintain four offices in Korea, three in China, three in Taiwan,
and one each in Malaysia, Singapore and India.


Leverage our Low Cost Manufacturing
Structure We perform all
system design, assembly and testing in-house, and outsource the
manufacture of major subassemblies. This manufacturing strategy
allows us to minimize our fixed costs and capital expenditures
and gives us the flexibility to increase capacity as needed.
Outsourcing also allows us to focus on product differentiation
through system design and quality control, and helps to ensure
that our subsystems incorporate the latest third-party
technologies in robotics, gas panels and microcomputers. We work
closely with our suppliers to achieve mutual cost reduction
through joint development projects.

Products



| |                        
| | -----------------------
| | Deposition Technologies

Our historical strength is rooted in deposition
products, where we have consistently maintained a leadership
position in the industry. We currently offer products that
address the needs of manufacturers across a number of different
deposition technologies  CVD, PVD and ECD.

Since the introduction of our Concept One
dielectric platform in 1987, we have offered a range of
processing systems for dielectric and metal deposition. In 1991,
we introduced the Concept Two platform  a modular,
integrated production system capable of depositing both
dielectric and conductive metal layers by combining one or more
processing chambers with a common, automated wafer handler. The
Concept Two enabled chipmakers to increase production throughput
and system capability by adding process modules, without having
to replace existing equipment. In 1997, we introduced the
Concept Three platform, which built on the foundation of Concept
Two to offer greater throughput in 300mm wafer manufacturing
applications.



| |             
| | ------------
| | CVD Products

In the CVD process, manufacturers place wafers in
a reaction chamber, introduce a variety of pure and precisely
metered gases into the chamber, and then add some form of energy
to activate a chemical reaction that deposits a film on the
wafer. The CVD process is the traditional method used to deposit
dielectric films on wafers. Manufacturers also use CVD to
deposit conductive metal layers, particularly tungsten, as it is
difficult to deposit such layers on devices with very small
features when using conventional PVD or other deposition
technologies.



| |                 
| | ----------------
| | HDP CVD Products

Concept Two
SPEED®  Introduced in
1996, Concept Two SPEED was the semiconductor industrys
first high-density plasma system capable of high-volume
manufacturing. Today, Concept Two SPEED is one of the top two
product offerings for the HDP CVD marketplace. Concept Two SPEED
is a single-wafer processing system for 200mm substrates. SPEED
is designed primarily to deposit dielectric materials in an
aluminum interconnect manufacturing process. Concept Two SPEED
may also be used to deposit pre-metal layers in copper
manufacturing processes.

Concept Three
SPEED®  The
Concept Three SPEED is designed to apply dielectric material in
the 300mm wafer manufacturing processes. Because it is based on
our production-proven Concept Two product, Concept Three SPEED
offers minimal risk to our customers in making the transition
from 200mm to 300mm wafers.



| |               
| | --------------
| | W-CVD Products

Concept Two
ALTUS In 1994, we
introduced the Concept Two ALTUS, used to deposit the tungsten
plugs and vias that connect aluminum interconnect lines in
aluminum-based chips. The Concept Two ALTUS combines the modular
architecture of the Concept Two with an advanced tungsten CVD
dual-process

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chamber. The system is ideal for meeting the
requirements of high-volume, automated 200mm wafer fabs
producing semiconductor devices at 0.18 micron and below.


Concept Three
ALTUS The Concept Three
ALTUS, introduced in 1997, provides the same advantages to 300mm
wafer tungsten deposition as its Concept Two ALTUS predecessor
delivers for 200mm wafer applications.



| |               
| | --------------
| | PECVD Products

Concept Two SEQUEL
Express®
Introduced in 1999, the Concept Two SEQUEL Express is designed
to deposit our CORAL® family of low-k
dielectric films, as well as other advanced films required for
manufacturing 0.18 micron-and-smaller semiconductor devices.
With a throughput in excess of 110 wafers per hour, Concept
Two SEQUEL Express delivers up to 40 percent higher capital
productivity and 40 percent lower cost of ownership than
competing PECVD systems.

VECTOR®
Introduced in 2000, VECTOR is a PECVD system for depositing
dielectric films on 300mm wafers. VECTOR delivers a fully
integrated low-k dielectric structure at
0.10 micron-and-smaller design rules. With approximately
two-thirds the footprint of the nearest competitor, and 33%
fewer critical subsystems, VECTOR delivers twice the capital
productivity of the nearest competitor.



| |             
| | ------------
| | PVD Products

PVD, also known as sputtering, is a
process where ions of an inert gas such as argon are
electrically accelerated in a high vacuum toward a target of
pure metal, such as tantalum or copper. Upon impact, the argon
ions sputter off the target material, which is then deposited as
a thin film on the silicon wafer. PVD processes are used to
create the barrier and seed layers in copper damascene
interconnect applications. We entered the PVD marketplace with
the acquisition of Varian Associates Thin Film Systems
Division in 1997.

INOVA®
The INOVA 200mm system was introduced in 1998 with a
multi-chamber, single-wafer processing design. The INOVAs
Hollow Cathode Magnetron (HCM) ionized PVD source continues
to gain market acceptance based on its superior barrier seed
step coverage.

INOVA xT
In 2000, we introduced the 300mm INOVA xT, which features HCM
technology. The INOVA xT continues to offer superior
barrier performance which leads to low via resistance and
improved device reliability.



| |                     
| | --------------------
| | ElectrofillProducts

Our Electrofill products are used to build the
copper primary conduction layers in advanced integrated
circuits. Electrofill uses copper to fill a structure created
within the circuits insulating layers in a manufacturing
process called copper damascene. Damascene manufacturing
reverses the manufacturing process used with aluminum, where the
metal is deposited first, then etched to create lines and vias,
and finally filled with insulating layers between the metal
lines. Our highly reliable and cost-effective Electrofill
products employ liquid chemistries and electrolytic principles
to deposit the copper wiring into the dielectric structure.

SABRE
The SABRE copper Electrofill system, introduced in 1998, is one
of the most reliable and technologically advanced copper ECD
systems available on the market. SABRE meets todays
technology requirements for copper metal layers to
90 nanometer, or 0.09 micron, line widths and beyond.
The SABRE employs a proprietary electrofilling cell that
eliminates contamination of the back of the wafer with copper.
It features a unique plating cell design that improves the
repeatability of the copper fill. The simplicity of SABREs
design is the key to the systems high reliability and
manufacturing availability. When coupled with the INOVA PVD
system, SABRE provides a complete system for depositing advanced
copper interconnects.

SABRE xT
The second generation SABRE xT, introduced in 1999, is the
industrys leading ECD platform for both 200mm and 300mm
wafers. New features on the SABRE xT that were not found on the
original SABRE include programmable electrical waveforms,
advanced plating chemistries, an integrated anneal module and
closed-loop chemical monitoring.

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SABRE
NExT Introduced in 2003,
the SABRE NExT (Nano Era xT) builds on the
SABRE xTs production track record, offering a
proprietary, single step chemistry, a new anode cell design, and
other hardware refinements to tackle the complex process
requirements of 90 nanometer, 65 nanometer and
45 nanometer interconnect structures. In comparison to the
SABRE xT, the SABRE NExT reduces chemical costs by over
30%, and when combined with improved throughput, cuts overall
cost of ownership by over 10% on what is already a highly
productive process.



| |                                     
| | ------------------------------------
| | Surface Preparation
    Technologies

Photoresist strip and clean processes represent
an area of semiconductor manufacturing that is becoming
increasingly important with the industrys migration to
copper interconnects. Chipmakers use surface preparation
products to remove photoresist and other potential contaminants
from a wafer before proceeding with the next deposition step in
the manufacturing process. We entered this application arena by
acquiring GaSonics in 2001, and today we are one of the
industrys leading suppliers of dry-clean surface
preparation products.

GAMMA2100  The GAMMA 2100 200mm photoresist removal
system uses a plasma source to strip photoresist. The GAMMA
architecture features a multi-station sequential processing
design with six strip stations, resulting in high wafer
throughput with a minimal number of critical subsystems.

GAMMA
2130 The GAMMA 2130 system
is a front-end-of-line photoresist strip system for 300mm
wafers. Our multi-station sequential processing architecture
incorporates six stations within a single process chamber,
enabling a 30% higher throughput rate than the closest
competitor.

PEP
IRIDIA®  The PEP
IRIDIA is an advanced cleaning system designed for
sub-0.18-micron 200mm wafer applications. The IRIDIAs
modular architecture allows manufacturers to configure the
system for both front-and back-end-of-line cleaning applications
down to 90 nanometers. Targeted at critical steps in the copper
and low-k manufacturing processes, the IRIDIA offers the highest
productivity of any 200mm dry-clean system currently on the
market.



| |                 
| | ----------------
| | CMP Technologies

CMP systems polish the surface of a wafer after a
deposition step to create a flat topography before moving on to
subsequent manufacturing steps. Since copper is more difficult
to polish and smooth than previous-generation aluminum
interconnects and low-k dielectrics are much more porous than
their predecessors, CMP has been elevated to the forefront of
the enabling technology required in a copper damascene
manufacturing process. In recognition of this trend, we acquired
SpeedFam-IPEC, a global supplier of CMP systems used in the
fabrication of advanced copper interconnects, in 2002. We
believe that the opportunity to integrate the planarization,
deposition and surface preparation steps and optimize them for
overall performance gives us an important advantage in extending
copper and low-k processes to advanced semiconductor devices.

MOMENTUM
MOMENTUM is a high-throughput, dry-in/dry-out CMP system for all
200mm wafer process applications. Designed with extendibility to
accommodate future reductions in line widths, the MOMENTUM has
four independent wafer-polishing platens that allow for maximum
manufacturing flexibility. MOMENTUM also employs a patented
orbital polishing motion that minimizes surface dishing and
erosion, and features a through-the-pad slurry delivery system
that results in more efficient consumption of polishing
chemicals.

MOMENTUM
300 Our MOMENTUM 300 is a
highly flexible, dry-in/dry-out CMP system that provides a
transition for manufacturers moving from 200mm to 300mm wafer
processing. The system is unique in that it combines a number of
advanced planarization and in-line inspection technologies to
produce highly effective throughput, yield management, superior
process capabilities and low cost of ownership.

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Marketing, Sales and Service

We market products worldwide to manufacturers of
semiconductor devices. In North America, we sell our products
through a direct sales force that operates out of eight sales
and support offices. In Europe, we sell our products through our
sales and support facilities in France, Germany, Ireland, Italy
and the United Kingdom. In Asia, we sell our products directly
in China, Japan, Korea, Malaysia, Singapore and Taiwan. Our
Japanese operations, with headquarters near Tokyo, include ten
sales offices.

The ability to provide prompt and effective field
support is critical to our sales efforts, and we believe the
support that we provide to our installed base has accelerated
the penetration of certain key accounts. We also believe that
our marketing efforts are enhanced by the technical expertise of
our research and development personnel, who provide customer
process applications support and participate in a number of
industry forums, conferences and technical symposia.

Equally significant, we believe that the design
simplicity of our systems substantially enhances our ability to
support our customers. In 1992, we became the first
semiconductor equipment manufacturer to extend our warranty up
to 24 months from shipment, and in 1993 we began to include
under warranty the cost of preventive maintenance as well as the
cost of consumable parts on some systems. We offer maintenance
contracts as an additional service to customers.

For the year ended December 31, 2003,
Samsung Electronics and Intel Corporation accounted for 27% and
12% of our net product sales, respectively. For the year ended
December 31, 2002, Samsung Electronics, Intel Corporation,
Taiwan Semiconductor Manufacturing Co. and IBM Corporation
accounted for 17%, 11%, 11% and 10% of our net product sales,
respectively. For the year ended December 31, 2001, Intel
Corporation accounted for 16% of our net product sales.
Historically, we have sold a significant proportion of systems
in any particular period to a limited number of customers. Sales
to our ten largest customers in 2003, 2002 and 2001 accounted
for 76%, 79% and 61% of our net sales, respectively. We expect
that sales of our products to relatively few
customers  none of which has entered into a long-term
agreement requiring it to purchase our products  will
continue to account for a high percentage of our net sales in
the foreseeable future.

Export sales  including sales by our
Japanese subsidiary  for the year ended
December 31, 2003 were $603.5 million, or 65% of net
sales. For the year ended December 31, 2002, export sales
were $513.6 million, or 61% of net sales, while export
sales for the year ended December 31, 2001 were
$733.9 million, or 55% of net sales.

Backlog

As of December 31, 2003, our backlog was
$341.0 million, with approximately $0.2 million of
cancellations in the period subsequent to December 31, 2003
to the date of this Annual Report on Form 10-K. As of
December 31, 2002, our backlog was $304.4 million,
with approximately $43.5 million of cancellations
subsequent to December 31, 2002. Our backlog includes only
those customer orders for which we have accepted purchase orders
and assigned shipment dates within twelve months. All orders are
subject to cancellation or rescheduling by customers, with
limited or no penalties. Some products are shipped in the same
quarter in which the order was received. For this reason, and
because of possible changes in delivery schedules, cancellations
of orders and delays in shipments, our backlog as of any
particular date is not necessarily a reliable indicator of
actual shipments for any succeeding period.

Research and Development

The highly cyclical semiconductor manufacturing
industry is subject to rapid technological change and continual
new product introductions and enhancements. Our ability to
remain competitive depends on our success in developing new and
enhanced systems, and introducing them at competitive prices on
a timely basis. For this reason, we devote a significant portion
of our personnel and financial resources to research and
development programs.

Our current research and development efforts are
directed at developing new systems and processes and improving
the capabilities of existing systems. Research and development
programs include advanced PVD

8



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systems, advanced gap fill technology, primary
conductor metals, low-k dielectric materials, CMP systems, and
additional advanced deposition and surface preparation
technologies for the next generation of smaller-geometry
fabrication lines. All new systems under development are capable
of processing 300mm wafers.


Expenditures for research and development during
2003, 2002 and 2001 were $227.4 million,
$222.3 million and $272.0 million, respectively. These
expenditures represented approximately 25%, 26% and 20% of our
net sales in 2003, 2002 and 2001, respectively. We believe that
research and development expenditures will continue to represent
a substantial percentage of our net sales in the future.

Manufacturing

Our manufacturing activities consist primarily of
assembling and testing components and subassemblies that we
acquire from third-party vendors and then integrate into a
finished system. We utilize an outsourcing strategy for the
manufacture of major subassemblies, and we perform all system
design, assembly and testing in-house. Our outsourcing strategy
enables us to minimize fixed costs and capital expenditures, and
provides us with the flexibility to increase production
capacity. This strategy also allows us to focus on product
differentiation through system design and quality control. We
believe that our use of outsourced product specialists enables
our subsystems to incorporate the latest and most advanced
technologies in robotics, gas panels and microcomputers without
the need for in-house expertise. We strive to work as closely as
possible with all of our suppliers to achieve mutual cost
reduction through joint development efforts.

Although we make reasonable efforts to ensure
that such parts are available from multiple suppliers, certain
key parts may only be obtained from a single or limited source.
These suppliers are, in some cases, thinly capitalized,
independent companies who generate significant portions of their
business from us and/or a small group of other companies in the
semiconductor industry. We seek to reduce our dependence on
single or limited source suppliers. However, disruptions in
parts delivery or termination of certain of these suppliers may
occur, and such disruptions and terminations could have an
adverse effect on our operations. A prolonged inability to
obtain certain parts could have a material adverse effect on our
business, financial condition or results of operations, and
could result in our inability to meet customer demands on time.

We manufacture our systems in clean-room
environments similar to those used by semiconductor
manufacturers for chip fabrication, which helps to minimize the
amount of particulates and other contaminants in the final
assembled system to improve yields and reduce the level of
contaminants for our customers. Following assembly, we package
our completed systems in plastic shrink-wrap to maintain
clean-room standards during shipment.

Competition

Significant competitive factors in the
semiconductor equipment market include system performance and
flexibility, cost, the size of each manufacturers
installed customer base, customer support capability and the
breadth of a companys product line. We believe that we
compete favorably in all of the market segments we serve because
of the fundamental advantages associated with our system
performance and flexibility, low cost of ownership, high wafer
yields and customer support. However, we face substantial
competition from both established competitors and potential new
entrants in each of these markets. Installing and integrating
capital equipment into a semiconductor production line
represents a substantial investment. For this reason, once a
manufacturer chooses a particular vendors capital
equipment, experience has shown that the manufacturer will
generally rely upon that equipment for the useful life of the
specific application. As a result, all of todays
semiconductor equipment makers typically have difficulty in
selling a product to a particular customer to replace or
substitute for a competitors product previously chosen or
qualified by that customer.

In the CVD, PECVD, HDP and PVD markets, our
principal competitor is Applied Materials, Inc. (Applied), a
major supplier of systems who has established a substantial base
of installed equipment among todays leading semiconductor
manufacturers. In the ECD market, our principal competitors are
Applied and Semitool, Inc. Our principal competitors in the
surface preparation product arena are Mattson Technologies, Inc.
and Axcelis Technologies, Inc. In the CMP market, our major
competitors are Applied and Ebara Corporation.

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Patents and Proprietary Rights

We intend to continue to pursue patent and trade
secret protection for our technology. We currently hold over 300
patents. We have many pending patent applications, and we intend
to file additional patent applications as appropriate. There can
be no assurance that patents will be issued from any of these
pending applications or future filings, or that any claims
allowed from existing patents or pending or future patent
applications will be sufficiently broad to protect our
technology. While we intend to vigorously protect our
intellectual property rights, there can be no assurance that any
patents we hold will not be challenged, invalidated or
circumvented, or that the rights granted thereunder will provide
competitive advantages to us. See Item 3, Legal
Proceedings, for further discussions.

We also rely on trade secrets and proprietary
technology that we protect through confidentiality agreements
with employees, consultants, and other parties. There can be no
assurance that these parties will not breach these agreements,
that we will have adequate remedies for any breach, or that our
trade secrets will not otherwise become known to or
independently developed by others.

There has been substantial litigation regarding
patent and other intellectual property rights in
semiconductor-related industries. We are currently involved in
such litigation. Except as set forth in Item 3, Legal
Proceedings, we are not aware of any significant claim of
infringement by our products of any patent or proprietary rights
of others; however, we could become involved in additional
litigation in the future. Although we do not believe the outcome
of current litigation will have a material impact on our
business, financial condition or results of operations, no
assurances can be given that current or future litigation will
not have such an impact. For further discussion see Item 3,
Legal Proceedings.

In addition to current litigation, our
operations  including the further commercialization
of our products  could provoke additional claims of
infringement from third parties. In the future, litigation may
be necessary to enforce patents issued to us, to protect trade
secrets or know-how that we own, to defend ourselves against
claimed infringement of the rights of others, or to determine
the scope and validity of the proprietary rights of others. Any
such litigation could result in substantial cost and diversion
of efforts and could have a material adverse effect on our
financial condition or operating results. In addition, adverse
determinations in such litigation could result in loss our of
proprietary rights, subject us to significant liabilities to
third parties, require us to seek licenses from third parties,
or prevent us from manufacturing or selling our products. Any of
these occurrences could have a material adverse effect on our
business, financial condition or results of operations.

Employees

On December 31, 2003, we had 2,902 full-time
and temporary employees. None of our employees are represented
by a labor union, and we have never experienced a work stoppage,
slowdown or strike. We consider our employee relations to be
good.

The success of our future operations depends in
large part on our ability to recruit and retain senior
management, engineers, technicians, marketing, sales and service
professionals and other key personnel. Qualified people are in
great demand across each of these industry disciplines, and
there can be no assurance that we will be successful in
retaining or recruiting key personnel.

Business Combinations

We acquired SpeedFam-IPEC on December 6,
2002 in a stock-for-stock acquisition. Each share of
SpeedFam-IPEC common stock and stock options outstanding as of
December 6, 2002 was converted into 0.1818 of a share of
Novellus common stock or options on a fixed exchange ratio basis.

Environmental Matters

Neither compliance with federal, state and local
provisions regulating discharge of materials into the
environment, nor remedial agreements or other actions relating
to the environment, has had  or is expected

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to have  a material effect on our
capital expenditures, financial condition, results of operations
or competitive position.







|        |           
|------- | ----------
|Item 2. | Properties

We conduct our operations primarily in thirteen
buildings with approximately 1,109,000 square feet of
space. Eight buildings totaling approximately
559,000 square feet are located in the San Jose, California
area, and four buildings totaling approximately 442,000 square
feet are located in the Portland, Oregon area. In addition, we
occupy one building of approximately 108,000 square feet in
Chandler, Arizona.

We own eight buildings in San Jose, which include
two manufacturing operations buildings, a research and
development facility, an applications demonstration lab, various
administrative and customer support offices, and our
headquarters.

In the Portland area, we own four buildings in
the city of Tualatin, located on 58 acres of owned land.
One building totaling approximately 65,000 square feet
includes manufacturing, research and development, and customer
support for our ECD operations. The remaining three buildings
totaling approximately 377,000 square feet consist of
manufacturing, research and development, engineering and
training facilities primarily for our PECVD operations.

Our Chandler facility consists of one building
leased under an operating lease that expires in 2017. This
building houses our CMP operations, including manufacturing,
research and development and engineering.

We lease several domestic field offices totaling
approximately 66,000 square feet of space. In addition, we
own one building totaling approximately 41,000 square feet
in the Chicago, Illinois area, which we obtained in conjunction
with the SpeedFam-IPEC acquisition. We also sublease, or have
available for sublease, approximately 778,000 square feet
of space in and around the San Jose, California and Chandler,
Arizona areas. We own and lease several sites outside of the
United States, which we use as sales and customer service
centers. These sites total approximately 171,000 square
feet of space, of which approximately 11,000 square feet
are owned.

Our European offices occupy approximately
21,000 square feet of leased space in various countries
throughout Europe, including France, Germany, Italy, and
Ireland. In addition, we own one office of approximately
9,000 square feet in Leicestershire, England. Our Asian
offices occupy approximately 141,000 square feet of leased
space in various countries throughout Asia, including China,
India, Japan, Korea, Malaysia, Singapore and Taiwan.

We believe that our current facilities are
sufficient to meet our requirements for the foreseeable future.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

Applied Materials, Inc.

On June 13, 1997, we agreed to purchase the
Thin Film Systems (TFS) business of Varian Associates, Inc.
On the same day, Applied Materials, Inc. sued Varian in the
United States District Court for the Northern District of
California for alleged patent infringement concerning several of
its physical vapor deposition, or PVD, patents (the Applied
Patents).

On June 23, 1997, we sued Applied in the
United States District Court for the Northern District of
California, claiming infringement by Applied of several of our
PVD patents acquired from Varian in the TFS purchase. Applied
has filed counterclaims in this suit, alleging that we infringed
the Applied Patents. We are seeking an injunction against future
infringement by Applied, damages for past infringement and
treble damages for alleged willful infringement.

On July 7, 1997, Applied amended its
complaint in its suit against Varian to add Novellus as a
defendant. We have requested that the Court dismiss us as a
defendant in this suit. The Court has not yet ruled on the
request or required us to file an answer in this lawsuit.

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The relief requested by Applied in both suits
includes a permanent injunction against future infringement,
damages for alleged past infringement and treble damages for
alleged willful infringement. Trial is currently set to commence
on May 24, 2004. Applied has recently indicated, however,
that it will not be seeking any relief against us in this trial.

We believe that we have meritorious claims
against Applied. We also believe that there are meritorious
defenses to Applieds allegations, including the defense
that our operations and products (including TFS products and
systems) do not infringe the Applied Patents, and that the
Applied Patents are invalid, unenforceable or both. As a result
of court rulings adverse to Applied, and in light of certain
indemnity obligations undertaken by Varian, which include
reimbursement of certain legal expenses and a portion of any
losses incurred from this litigation, we do not believe that
Applieds claims will have a material adverse effect on our
business, financial condition or results of operations.

Semitool, Inc.

On June 11, 2001, Semitool, Inc. sued
Novellus for patent infringement in the United States District
Court for the District of Oregon. In this lawsuit, Semitool
alleges that Novellus infringes one of Semitools patents
related to copper electroplating. Semitool seeks an injunction
against future infringement by Novellus, damages for past
infringement, and treble damages for alleged willful
infringement.

On November 13, 2001, we countersued
Semitool for patent infringement in the United States District
Court for the District of Oregon. We allege that Semitool
infringes certain Novellus patents related to copper
electroplating. We seek an injunction against Semitool, damages
for past infringement, and treble damages for willful
infringement by Semitool.

The Court has issued claim construction orders
regarding all of the patents-in-suit, and discovery has closed.
The Court has not yet ruled on any of the motions for summary
judgment submitted by Semitool against the Novellus patents. The
case is presently scheduled to proceed to trial in November of
2004. We believe that we have meritorious claims against
Semitool and meritorious defenses to Semitools claims
against us, and that this litigation will not have a material
adverse impact on our business, financial condition, or results
of operations. However, the outcome of patent disputes is often
affected by uncertainty in the resolution of complex issues of
fact and law. If Semitool were to prevail against us, the
adverse effect on our business, financial condition, or results
of operations could be material.

Plasma Physics Corporation and Solar Physics
Corporation

On June 14, 2002, certain of our present and
former customers  including Agilent Technologies,
Inc., Micron Technology, Inc., Agere Systems, Inc., National
Semiconductor Corporation, Koninklijke Philips Electronics N.V.,
Texas Instruments, Inc., ST Microelectronics, Inc., LSI Logic
Corporation, International Business Machines Corporation,
Conexant Systems, Inc., Motorola, Inc., Advanced Micro Devices,
Inc. and Analog Devices Inc.  were sued for patent
infringement by Plasma Physics Corporation and Solar Physics
Corporation. We have not been sued by Plasma Physics, Solar
Physics, or any other party for infringement of any Plasma
Physics or Solar Physics patent. Certain defendants in the case,
however, contend that we allegedly have indemnification
obligations and liability relating to these lawsuits. We believe
that these matters will not have a material adverse impact on
our business, financial condition, or results of operations.
There can be no assurance, however, that we will prevail in the
above lawsuit or in any other lawsuit filed in connection with
the alleged indemnification obligations. If one or more parties
were to prevail against us in such a suit and damages were
awarded, the adverse impact on our business, financial
condition, or results of operations could be material.

Linear Technology Corporation

On March 12, 2002, Linear Technology
Corporation filed a complaint against Novellus, among other
parties, in the Superior Court of the State of California for
the County of Santa Clara. The complaint sought damages
(including punitive damages) and injunctions for causes of
actions involving alleged breach of contract, fraud, unfair
competition, breach of warranty, and declaratory relief. We
filed a demurrer to Linears

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complaint, which the court granted on
April 11, 2003, with leave to amend. On May 2, 2003,
Linear filed a second amended complaint. We filed a demurrer to
Linears second amended complaint, which the court granted
on August 14, 2003, with leave to amend. On
September 15, 2003, Linear filed a third amended complaint.
We filed a demurrer to Linears third amended complaint,
which the court granted on January 15, 2004, with leave to
amend. Linear has not yet filed another complaint.


This litigation is in its early stages and is
therefore inherently difficult to assess. We believe that this
litigation will not have a material adverse impact on our
business, financial condition, or results of operations.
However, the outcome of patent disputes is often affected by
uncertainty in the resolution of complex issues of fact and law.
If Linear were to prevail against us, the adverse effect on our
business, financial condition, or results of operations could be
material.

Employment Litigation

On April 4, 2003, Thomas Graziani, et al. filed a
class action lawsuit against Novellus in the United States
District Court for the District of Oregon. On August 1, 2003,
David Robinson, et al. filed a class action lawsuit against
Novellus in the United States District Court for the Northern
District of California, San Jose Division. Both lawsuits seek
collective and/or class action status for field service
engineers who work for Novellus and both lawsuits allege that
field service engineers are entitled to compensatory damages in
the form of overtime pay, liquidated damages, interest and
attorneys fees and costs. We are currently engaged in
mediation with the plaintiffs in these actions. At a mediation
held on March 1, 2004, the parties to both lawsuits agreed to a
settlement to be documented on or before April 2, 2004. As of
the date of this Annual Report on Form 10-K, there is no written
agreement binding the parties. Moreover, the settlement requires
court approval, which may or may not be received. Approval is
expected to be sought in the second quarter of 2004. Because the
settlement has not yet been documented or approved and because
members of the class may be permitted to opt out of the class
and file individual claims, we are unable to determine the total
amount or a range of amounts for the settlement at this time. If
efforts to settle these lawsuits are not successful, we intend
to vigorously defend against them.

Other Litigation

We are a defendant or plaintiff in various
actions that arose in the normal course of business. We believe
that the ultimate disposition of these matters will not have a
material adverse effect on our business, financial condition or
results of operations.

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|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

Not applicable.




PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity
    and Related Shareholder Matters

Stock Information

Novellus common stock is traded on the
NASDAQ Stock Market and is quoted on the NASDAQ National Market
under the symbol NVLS. The following table sets
forth the high and low prices of our common stock as reported by
the NASDAQ National Market for the periods indicated:

|               |  |      |       |     |  |   |       | 
|-------------- |  | ---- | ----- | --- |  | - | ----- | 
|2003           |  | High |       | Low
|               |  |      |       |    
|First Quarter  |  | $    | 34.74 |     |  | $ | 25.27 | 
|Second Quarter |  |      | 38.53 |     |  |   | 26.28 | 
|Third Quarter  |  |      | 40.85 |     |  |   | 33.32 | 
|Fourth Quarter |  |      | 45.03 |     |  |   | 33.60 | 

|               |  |      |       |     |  |   |       | 
|-------------- |  | ---- | ----- | --- |  | - | ----- | 
|2002           |  | High |       | Low
|               |  |      |       |    
|First Quarter  |  | $    | 54.48 |     |  | $ | 36.18 | 
|Second Quarter |  |      | 54.45 |     |  |   | 29.69 | 
|Third Quarter  |  |      | 34.56 |     |  |   | 19.61 | 
|Fourth Quarter |  |      | 38.09 |     |  |   | 19.40 | 

We have not paid cash dividends on our common
stock since inception, and our Board of Directors presently
plans to reinvest our earnings in the business. Accordingly, it
is anticipated that no cash dividends will be paid to holders of
common stock in the foreseeable future. As of March 5,
2004, there were 994 holders of record of our common stock.






|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

Set forth below is a summary of certain
consolidated financial information with respect to Novellus as
of the dates and for the periods indicated. The consolidated
statements of operations data set forth below for the five years
ended December 31, 2003 and the consolidated balance sheet
data at each year end for the five years ended December 31,
2003 have been derived from our consolidated financial
statements, which have been audited. We acquired GaSonics on
January 10, 2001, in a transaction accounted for as a
pooling-of-interests. The selected financial data includes the
operating results and financial data of Novellus and GaSonics
for all periods. We acquired SpeedFam-IPEC on December 6,
2002, in a transaction accounted for as a purchase business
combination. The selected financial data includes the operating
results and financial data of SpeedFam-IPEC from
December 6, 2002.

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Selected Consolidated Financial Data

|                                                                                                                                       |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |         |      | 
|-------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ------------------------------------- | ------- | ----- | - | ---- | ------- | ------- | - | ---- | --------- | ----- | - | - | --------- | ----- | - | - | ------- | ------- | ---- | 
|                                                                                                                                       |                       |                                      
|                                                                                                                                       |                       | Years Ended December 31,             
|                                                                                                                                       |                       |                                      
|                                                                                                                                       |                       | 2003                                  |         | 2002  |   | 2001 |         | 2000(6) |   | 1999
|                                                                                                                                       |                       |                                       |         |       |   |      |         |         |   |     
|                                                                                                                                       |                       |                                      
|                                                                                                                                       |                       | (in thousands, except per share data)
|Consolidated Statements of Operations
    Data:                                                                                        |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |        
|Net sales                                                                                                                              |                       | $                                     | 925,070 |       |   | $    | 839,958 |         |   | $    | 1,339,322 |       |   | $ | 1,319,486 |       |   | $ | 657,021 |        
|Gross profit                                                                                                                           |                       |                                       | 380,000 | (2)   |   |      | 378,523 |         |   |      | 691,351   |       |   |   | 730,893   |       |   |   | 351,839 |        
|Income (loss) before cumulative effect of change
    in accounting principle                                                           |                       |                                       | (5,034  | )     |   |      | 22,920  |         |   |      | 144,470   |       |   |   | 239,168   |       |   |   | 68,707  |        
|Cumulative effect of change in accounting
    principle                                                                                |                       |                                       | (62,780 | ) (1) |   |      |        |         |   |      |          |       |   |   | (89,788   | )     |   |   |        |        
|Net income (loss)                                                                                                                      |                       | $                                     | (67,814 | ) (2) |   | $    | 22,920  | (3,4)   |   | $    | 144,470   | (3,5) |   | $ | 149,380   |       |   | $ | 68,707  |        
|Per common share:                                                                                                                      |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |        
|Income (loss) before cumulative effect of change
    in accounting principle                                                           |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |        
|                                                                                                                                       | Basic                 |                                       | $       | (0.03 | ) |      | $       | 0.16    |   |      | $         | 1.01  |   |   | $         | 1.76  |   |   | $       | 0.56    |     
|                                                                                                                                       | Diluted               |                                       | $       | (0.03 | ) |      | $       | 0.15    |   |      | $         | 0.97  |   |   | $         | 1.66  |   |   | $       | 0.54    |     
|Cumulative effect of change in accounting
    principle, net of tax                                                                    |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |        
|                                                                                                                                       | Basic                 |                                       |         | (0.42 | ) |      |         |        |   |      |           |      |   |   | $         | (0.66 | ) |   |         |        |     
|                                                                                                                                       | Diluted               |                                       |         | (0.42 | ) |      |         |        |   |      |           |      |   |   | $         | (0.62 | ) |   |         |        |     
|Net income (loss)                                                                                                                      |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |        
|                                                                                                                                       | Basic                 |                                       | $       | (0.45 | ) |      | $       | 0.16    |   |      | $         | 1.01  |   |   | $         | 1.10  |   |   | $       | 0.56    |     
|                                                                                                                                       | Diluted               |                                       | $       | (0.45 | ) |      | $       | 0.15    |   |      | $         | 0.97  |   |   | $         | 1.04  |   |   | $       | 0.54    |     
|Shares used in basic per share calculations                                                                                            |                       |                                       | 150,680 |       |   |      | 144,371 |         |   |      | 142,462   |       |   |   | 135,728   |       |   |   | 122,261 |        
|Shares used in diluted per share calculations                                                                                          |                       |                                       | 150,680 |       |   |      | 148,748 |         |   |      | 148,924   |       |   |   | 143,654   |       |   |   | 127,826 |        
|Pro forma amounts with the change in accounting
    principle related to revenue recognition applied retroactively:
    (unaudited)(6) |                       |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |        
|                                                                                                                                       | Net revenues          |                                       |         |      |   |      |         |        |   |      |           |      |   |   |           |      |   |   |         | 582,397 |     
|                                                                                                                                       | Net income            |                                       |         |      |   |      |         |        |   |      |           |      |   |   |           |      |   |   |         | 39,550  |     
|                                                                                                                                       | Net income per share: |                                       |         |       |   |      |         |         |   |      |           |       |   |   |           |       |   |   |         |         |     
|                                                                                                                                       |                       | Basic                                 |         |       |  |      |         |         |  |      |           |       |  |   |           |       |  |   |         | $       | 0.32 | 
|                                                                                                                                       |                       | Diluted                               |         |       |  |      |         |         |  |      |           |       |  |   |           |       |  |   |         | $       | 0.31 | 

|                                                  |  |      |           |      |  |      |           |      |  |      |           |  |  |   |           |  |  |   |           | 
|------------------------------------------------- |  | ---- | --------- | ---- |  | ---- | --------- | ---- |  | ---- | --------- |  |  | - | --------- |  |  | - | --------- | 
|December 31,                                      |  | 2003 |           | 2002 |  | 2001 |           | 2000 |  | 1999
|                                                  |  |      |           |      |  |      |           |      |  |     
|Consolidated Balance Sheet Data:                  |  |      |           |      |  |      |           |      |  |      |           |  |  |   |           |  |  |   |           | 
|Cash, cash equivalents and short-term investments |  | $    | 1,002,132 |      |  | $    | 1,019,652 |      |  | $    | 921,822   |  |  | $ | 1,219,664 |  |  | $ | 413,014   | 
|Working capital                                   |  |      | 1,350,906 |      |  |      | 1,252,324 |      |  |      | 1,395,902 |  |  |   | 1,410,836 |  |  |   | 646,063   | 
|Total assets                                      |  |      | 2,338,900 |      |  |      | 2,493,994 |      |  |      | 3,031,124 |  |  |   | 2,205,474 |  |  |   | 1,000,352 | 
|Long-term obligations                             |  |      |          |      |  |      |          |      |  |      |          |  |  |   |          |  |  |   |          | 
|Shareholders equity                              |  |      | 2,071,860 |      |  |      | 2,055,688 |      |  |      | 1,871,994 |  |  |   | 1,641,475 |  |  |   | 837,537   | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As a result of the early adoption of Financial
    Accounting Standards Board Interpretation No. 46,
    Consolidation of Variable Interest Entities, an
    Interpretation of ARB No. 51, we recorded a non-cash
    charge of $62.8 million, net of tax, for the year ended
    December 31, 2003, as a cumulative effect of a change in
    accounting principle from the consolidation of properties
    previously accounted for as synthetic leases.

15



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##### Table of Contents





|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | We recorded $59.8 million of pre-tax charges
    for the year ended December 31, 2003 as a result of a
    restructuring plan to align our cost structure with business
    conditions. The charges consisted of an inventory write-down of
    $44.0 million, asset write-offs of $7.9 million,
    facilities charges of $4.1 million, and severance of
    $3.8 million. In addition, we recorded a charge for
    litigation settlements of $2.7 million.                                                                                                                                                                                                                                                                                                          
|   
|(3) | We adopted Statement of Financial Accounting
    Standards No. 142, Goodwill and Other Intangible
    Assets, or SFAS No. 142, in the first quarter of
    2002. As a result of its adoption, we no longer amortize
    goodwill, which resulted in an increase in net income of
    $3.6 million for the year ended December 31, 2002.
    Retroactive application of SFAS No. 142 would have resulted
    in an increase in net income for the year ended
    December 31, 2001 of $3.5 million, or $0.02 per
    diluted share. Amortization of goodwill was not material in
    years shown prior to 2001.                                                                                                                                                       
|   
|(4) | We recorded $32.5 million of pre-tax charges
    for the year ended December 31, 2002 associated with
    restructuring and severance activities of $6.5 million,
    write-off of debt issuance costs of $17.0 million, and an
    acquired in-process research and development charge relating to
    the acquisition of SpeedFam-IPEC of $9.0 million.
    Additionally, we recorded a pre-tax benefit of
    $12.3 million for the year ended December 31, 2002
    associated with the recovery of a previously written off
    receivable of $7.7 million and a gain on the sale of an
    equity investment of $4.6 million.                                                                                                                                    
|   
|(5) | We recorded $84.5 million of pre-tax charges
    for the year ended December 31, 2001. These charges include
    $55.0 million related to restructuring and asset
    impairment, $13.2 million of costs related to the GaSonics
    acquisition, $8.6 million for an other than temporary
    decline in the value of an investment, and $7.7 million of
    a bad debt write-off.                                                                                                                                                                                                                                                                                                                                                                                    
|   
|(6) | We recorded a non-cash charge of
    $89.8 million, after reduction for income taxes of
    $48.6 million, or $0.62 per diluted share, to reflect the
    cumulative effect of a change in accounting principle as of
    January 1, 2000 related to the adoption of the Securities
    and Exchange Commission Staff Accounting Bulletin No. 101,
    Revenue Recognition in Financial Statements. If the
    change in accounting principle had been applied retroactively to
    1999, net sales would have been $582.4 million. Net income
    for the year ended December 31, 2000 also included a
    $6.0 million pre-tax charge for acquired in-process
    research and development associated with GaSonics
    acquisition of Gamma Precision Technology.






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

Introduction

The following Managements Discussion and
Analysis of Financial Condition and Results of Operations
(MD&A) is intended to provide readers with an understanding
of the Company. The following are included in our MD&A:



| |   |                                       
| | - | --------------------------------------
| |  | Overview of our Business and Industry;
|
| |  | Results of Operations;                
|
| |  | Critical Accounting Policies;         
|
| |  | Liquidity and Capital Resources;      
|
| |  | Off-balance Sheet Arrangements;       
|
| |  | Contractual Obligations;              
|
| |  | Related Parties;                      
|
| |  | Recent Accounting Pronouncements;     
|
| |  | Forward-Looking Statements; and       
|
| |  | Risk Factors                          

16



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##### Table of Contents



Overview of Our Business and
Industry

Novellus is a global supplier of equipment used
in the fabrication of integrated circuits. We develop,
manufacture, sell and service equipment used by manufacturers of
integrated circuits, or chips, who either incorporate the chips
in their own products or sell the chips to other companies for
use in electronic devices. Our goal is to use our expertise to
increase our market share and strengthen our position as a
leading supplier of semiconductor processing equipment by
providing our customers with highly reliable products which help
them reduce costs, increase productivity and remain competitive.

Our business depends on capital expenditures made
by chip manufacturers, who in turn are dependent on corporate
and consumer demand for chips and the devices which use them.
Since the industry in which we operate is driven by spending for
electronic products, our business is directly affected by growth
or contraction in the global economy as well as by the adoption
of new technologies. Demand for personal computers, the
expansion of the Internet and telecommunications industries, and
the emergence of new applications in consumer electronics have a
direct impact on our business. In addition, the industry is
characterized by intense competition and rapidly changing
technology. During the recent global recession, we continued to
work closely with our customers and make substantial investments
in research and development in order to continue delivering
innovative products which enhance productivity for our customers
and utilize the latest technology. We believe these investments
have positioned us for growth in the coming year.

We focus on certain key quarterly financial data
to manage our business. Net sales, gross profit, net income
(loss) and net income (loss) per share are the primary measures
we use to monitor performance. Net orders are used to forecast
and plan future operations. The following table sets forth
certain quarterly and annual financial information for the
periods indicated:

|      |                                     |                          |   |         |  |         |   |         |  |              |   |         |   |  |   |         |  |  |   |           |  
|----- | ----------------------------------- | ------------------------ | - | ------- |  | ------- | - | ------- |  | ------------ | - | ------- | - |  | - | ------- |  |  | - | --------- | -
|      |                                     |                          |   |        
|      |                                     | Quarterly Financial Data |   |        
|      |                                     |                          |   |        
|      |                                     | First                    |   | Second  |  | Third   |   | Fourth  |  | Year Ended  
|      |                                     | Quarter                  |   | Quarter |  | Quarter |   | Quarter |  | December 31,
|      |                                     |                          |   |         |  |         |   |         |  |             
|2003: |                                     |                          |   |         |  |         |   |         |  |              |   |         |   |  |   |         |  |  |   |          
|      | Net sales                           |                          | $ | 238,410 |  |         | $ | 239,050 |  |              | $ | 221,099 |   |  | $ | 226,511 |  |  | $ | 925,070   |  
|      | Gross profit                        |                          |   | 109,814 |  |         |   | 105,322 |  |              |   | 58,776  |   |  |   | 106,088 |  |  |   | 380,000   |  
|      | Net income (loss)                   |                          |   | 11,872  |  |         |   | 7,430   |  |              |   | (97,568 | ) |  |   | 10,452  |  |  |   | (67,814   | )
|      | Diluted net income (loss) per share |                          |   | 0.08    |  |         |   | 0.05    |  |              |   | (0.64   | ) |  |   | 0.07    |  |  |   | (0.45     | )
|      | Net orders                          |                          |   | 241,825 |  |         |   | 198,759 |  |              |   | 220,775 |   |  |   | 275,219 |  |  |   | 936,578   |  
|2002: |                                     |                          |   |         |  |         |   |         |  |              |   |         |   |  |   |         |  |  |   |          
|      | Net sales                           |                          |   | 169,679 |  |         |   | 222,147 |  |              |   | 230,495 |   |  |   | 217,637 |  |  |   | 839,958   |  
|      | Gross profit                        |                          |   | 71,530  |  |         |   | 101,564 |  |              |   | 109,382 |   |  |   | 96,047  |  |  |   | 378,523   |  
|      | Net income                          |                          |   | 3,836   |  |         |   | 12,013  |  |              |   | 4,083   |   |  |   | 2,988   |  |  |   | 22,920    |  
|      | Diluted net income per share        |                          |   | 0.03    |  |         |   | 0.08    |  |              |   | 0.03    |   |  |   | 0.02    |  |  |   | 0.15      |  
|      | Net orders                          |                          |   | 170,304 |  |         |   | 275,888 |  |              |   | 202,409 |   |  |   | 219,434 |  |  |   | 868,035   |  
|2001: |                                     |                          |   |         |  |         |   |         |  |              |   |         |   |  |   |         |  |  |   |          
|      | Net sales                           |                          |   | 458,705 |  |         |   | 376,899 |  |              |   | 303,687 |   |  |   | 200,031 |  |  |   | 1,339,322 |  
|      | Gross profit                        |                          |   | 254,985 |  |         |   | 199,624 |  |              |   | 140,138 |   |  |   | 96,604  |  |  |   | 691,351   |  
|      | Net income (loss)                   |                          |   | 82,102  |  |         |   | 59,221  |  |              |   | (14,019 | ) |  |   | 17,166  |  |  |   | 144,470   |  
|      | Diluted net income (loss) per share |                          |   | 0.55    |  |         |   | 0.40    |  |              |   | (0.10   | ) |  |   | 0.12    |  |  |   | 0.97      |  
|      | Net orders                          |                          |   | 209,751 |  |         |   | 212,490 |  |              |   | 124,044 |   |  |   | 110,189 |  |  |   | 656,474   |  

The semiconductor equipment industry is subject
to cyclical conditions which play a major role in the
fluctuations in demand, as defined by net orders. These
fluctuations, in turn, affected our net sales over the past
three years. A decline in net orders for semiconductor equipment
began in early 2001 and continued through 2002. While we have
experienced a modest increase from 2002, demand was weak through
the first

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three quarters of 2003. Net orders during the
first three quarters of 2003 were sequentially volatile with a
10% increase in the first quarter, an 18% decrease in the second
quarter, and an 11% increase in the third quarter, reflecting
uncertainty in the demand for semiconductor devices. In the
fourth quarter of 2003, we experienced a 25% sequential increase
in net orders. The net order growth in the fourth quarter was
driven primarily by strengthening demand for corporate and
consumer electronic devices, which resulted in an increase in
our customers capacity utilization. In addition, we
experienced increased demand as a result of our customers
transition to 300mm fabrication equipment. We believe the
increase in demand for our products during the fourth quarter of
2003 could be an indication of an industry recovery.


The receipt of net orders in a particular quarter
affects revenue in subsequent quarters. Net orders turn to
revenue either at shipment or upon customer acceptance of the
equipment. Our revenue recognition policy addresses the
distinction between revenue recognized upon shipment and revenue
recognized upon customer acceptance. Equipment generally ships
within two or three months of receiving the related order and if
applicable, customer acceptance is typically received six to
eight months after shipment. These time lines are general
estimates and actual times may vary depending on specific
customer circumstances.

Demand for our systems can vary significantly
from period to period as a result of several factors, including,
but not limited to, downturns in the economy and semiconductor
industry, supply of and demand for semiconductor devices, and
competition in the semiconductor industry among suppliers of
similar products. For these and other reasons, our results of
operations for fiscal years 2001, 2002 and 2003 may not
necessarily be indicative of future operating results.

Results of Operations

(dollars in thousands, except per share
amount)




| |          
| | ---------
| | Net Sales

|          |  |                          |         |          |  |          |         |         |  |         |           |  |  |  |    |   |  |  |     |   
|--------- |  | ------------------------ | ------- | -------- |  | -------- | ------- | ------- |  | ------- | --------- |  |  |  | -- | - |  |  | --- | --
|          |  |                          |         |          |  |         
|          |  | Years Ended December 31, |         |          |  |         
|          |  |                          |         | % Change |  | % Change
|          |  | 2003                     |         | 2002     |  | 2001     |         | in 2003 |  | in 2002
|          |  |                          |         |          |  |          |         |         |  |        
|Net Sales |  | $                        | 925,070 |          |  | $        | 839,958 |         |  | $       | 1,339,322 |  |  |  | 10 | % |  |  | (37 | )%

The increase in net sales of $85.1 million,
or 10%, from 2002 to 2003 was primarily due to slightly improved
market conditions during 2003, driven mainly by increased
volume. The increase in volume was a result of increased capital
spending by our customers as demand for semiconductor devices
began to increase.

The decrease in net sales of $499.4 million,
or 37%, from 2001 to 2002 was primarily a result of reduced
volume due to a substantial reduction in customer capital
spending in response to weakened worldwide demand for
semiconductor devices. The demand for semiconductor
manufacturing equipment has historically fluctuated with changes
in the supply of and demand for semiconductor devices and other
factors, including rapid technological advances in semiconductor
manufacturing processes. Although net orders grew by
$211.6 million, or 32%, to $868.0 million in 2002 from
$656.4 million in 2001, net sales decreased. We experienced
unprecedented demand for our equipment in 2000 and therefore, at
the end of 2000 and prior to the industry-wide downturn in early
2001, we had a substantial amount of backlog, which shipped in
the early part of 2001 and accounted for a significant portion
of our net sales for that year.

Geographical net sales as a percentage of total
net sales were as follows (based on the location of the
customers facilities):

|              |  |              |    |      |  |      |    |   |  |  |    |  
|------------- |  | ------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|              |  |             
|              |  | Years Ended 
|              |  | December 31,
|              |  |             
|              |  | 2003         |    | 2002 |  | 2001
|              |  |              |    |      |  |     
|North America |  |              | 35 | %    |  |      | 39 | % |  |  | 45 | %
|Europe        |  |              | 10 | %    |  |      | 7  | % |  |  | 7  | %
|Asia          |  |              | 55 | %    |  |      | 54 | % |  |  | 48 | %

The increase in net sales in Europe and Asia as a
percentage of total net sales during 2003 was attributable to
higher demand in Japan, Korea, and Europe, partially offset by
lower demand in Taiwan and

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China. A significant portion of our net sales is
generated in Asia, primarily due to the fact that a substantial
portion of the worlds semiconductor manufacturing capacity
is located there. We plan to continue to focus on expanding our
market presence in Asia as we believe that significant
additional growth potential exists in this region over the long
term.




| |             
| | ------------
| | Gross Profit

|               |  |                          |         |          |  |          |         |         |  |         |         |  |  |  |     |   |  |  |     |   
|-------------- |  | ------------------------ | ------- | -------- |  | -------- | ------- | ------- |  | ------- | ------- |  |  |  | --- | - |  |  | --- | --
|               |  |                          |         |          |  |         
|               |  | Years Ended December 31, |         |          |  |         
|               |  |                          |         | % Change |  | % Change
|               |  | 2003                     |         | 2002     |  | 2001     |         | in 2003 |  | in 2002
|               |  |                          |         |          |  |          |         |         |  |        
|Gross profit   |  | $                        | 380,000 |          |  | $        | 378,523 |         |  | $       | 691,351 |  |  |  | 0.4 | % |  |  | (45 | )%
|% of net sales |  |                          | 41%     |          |  |          | 45%     |         |  |         | 52%     |  |  |  |     |   |  |  |     |   

The decline in gross profit as a percentage of
net sales in 2003 compared to 2002 is due primarily to a
$44.0 million write-down of inventory in 2003, changes in
product mix, and continued low absorption of our manufacturing
overhead costs. In the third quarter of 2003, we experienced a
sustained shift in our customers order patterns from 200mm
to 300mm equipment, which resulted in reduced demand for our
200mm equipment. Furthermore, the levels of required spares
inventory were reduced due to a streamlining of our worldwide
spares distribution system. These changes resulted in a portion
of our inventory becoming excess or obsolete and led to a
$44.0 million write-down of inventory. The prolonged
weakness in demand for semiconductor capital equipment has also
continued to negatively affect our gross margin as we have
continued to experience low absorption of our fixed overhead
costs.

The decline in gross profit as a percentage of
net sales in 2002 compared to 2001 was primarily due to reduced
absorption of fixed overhead costs resulting from lower
production and shipments. During 1999 and 2000, and through our
acquisition of GaSonics in January 2001, we expanded our
manufacturing facilities to accommodate the unprecedented growth
in demand for semiconductor manufacturing equipment. As a result
of the industry downturn and overall slowing economy that began
in 2001 and continued through 2002, net orders for our equipment
were low and we continued to have low absorption of our fixed
overhead costs related to the facilities in those periods. The
2001 gross profit was reduced by a $7.1 million charge
associated with the write-off of inventory related to two
products, which we discontinued in connection with our 2001
restructuring plan. The gross profit in 2001 was also impacted
by a benefit of $4.4 million related to our decision not to
pay our bonuses and profit sharing because we did not meet the
minimum performance guidelines required for these payments.

Our gross profit from period to period is
affected by the treatment of certain product sales in accordance
with Securities and Exchange Commission (SEC) Staff
Accounting Bulletin (SAB) No. 104, Revenue
Recognition, or SAB 104, which superseded the earlier
related guidance in SAB No. 101, Revenue Recognition
in Financial Statements, or SAB 101. For these sales, we
recognize all of a products cost upon shipment even though
a portion of a products revenue may be deferred until
final payment is due, typically upon customer acceptance.



| |                                               
| | ----------------------------------------------
| | Selling, General and Administrative
    (SG&A)

|               |  |                          |         |          |  |          |         |         |  |         |         |  |  |  |   |   |  |  |     |   
|-------------- |  | ------------------------ | ------- | -------- |  | -------- | ------- | ------- |  | ------- | ------- |  |  |  | - | - |  |  | --- | --
|               |  |                          |         |          |  |         
|               |  | Years Ended December 31, |         |          |  |         
|               |  |                          |         | % Change |  | % Change
|               |  | 2003                     |         | 2002     |  | 2001     |         | in 2003 |  | in 2002
|               |  |                          |         |          |  |          |         |         |  |        
|SG&A           |  | $                        | 165,618 |          |  | $        | 154,172 |         |  | $       | 198,567 |  |  |  | 7 | % |  |  | (22 | )%
|% of net sales |  |                          | 18%     |          |  |          | 18%     |         |  |         | 15%     |  |  |  |   |   |  |  |     |   

SG&A expense includes compensation and
benefits for corporate, financial, marketing, and administrative
personnel as well as travel expenses and professional fees. Also
included are expenses for rents, utilities, and depreciation and
amortization related to the assets utilized by these functions.

As a percentage of net sales, SG&A expense in
2003 is consistent with 2002. The increase in absolute dollars
for the year ended December 31, 2003 is primarily due to
higher salaries and litigation costs in 2003, the expense
resulting from the operations of SpeedFam-IPEC for the full
year, and increased depreciation

19



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##### Table of Contents



expense as a result of our early adoption of FIN
46 and subsequent purchase of properties previously accounted
for as synthetic leases during the third quarter of 2003.


The increase in SG&A expense as a percentage
of net sales in 2002 over 2001 was primarily due to a
substantial reduction in net sales in 2002 as compared to 2001.
The decrease in absolute dollars reflects the impact of the cost
reduction measures that we implemented in the second half of
2001, which contributed to cost savings in 2002. These cost
reduction measures included executive and employee salary
reductions and the consolidation of our facilities. In addition,
we had workforce reductions in the first and fourth quarter of
2002.



| |                                   
| | ----------------------------------
| | Research and Development
    (R&D)

|                         |  |                          |         |          |  |          |         |         |  |         |         |  |  |  |   |   |  |  |     |   
|------------------------ |  | ------------------------ | ------- | -------- |  | -------- | ------- | ------- |  | ------- | ------- |  |  |  | - | - |  |  | --- | --
|                         |  |                          |         |          |  |         
|                         |  | Years Ended December 31, |         |          |  |         
|                         |  |                          |         | % Change |  | % Change
|                         |  | 2003                     |         | 2002     |  | 2001     |         | in 2003 |  | in 2002
|                         |  |                          |         |          |  |          |         |         |  |        
|Research and development |  | $                        | 227,439 |          |  | $        | 222,344 |         |  | $       | 272,032 |  |  |  | 2 | % |  |  | (18 | )%
|% of net sales           |  |                          | 25%     |          |  |          | 26%     |         |  |         | 20%     |  |  |  |   |   |  |  |     |   

R&D expense includes compensation and
benefits for our research and development personnel, project
materials, chemicals and other direct expenses incurred in
product and technology development. Also included are expenses
for equipment repairs and maintenance, rents, utilities,
depreciation, and amortization expense associated with patents
and purchased technologies. Our significant investments in
R&D over the past several years reflect our strong
commitment to the continuous improvement of our current product
lines and the development of new products and technologies.
Despite the prolonged downturn in the industry and weakened
demand for semiconductor equipment, we continue to believe that
significant investment in R&D is required to remain
competitive, and we plan to continue to invest in new products
and enhancement of our current product lines.

As a percentage of net sales, R&D expense in
2003 remained relatively flat compared to 2002. The increase in
absolute dollars in 2003 is primarily due to additional spending
related to the continuing development of CMP technologies, which
were acquired through the acquisition of SpeedFam-IPEC in
December 2002, and higher depreciation expense as a result of
our early adoption of FIN 46 and subsequent purchase of
properties previously accounted for as synthetic leases during
the third quarter of 2003.

The increase in R&D expense as a percentage
of net sales in 2002 over 2001 was primarily due to a
substantial reduction in net sales in 2002 compared to 2001. The
increase reflected our continued commitment to the development
of new products and technologies to provide competitive cost
advantages for our customers.



| |                                                         
| | --------------------------------------------------------
| | Acquired In-Process Research and
    Development (IPR&D)

|               |  |              |   |          |  |          |       |         |  |         |   |  |  |  |      |    |  |  |     |  
|-------------- |  | ------------ | - | -------- |  | -------- | ----- | ------- |  | ------- | - |  |  |  | ---- | -- |  |  | --- | -
|               |  |              |   |          |  |         
|               |  | Years Ended  |   |          |  |         
|               |  | December 31, |   |          |  |         
|               |  |              |   | % Change |  | % Change
|               |  | 2003         |   | 2002     |  | 2001     |       | in 2003 |  | in 2002
|               |  |              |   |          |  |          |       |         |  |        
|IPR&D          |  | $            |  |          |  | $        | 9,003 |         |  | $       |  |  |  |  | (100 | )% |  |  | 100 | %
|% of net sales |  |              |  |          |  |          | 1%    |         |  |         |  |  |  |  |      |    |  |  |     |  

In connection with the acquisition of
SpeedFam-IPEC in December 2002, we recorded a $9.0 million
charge to write-off certain acquired IPR&D in 2002. Projects
which qualify as IPR&D had not yet reached technological
feasibility and had no alternative future use. Technological
feasibility is defined as being equivalent to completion of a
beta-phase working prototype in which there is no significant
remaining risk relating to the development.

The value assigned to IPR&D was determined by
considering the importance of each project to the overall
development plan, estimating costs to develop the acquired
IPR&D into commercially viable products, estimating the
resulting net cash flows from the projects when completed and
discounting the net cash flows to their present value. The
revenue estimates used to value the purchased IPR&D were
based on estimates of

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##### Table of Contents



relevant market sizes and growth factors,
expected trends in technology and the nature and expected timing
of new product introductions by SpeedFam-IPEC and its
competitors.


The rates utilized to discount the net cash flows
to their present value were based on a weighted-average cost of
capital determined by examining market information for several
comparable companies. The weighted-average cost of capital was
adjusted to reflect the difficulties and uncertainties in
completing each project and thereby achieving technological
feasibility, the percentage of completion of each project,
anticipated market acceptance and penetration, market growth
rates and risks related to the impact of potential changes in
future target markets. Based on these factors, a discount rate
of 25% was deemed appropriate for valuing the IPR&D. The
estimates used in valuing IPR&D were based upon assumptions
believed to be reasonable but which are inherently uncertain and
unpredictable. As a result, actual results may differ materially
from our estimates.



| |                                    
| | -----------------------------------
| | Restructuring and Other
    Charges

|                                |  |                          |        |          |  |          |       |         |  |         |        |  |  |  |     |   |  |  |     |   
|------------------------------- |  | ------------------------ | ------ | -------- |  | -------- | ----- | ------- |  | ------- | ------ |  |  |  | --- | - |  |  | --- | --
|                                |  |                          |        |          |  |         
|                                |  | Years Ended December 31, |        |          |  |         
|                                |  |                          |        | % Change |  | % Change
|                                |  | 2003                     |        | 2002     |  | 2001     |       | in 2003 |  | in 2002
|                                |  |                          |        |          |  |          |       |         |  |        
|Restructuring and other charges |  | $                        | 18,529 |          |  | $        | 6,467 |         |  | $       | 61,106 |  |  |  | 187 | % |  |  | (89 | )%
|% of net sales                  |  |                          | 2%     |          |  |          | 1%    |         |  |         | 5%     |  |  |  |     |   |  |  |     |   

The $18.5 million restructuring and other
charges for the year ended December 31, 2003 consisted of
$7.9 million for asset write-offs (including fixed assets
and purchased technology), $4.1 million for vacated
facilities, $3.8 million for severance, and
$2.7 million for legal settlements. The asset write-offs,
facilities charges, and severance charges were recorded in
connection with activities undertaken to align our cost
structure with current business conditions.

Restructuring and other charges in 2002 consisted
of $1.5 million related to vacated facilities and
$5.0 million of severance benefits for workforce
reductions. In 2001, we implemented a restructuring plan and
recorded restructuring and asset impairment charges of
$47.9 million and acquisition costs of $13.2 million
related to the acquisition of GaSonics. The restructuring and
asset impairment charges included $33.8 million related to
vacated facilities, $9.5 million related to abandoned
assets associated with the discontinuation of certain projects
and $4.6 million related to a write-off of abandoned
purchased technology. The discontinuation of two products
resulted in a $7.1 million inventory write-down in 2001,
which is included in cost of sales for that year.

The charge for vacated facilities relates to rent
obligations after the abandonment of certain facilities
currently under long-term operating lease agreements. When
applicable, anticipated future sublease income related to the
vacated buildings has been offset against the charge for the
remaining lease payments. Additionally, certain fixed assets,
including leasehold improvements, associated with the abandoned
facilities that had no future economic benefit have been written
off. Substantially all actions under the restructuring plans had
been achieved as of December 31, 2003, except for future
rent obligations of $50.5 million, which are to be paid in
cash through year 2017. For further discussion, see Note 8 to
the Consolidated Financial Statements.

The restructuring plans reduced our expenses by
approximately $11.5 million in 2003, of which
$10.2 million relates to savings from vacated facilities
and $1.3 million relates to savings from workforce
reductions. We estimate cost savings related to facilities of
approximately $9.1 in 2004 resulting from the restructuring
plans implemented prior to 2004. The 2001 restructuring saved us
approximately $38.8 million of expenses in fiscal 2002, of
which, $9.8 million relates to savings from vacated
facilities and $29.0 million relates to savings from
workforce reductions.



| |                              
| | -----------------------------
| | Bad Debt Write-off (Recovery)

|                              |  |                          |   |          |  |          |          |         |  |         |       |  |  |  |     |   |  |  |      |   
|----------------------------- |  | ------------------------ | - | -------- |  | -------- | -------- | ------- |  | ------- | ----- |  |  |  | --- | - |  |  | ---- | --
|                              |  |                          |   |          |  |         
|                              |  | Years Ended December 31, |   |          |  |         
|                              |  |                          |   | % Change |  | % Change
|                              |  | 2003                     |   | 2002     |  | 2001     |          | in 2003 |  | in 2002
|                              |  |                          |   |          |  |          |          |         |  |        
|Bad debt write-off (recovery) |  | $                        |  |          |  |          | $(7,662) |         |  | $       | 7,662 |  |  |  | 100 | % |  |  | (200 | )%
|% of net sales                |  |                          |  |          |  |          | (1)%     |         |  |         | 1%    |  |  |  |     |   |  |  |      |   

21



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In September 2001, an outstanding account
receivable balance was at risk for collection because the
customer was facing financial difficulties, payment was overdue
and overall industry conditions continued to deteriorate.
Accordingly, we recorded a write-off of $7.7 million.
However, in the first quarter of 2002, all amounts owed under
this account receivable balance were collected, resulting in a
benefit to operations of $7.7 million.



| |                  
| | -----------------
| | Other Income, net

|                  |  |                          |        |          |  |          |        |         |  |         |        |  |  |  |     |    |  |  |     |   
|----------------- |  | ------------------------ | ------ | -------- |  | -------- | ------ | ------- |  | ------- | ------ |  |  |  | --- | -- |  |  | --- | --
|                  |  |                          |        |          |  |         
|                  |  | Years Ended December 31, |        |          |  |         
|                  |  |                          |        | % Change |  | % Change
|                  |  | 2003                     |        | 2002     |  | 2001     |        | in 2003 |  | in 2002
|                  |  |                          |        |          |  |          |        |         |  |        
|Other income, net |  | $                        | 16,266 |          |  | $        | 28,721 |         |  | $       | 57,393 |  |  |  | (43 | )% |  |  | (50 | )%
|% of net sales    |  |                          | 2%     |          |  |          | 3%     |         |  |         | 4%     |  |  |  |     |    |  |  |     |   

Other income, net, includes interest income,
interest expense and other non-operating income and expenses.
The decrease in other income, net, in 2003 from 2002 is
attributable to lower interest income resulting from declining
interest rates on interest-bearing investments and a change in
accounting related to properties previously accounted for under
synthetic leases. The change in synthetic lease accounting
reduced our interest income by approximately $3.0 million
for the year ended December 31, 2003. In the first quarter
of 2003, we also recorded a loss of $0.6 million related to
the redemption of the SpeedFam-IPEC convertible subordinated
notes.

The decrease in other income, net, as a
percentage of net sales and in absolute dollars, in 2002 from
2001 was partially due to a decrease in interest income. The
decrease in interest income was primarily due to a continued
decline in interest rates and a decrease in interest-bearing
investments after we used $880.0 million of restricted
investments to retire our Liquid Yield Option
NotesTM, or LYONS, in the third quarter of 2002. We
also recorded a non-cash charge of $17.0 million for the
write-off of unamortized issuance costs related to the
retirement of the LYONs in the third quarter of 2002. The
decrease in other income in 2002 was partially offset by a
$4.6 million gain on the sale of an equity investment.



| |                                         
| | ----------------------------------------
| | Provision (Benefit) for Income
    Taxes

The provision (benefit) for income taxes
reflects an effective tax rate of (67%) in 2003, zero percent in
2002 and 31% in 2001. The effective tax rate benefit in 2003 was
higher than in 2002 as a result of the combined benefit of the
net operating loss and tax credit carryforwards. The effective
tax rate in 2002 was lower than in 2001 as a result of the
larger benefits from tax credits in relation to lower
profitability. Management believes the benefits of the net
operating loss and tax credit carryforwards will be realized due
to anticipated future taxable income. Our future effective
income tax rate depends on various factors, such as the
companys profits (losses) before taxes, tax
legislation, the geographic composition of pre-tax income and
non-deductible expenses incurred in connection with acquisitions.

Critical Accounting Policies

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America requires that we make estimates and
judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and the related disclosure of
contingent assets and liabilities. On an ongoing basis, we
evaluate our estimates, including those related to revenue
recognition, inventory valuation, goodwill and other intangible
assets, deferred tax assets, warranty obligations and
restructuring and impairment charges. We base our estimates on
historical experience and on various other assumptions that are
believed to be reasonable under the current circumstances, the
results of which form the basis for making judgments about the
carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions. We
believe the following critical accounting policies affect the
more significant judgments and estimates used in the preparation
of our consolidated financial statements.

22



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| |                    
| | -------------------
| | Revenue Recognition

We recognize revenue in accordance with SAB 104,
which superseded the earlier related guidance in SAB 101. We
recognize revenue when persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered,
the sellers price is fixed or determinable, and
collectibility is reasonably assured.

Certain of our product sales are accounted for as
multiple-element arrangements. A multiple-element arrangement is
a transaction which may involve the delivery or performance of
multiple products, services, or rights to use assets, and
performance may occur at different points in time or over
different periods of time. If we have met defined customer
acceptance experience levels with both the customer and the
specific type of equipment, we recognize equipment revenue upon
shipment and transfer of title, with the remainder generally
recognized at the later of completion of the installation
services or customer acceptance.

Installation services are not essential to the
functionality of the delivered equipment. We allocate revenue
based on the residual method as a fair value has been
established for installation services. However, since final
payment is not typically due until customer acceptance, we defer
revenue for the final payment, which is in excess of the fair
value of the installation services. All other equipment sales
are recognized upon customer acceptance.

Revenue related to sales of spare parts is
recognized upon shipment. Revenue related to maintenance and
service contracts is recognized ratably over the duration of the
contracts. Unearned maintenance and service contract revenue is
included in other accrued liabilities.



| |                    
| | -------------------
| | Inventory Valuation

We periodically assess the recoverability of all
inventories, including raw materials, work-in-process, finished
goods, and spare parts, to determine whether adjustments for
impairment are required. Inventory that is obsolete or in excess
of our forecasted usage is written down to its estimated
realizable value based on assumptions about future demand and
market conditions. If actual demand is lower than our forecast,
additional inventory write-downs may be required.



| |                                         
| | ----------------------------------------
| | Goodwill and Other Intangible
    Assets

We account for goodwill and other intangible
assets in accordance with Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible
Assets, or SFAS No. 142. SFAS No. 142 requires
that goodwill and identifiable intangible assets with indefinite
useful lives no longer be amortized, but instead be tested for
impairment at least annually. SFAS No. 142 also requires
that intangible assets with estimable useful lives be amortized
over their respective estimated useful lives to their estimated
residual values, and reviewed for impairment in accordance with
SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets.

We review our long-lived assets, including
goodwill and other intangible assets, for impairment at least
annually or whenever events or changes in circumstances indicate
that the carrying amount of these assets may not be recoverable.
According to our policy, we completed goodwill impairment tests
in the third and fourth quarters of 2003. The test performed in
the third quarter was completed in connection with our
restructuring plan implemented in that quarter. Our annual
goodwill impairment test was completed in the fourth quarter.
The first step of the test identifies when impairment may have
occurred, while the second step of the test measures the amount
of the impairment, if any. The results of our impairment tests
did not indicate impairment.



| |                    
| | -------------------
| | Deferred Tax Assets

We record a valuation allowance to reduce our
deferred tax assets to the amount that is more likely than not
to be realized. As of December 31, 2003, we had
approximately $168.5 million of deferred tax assets, net of
a valuation allowance of $76.5 million principally related
to acquired net operating loss carryforwards and foreign tax
credits that are not realizable until 2006 and beyond. The
valuation allowance includes $38.0 million related to
acquired deferred tax assets of SpeedFam-IPEC which will be
credited to goodwill

23



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##### Table of Contents



when realized and $26.5 million related to
stock option deductions which will be credited to equity when
realized. Management believes the majority of deferred tax
assets will be realized due to anticipated future income. We
have considered future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for the
valuation allowance. If in the future we determine that we would
not be able to realize all or part of our net deferred tax
assets, an increase to the valuation allowance for deferred tax
assets would decrease income in the period in which such
determination is made.




| |                     
| | --------------------
| | Warranty Obligations

Our warranty policy generally states that we will
provide warranty coverage for a predetermined amount of time on
systems and modules for material and labor to repair and service
the equipment. We record the estimated cost of warranty coverage
to cost of sales upon system shipment. The estimated cost of
warranty is determined by the warranty term, as well as the
average historical labor and material costs for a specific
product. Should actual product failure rates or material usage
differ from our estimates, revisions to the estimated warranty
liability may be required. These revisions could have a positive
or negative impact on gross profit. We review the actual product
failure rates and material usage rates on a quarterly basis and
adjust our warranty liability as necessary.



| |                                         
| | ----------------------------------------
| | Restructuring and Impairment
    Charges

Restructuring activities initiated prior to
December 31, 2002 were recorded in accordance with Emerging
Issues Task Force Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring), and restructuring activities after
December 31, 2002 were recorded under the provisions of
SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities, or SFAS No. 146; SFAS
No. 112, Employers Accounting for
Postemployment Benefits; and SAB 100,
Restructuring and Impairment Charges. SFAS
No. 146 requires that a liability for costs associated with
an exit or disposal activity be recognized when the liability is
incurred, rather than when the exit or disposal plan is approved.

We account for business combination
restructurings under the provisions of EITF Issue No. 95-3,
Recognition of Liabilities in Connection with a Purchase
Business Combination and SAB 100. Accordingly,
restructuring accruals are recorded when management initiates an
exit plan that will cause us to incur costs that have no future
economic benefit. Certain restructuring charges related to
long-lived asset impairments are recorded in accordance with
SFAS No. 144. The restructuring accrual related to vacated
facilities is calculated net of estimated sublease income.
Sublease income is estimated based on current market quotes for
similar properties and expected occupancy dates. If we are
unable to sublet these vacated properties as forecasted, if we
are forced to sublet them at rates below our current estimates
due to changes in market conditions, or if we change our
sublease income estimate, we adjust the restructuring accruals
accordingly.



| |                            
| | ---------------------------
| | Foreign Currency Accounting

The local currency is the functional currency for
all foreign operations. Accordingly, translation gains or losses
related to our foreign subsidiaries are included as a component
of accumulated other comprehensive income (loss).



| |                           
| | --------------------------
| | Foreign Exchange Contracts

We conduct portions of our business in various
foreign currencies. Forward foreign exchange contracts are used
to hedge against the short-term impact of foreign currency
fluctuations on intercompany accounts payable denominated in
U.S. dollars recorded by our Japanese subsidiary. We also enter
into forward foreign exchange contracts to buy and sell foreign
currencies to hedge our intercompany balances denominated in a
currency other than the U.S. dollar. In 2003 and 2002, these
hedging contracts were denominated primarily in the Japanese
Yen, Taiwanese Dollar, and Korean Won. The forward foreign
exchange contracts we use are generally short-term in nature.
The effect of exchange rate changes on forward foreign exchange
contracts is expected to offset the effect of exchange rate
changes on the underlying hedged items. We believe these

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##### Table of Contents



financial instruments do not subject us to
speculative risk that would otherwise result from changes in
currency exchange rates. Net foreign currency gains and losses
for effective and ineffective hedges have not been material to
our results of operations.


Liquidity and Capital Resources

We have historically financed our operating and
capital resource requirements through cash flows from
operations, sales of equity securities and borrowings. Our
primary source of funds as of December 31, 2003 consisted
of approximately $1,002.1 million of cash, cash equivalents
and short-term investments. This amount represents a decrease of
$17.5 million from the December 31, 2002 balance of
$1,019.7 million. The decrease was due primarily to the
repayment of the SpeedFam-IPEC convertible subordinated notes at
a redemption price of $117.1 million, plus accrued interest
of $2.2 million, and capital expenditures of
$31.1 million. The decrease was partially offset by
positive cash generated from operations of $43.1 million,
proceeds from the issuance of common stock in connection with
stock option exercises of $75.7 million, and net borrowings
under lines of credit of $10.2 million.

Net cash provided by operating activities for the
year ended December 31, 2003 was $43.1 million. The
primary sources of cash from operating activities were net
income, as adjusted to exclude non-cash charges and benefits and
changes in working capital accounts. The changes in working
capital accounts include a decrease in prepaid and other current
assets of $22.5 million, a decrease in inventories of
$9.8 million, an increase in accounts receivable of $38.9
million, and the combined effect of decreases in accounts
payable, accrued payroll and related expenses, income tax
payable, deferred profit and other accrued liabilities of
$70.7 million. The decrease in prepaid and other current
assets was primarily attributable to an $18.5 million
income tax refund received in the first quarter of 2003.

Net cash used in investing activities in the year
ended December 31, 2003 was $129.3 million, which
consisted primarily of capital expenditures of
$31.1 million and net purchases of short-term investments
of $101.9 million, offset by a decrease in other assets of
$3.7 million. A significant amount of the
$31.1 million of capital expenditures relates to our new
Enterprise Resource Management (ERM) system. As of
December 31, 2003, we did not have any significant
commitments to purchase property and equipment, except for
additional capital expenditures of approximately
$2.7 million required to complete the implementation of our
new ERM system. However, we expect to expend additional
resources in the future to enhance the functionality of our ERM
system.

Net cash used in financing activities for the
year ended December 31, 2003 was $32.5 million, which
is primarily due to the repayment of the SpeedFam-IPEC
convertible subordinated notes at a redemption price of
$117.1 million, partially offset by proceeds from employee
stock compensation plans of $75.7 million and net lines of
credit borrowings of $10.2 million.

On February 24, 2004, our board of directors
renewed a stock repurchase program originally approved in
September 2001. Under the repurchase program, we may repurchase
up to $500 million of our outstanding common stock through
February 13, 2007.

We believe that our current cash position, cash
generated through operations and equity offerings, and available
borrowings will be sufficient to meet our needs through at least
the next twelve months.

Off-Balance Sheet Arrangements



| |                           
| | --------------------------
| | Variable Interest Entities

In January 2003, the Financial Accounting
Standards Board, or FASB, issued FASB Interpretation
No. 46, Consolidation of Variable Interest Entities,
an Interpretation of ARB No. 51, or FIN 46.
FIN 46 requires variable interest entities to be
consolidated by the primary beneficiary of the entity. An entity
is considered a variable interest entity if the equity investors
in the entity do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for
the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46
is effective for all new variable interest entities created or
acquired after January 31, 2003. For variable interest
entities created or acquired

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##### Table of Contents



prior to February 1, 2003, the provisions of
FIN 46 were to be applied at the end of periods ending
after June 15, 2003. In October 2003, the FASB issued a
FASB Draft Position on FIN 46, delaying the effective date
of FIN 46 to periods ending after December 15, 2003,
but encouraging early adoption. We early-adopted FIN 46 on
June 29, 2003.


Pursuant to the guidelines of FIN 46, we
concluded that the lessor in our synthetic leases was a variable
interest entity and that we were the primary beneficiary of the
variable interest entity. As such, we were required to
consolidate the variable interest lessor beginning on
June 29, 2003. Additionally, since each of the other
lessees involved with this lessor had a variable interest in
specified assets and liabilities of the variable interest
lessor, we were only required to consolidate the specific
assets, liabilities, and operating results associated with our
synthetic leases. As a result of the early adoption of
FIN 46, we recorded a non-cash charge of approximately
$62.8 million, net of tax, in the third quarter of fiscal
2003 as a cumulative effect of a change in accounting principle
in accordance with Accounting Principles Board Opinion
No. 20, Accounting Changes. The gross charge
represents approximately $95.8 million of pre-tax
depreciation that would have been recorded had we consolidated
these assets from inception of the leases. As a result of the
adoption of FIN 46 and the exercise of our option to
purchase the properties subject to the synthetic leases in
September 2003, property and equipment increased on a net basis
by approximately $360.6 million and notes receivable and
other non-current assets decreased by $456.4 million. The
purchase of these properties in September 2003 eliminated our
interest in the variable interest entity.

The consolidation of the variable interest
entities and subsequent purchase of the facilities previously
accounted for as synthetic leases increased our depreciation
expense by approximately $8.5 million per quarter and
decreased both our rent expense and interest income by
approximately $3.0 million per quarter from historical
levels, which decreased our quarterly earnings per share by
approximately $0.04. The adoption of FIN 46 and the
exercise of our purchase option had no impact on our liquidity.



| |                          
| | -------------------------
| | Standby Letters of Credit

We provide standby letters of credit to certain
parties as required for certain transactions we initiated during
the ordinary course of business. As of December 31, 2003,
the maximum potential amount of future payments that we could be
required to make under these letters of credit was approximately
$4.8 million. We have not recorded any liability in
connection with these arrangements beyond that required to
appropriately account for the underlying transaction being
guaranteed. We do not believe, based on historical experience
and information currently available, that it is probable that
any amounts will be required to be paid under these arrangements.



| |                       
| | ----------------------
| | Guarantee Arrangements

We also have additional guarantee arrangements on
behalf of certain of our consolidated subsidiaries. These
guarantee arrangements are for line-of-credit borrowings,
overdrafts and operating leases. The available credit facilities
with various financial institutions total $31.3 million.
These credit facilities bear interest at various rates, expire
on various dates through December 2004 and are used for general
corporate purposes. As of December 31, 2003, our
subsidiaries had $13.0 million outstanding under the lines
of credit at an annual weighted-average interest rate of 1.2%,
which, on a consolidated basis, we will be required to repay. In
the event of default of these facilities by our subsidiaries,
such arrangements would be guaranteed by us to a maximum
exposure of $29.9 million as of December 31, 2003. As of
December 31, 2002, amounts outstanding under these lines of
credit were $2.8 million, at an annual weighted-average
interest rate of 1.4%.

In addition, certain subsidiaries have lease
arrangements, which we guarantee. These leases will expire
between 2004 and 2010. In the event that our subsidiaries do not
make the required payments, we could be required to pay the
leases on their behalf. The annual lease obligations under these
arrangements are included in our consolidated minimum lease
payments table below. As of December 31, 2003, we have not
recorded any liability related to guarantees of subsidiary
obligations. Based on historical experience and information
currently available to us, we do not expect that it is probable
any amounts will be required to be paid under these guarantee
arrangements.

26



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##### Table of Contents



Contractual Obligations

We have non-cancelable operating leases for
various facilities. Rent expense was approximately
$13.1 million, $10.4 million and $16.9 million
for the years ended December 31, 2003, 2002 and 2001,
respectively, net of sublease income of $7.9 million,
$7.4 million and $7.2 million, respectively. Certain
of the operating leases contain renewal options, at our
discretion, at the end of the lease terms.

The following is a table summarizing future
minimum lease payments under all non-cancelable operating
leases, with initial or remaining terms in excess of one year.
We had no other significant commitments as of December 31,
2003 (in thousands):

|                                |  |                           |        |          |  |      |        |      |  |      |        |            |  |        |       |       |  |   |       |  |  |   |        |  |  |   |         |   |  |   |        | 
|------------------------------- |  | ------------------------- | ------ | -------- |  | ---- | ------ | ---- |  | ---- | ------ | ---------- |  | ------ | ----- | ----- |  | - | ----- |  |  | - | ------ |  |  | - | ------- | - |  | - | ------ | 
|                                |  |                           |        |          |  |     
|                                |  | Years Ending December 31, |        |          |  |     
|                                |  |                           |        | Sublease |  | Net 
|                                |  | 2004                      |        | 2005     |  | 2006 |        | 2007 |  | 2008 |        | Thereafter |  | Income |       | Total
|                                |  |                           |        |          |  |      |        |      |  |      |        |            |  |        |       |      
|Non-cancelable operating leases |  | $                         | 14,042 |          |  | $    | 13,188 |      |  | $    | 11,644 |            |  | $      | 6,982 |       |  | $ | 7,082 |  |  | $ | 46,781 |  |  | $ | (21,147 | ) |  | $ | 78,572 | 

Purchase orders or contracts for the purchase of
raw materials and other goods and services are not included in
the table above. Based upon the agreements with our
manufacturing suppliers, we do not have firm purchase
commitments. However, in order to reduce our manufacturing lead
times and ensure adequate levels of inventory on hand, we place
cancelable orders based upon our build forecasts. We are not
able to determine the aggregate amount of such purchase orders
that represent contractual obligations, as purchase orders may
represent authorizations to purchase rather than binding
agreements. For the purposes of this table, contractual
obligations for purchase of goods or services are defined as
agreements that are enforceable and legally binding on Novellus
and that specify all significant terms, including: fixed or
minimum quantities to be purchased; fixed, minimum or variable
price provisions; and the approximate timing of the transaction.
Our purchase orders generally contain clauses allowing for
cancellation without significant penalty. In the event we modify
or cancel open orders with our manufacturing suppliers, we could
be required to reimburse the suppliers for all or for a portion
of the order amount in accordance with the terms of our
contractual agreements. Our policy with respect to all purchase
commitments is to record losses, if any, when they are probable
and reasonably estimable. We have made adequate provision for
potential exposure related to inventory on order which may go
unused.

Related Parties

In March 2002, we began leasing an aircraft from
NVLS I, LLC, a third-party entity wholly owned by
Richard S. Hill, our Chairman and Chief Executive Officer.
Under the aircraft lease agreement, we incurred lease expense of
$0.8 million and $0.2 million for the years ended
December 31, 2003 and 2002, respectively.

A member of our Board of Directors, D. James
Guzy, is also a member of the Board of Directors of Intel
Corporation, which is one of our significant customers. Intel
Corporation represented approximately 12%, 11% and 16% of net
sales for the years ended December 31, 2003, 2002 and 2001,
respectively. Intel Corporation also accounted for 6% and 18% of
our accounts receivable as of December 31, 2003 and 2002,
respectively.

From time to time we have made secured and
unsecured relocation loans to our executive officers, vice
presidents and key personnel. As of December 31, 2003, we
do not have any outstanding loans to our executive officers as
defined by the Securities and Exchange Commission. However, we
do have outstanding loans to certain non-executive vice
presidents and key personnel. As of December 31, 2003 and
2002, the total outstanding balance of loans to non-executive
vice presidents and key personnel was approximately
$5.7 million and $6.0 million, respectively. Of the
amount outstanding at December 31, 2003, $4.8 million
was secured by collateral. Excluding relocation loans, all other
loans bear interest. We have not realized material bad debts
related to the loans to our personnel.

Recent Accounting Pronouncements

In May 2003, the FASB, issued SFAS No. 150,
Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, or SFAS
No. 150. SFAS No. 150 establishes standards for the
classification and measurement of financial instruments with
characteristics of both liabilities and equity.

27



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SFAS No. 150 became effective for three
types of financial instruments entered into or modified after
May 31, 2003. The adoption of SFAS No. 150 does not
have a material impact on our results of operations or financial
condition.


Forward-Looking Statements

The following information should be read in
conjunction with Part I, Item 1. Business,
Part II, Item 7. Managements Discussion
and Analysis of Financial Condition and Results of
Operations, and Part II, Item 8.
Consolidated Financial Statements and notes thereto
included in this Annual Report. This Annual Report on
Form 10-K and certain information incorporated herein by
reference contain forward-looking statements within the
safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements in
this Annual Report on Form 10-K include, without limitation:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Statements about the growth of the semiconductor
    industry; market size, share and demand (particularly demand for
    corporate and consumer electronic devices); product performance;
    our expectations, objectives, anticipations, intentions and
    strategies regarding the future; expected operating results,
    revenues and earnings; and current and potential litigation,
    which statements are subject to various uncertainties,
    including, without limitation, those discussed in
    Item 7. Managements Discussion and Analysis of
    Financial Condition and Results of Operations  Risk
    Factors;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| |  | The statements under the heading
    Item 1. Business concerning (1) the
    semiconductor industrys migration to the use of copper and
    low-k dielectrics and (2) the growing importance of the
    surface preparation and CMP manufacturing steps, which
    statements are subject to various risks and uncertainties,
    including, without limitation, the failure of our expectations
    regarding the future direction of the semiconductor industry and
    our failure to combine the recently-acquired product offerings
    of GaSonics International Corporation and SpeedFam-IPEC, Inc.
    with our offerings;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | The statements under the heading
    Item 1. Business  Industry
    Background regarding our beliefs that (1) unit demand
    for semiconductor devices will continue to increase;
    (2) the next generation of chips will likely see line
    widths as small as 90 nanometers and below; (3) there
    will be a transition from aluminum to copper conductive
    material; (4) there will be a transition from silicon oxide
    films to low-k dielectric insulators; and (5) there is a
    trend toward larger wafer sizes, which statements are subject to
    various risks and uncertainties, including, without limitation,
    periodic downturns in the semiconductor industry, slowdowns in
    the rate of capital investment by semiconductor manufacturers,
    shifts in demand from expensive, high-performance products to
    lower priced, conventional products, and the failure of our
    expectations regarding the future direction of the semiconductor
    industry;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | The statements under the heading
    Item 1. Business  Strategy,
    concerning (1) our objective to increase our market share
    in the interconnect manufacturing market and strengthen our
    position as a leading supplier of semiconductor processing
    equipment; (2) our emphasis on high-productivity systems;
    (3) our focus on reducing customer costs; (4) our
    service differentiation philosophy; (5) our goal to lead in
    our target markets; (6) our goal to broaden our
    interconnect offerings; (7) our focus on major
    semiconductor manufacturers; (8) our intention to expand
    our market presence in Asia; and (9) our intention to
    leverage our low cost manufacturing structure, which statements
    are subject to various risks and uncertainties, including,
    without limitation, shifts in demand from expensive,
    high-performance products to lower priced, conventional
    products, resulting in reduced profit for semiconductor
    manufacturers, the current and other periodic downturns in the
    semiconductor industry and the economy in general, slowdowns in
    the rate of capital investment by semiconductor manufacturers
    and future product developments, introductions by competitors,
    increased competition in the semiconductor equipment industry,
    and risks and uncertainties associated with international
    operations, including economic downturns, trade balance issues,
    political instability, banking issues, fluctuations in interest
    and foreign currency exchange rates, and slower economic
    development in Asia;
|
| |  | The statements under the heading
    Item 1. Business  Products of our
    beliefs regarding our products, including (1) that Concept
    Two enables increased production throughput and system                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | capability; (2) that Concept Three offers
    greater throughput in 300mm wafer-manufacturing applications;
    (3) that Concept Three SPEED offers minimal risk to our
    customers in making the transition from 200mm to 300mm volume
    chipmaking; (4) that Concept Two ALTUS is ideal for meeting
    the requirements of high-volume, automated 200mm wafer fabs
    producing semiconductor devices at 0.18 micron and below;
    (5) that the INOVA 200mm system will continue to gain
    market acceptance based on barrier seed step coverage
    performance; (6) that the 300mm INOVA xT with Hollow
    Cathode Magnetron or HCM will continue to offer superior barrier
    performance; (7) that our Electrofill products are highly
    reliable and cost-effective; (8) the increasing importance
    of photoresist strip and clean processes; (9) that IRIDIA
    offers the highest productivity of any 200 mm dry-clean system
    currently on the market; (10) that the opportunity to
    integrate and optimize the planarization, deposition and surface
    preparation steps gives us an important advantage in extending
    copper/low-k processes to advanced semiconductor devices; and
    (11) that MOMENTUM allows for maximum manufacturing
    flexibility, which statements are subject to various risks and
    uncertainties, including, among others, the inaccuracy of our
    assessment of the capabilities of our products, the greater
    financial, marketing, technical or other resources, broader
    product lines, greater customer service capabilities and larger
    and more established sales organizations and customer bases that
    some of our competitors possess, future competition from new
    market entrants our competitors improvement of the design
    and performance of their products that may offer superior price
    or performance features over our products, and difficulties in
    selecting, developing, manufacturing and marketing our new
    products or enhancing our existing products;
|
| |  | The statements under the heading
    Item 1. Business  Marketing, Sales and
    Service of our beliefs that (1) our strategy of
    supporting our installed base through customer support and
    R&D groups has accelerated penetration of certain key
    accounts; (2) our marketing efforts are enhanced by the
    technical expertise of our R&D personnel; and (3) our
    customer service is enhanced by the design simplicity of our
    systems, which statements are subject to certain risks and
    uncertainties, including, without limitation, that during
    periods of rapid growth, we may not be able to hire, assimilate
    and retain a sufficient number of qualified people and our
    failure to design simple, streamlined systems;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | Our statement under the heading
    Item 1. Business  Research and
    Development regarding our expectation that research and
    development expenditures will continue to represent a
    substantial percentage of sales, which statement is subject to
    certain risks and uncertainties, including, among others, that
    we may be unable to allocate substantial resources to research
    and development;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  | The statements under the heading
    Item 1. Business  Manufacturing
    regarding (1) our belief that our outsourcing strategy
    enables us to minimize our fixed costs and capital expenditures
    while also providing the flexibility to increase capacity as
    needed and allows us to focus on product differentiation through
    system design and quality control; (2) our belief that the
    use of manufacturing specialists for our subsystems incorporate
    the most advanced technologies in robotics, gas panels and
    microcomputers; (3) our goal to work with suppliers to
    achieve mutual cost reduction through joint design efforts; and
    (4) our goal of reduced dependence on limited suppliers for
    certain key parts, which statements are subject to various risks
    and uncertainties, including, without limitation, the possible
    occurrence of a disruption or termination of certain limited
    source suppliers, our prolonged inability to obtain certain
    components our failure to work efficiently with supplies, and
    our inability to establish relationships with alternative
    suppliers of key parts;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | The statement under the heading
    Item 1. Business  Competition
    regarding our belief as to our favorable competitiveness in our
    market segments, which statement is subject to various risks and
    uncertainties, including, among others, the greater financial,
    marketing, technical or other resources, broader product lines,
    greater customer service capabilities and larger and more
    established sales organizations and customer bases that some of
    our competitors possess, future competition from new market
    entrants from overseas and domestic sources, our
    competitors improvement of the design and performance of
    their products that may offer superior price or performance
    features as compared to our products, and our success in
    selecting, developing, manufacturing and marketing our new
    products or enhancing our existing products;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The statements under the heading
    Item 1. Business  Patents and Proprietary
    Rights regarding our beliefs and intentions (1) to
    pursue the legal protection of our technology primarily through
    patent and trade secret protection; (2) to file additional
    patent applications; (3) to vigorously protect our
    intellectual property rights; (4) that the outcomes of
    current litigation will not have a material impact on our
    business; and (5) that in the future, litigation may be
    necessary to enforce patents issued to us, to protect trade
    secrets or know-how owned by us or to defend us against claimed
    infringement of the rights of others and to determine the scope
    and validity of the proprietary rights of others, which
    statements are subject to various risks and uncertainties,
    including, without limitation, the absence of assurance that
    patents will be issued from any of our pending applications or
    that any claims allowed from existing or pending patents will be
    sufficiently broad to protect our technology, the fact that
    litigation could result in substantial cost and diversion of our
    effort and the fact that adverse litigation determinations could
    result in a loss of our proprietary rights, subject us to
    significant liabilities to third parties, require us to seek
    licenses from third parties or prevent us from manufacturing or
    selling our products;
|
| |  | The statements under the heading
    Item 1. Business  Employees that our
    success depends upon (1) our ability to recruit and retain
    engineers and technicians, marketing, sales, service and other
    key personnel and (2) the retention of a limited number of
    key employees and other members of our senior management, which
    statements are subject to risks and uncertainties, including,
    among others, our inability to successfully retain or recruit
    key personnel and our inability to effectively manage growth;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | The statement under the heading
    Item 1. Business  Environmental
    Matters that neither compliance with federal, state and
    local provisions regulating discharge of materials into the
    environment nor remedial agreements or other environmental
    actions is expected to have a material affect on our capital
    expenditures, financial condition, results of operations or
    competitive position, which statement is subject to various
    risks and uncertainties, including, among others, that we have
    inaccurately assessed the compliance requirements of
    environmental provisions;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|
| |  | The statement under the heading
    Item 2. Properties of our belief that our
    current properties will be sufficient to meet our requirements
    for the foreseeable future is subject to various risks and
    uncertainties, including, without limitation, growth in net
    sales placing unexpected strains on our resources and properties;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | The statements under the headings
    Item 3. Legal Proceedings and
    Item 8. Financial Statements and Supplementary
    Data  Notes to Consolidated Financial
    Statements  Note 11. Litigation of our
    beliefs (1) that there are meritorious defenses in the
    Applied Materials, Inc., Semitool, Inc., Plasma Physics
    Corporation, Solar Physics Corporation and Linear Technology
    Corporation litigation matters, and (2) regarding the
    outcome of, and the impact on our business, financial condition,
    or results of operations of, the Applied, Semitool, Plasma
    Physics, Solar Physics and Linear Technology litigation matters,
    which statements are subject to various uncertainties,
    including, without limitation, our inability to accurately
    predict the determination of complex issues of fact and law;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | The statements under the heading
    Item 7. Managements Discussion and Analysis of
    Financial Condition and Results of Operations 
    Critical Accounting Policies regarding calculation of
    allowances, reserves, and other estimates that are based on
    historical experience, the judgment of management, and various
    other assumptions that are believed to be reasonable under the
    circumstances, the results of which form the basis for making
    judgments about the carrying values of assets and liabilities
    that are not readily apparent from other sources, our beliefs
    about critical accounting policies, and the significant
    judgments and estimates used in the preparation of our
    consolidated financial statements, which statements are subject
    to certain risks, including, among others, the inaccuracy of our
    beliefs regarding critical accounting policies and that actual
    product failure rates, material usage, installation costs,
    customer reserves or other estimates may be different from our
    estimates, requiring revisions to the Companys estimated
    doubtful account allowances, additional inventory write-downs,
    restructuring charges, litigation, warranty, and other reserves;                                                                                                                                                                                                               

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The statements under the heading
    Item 7. Managements Discussion and Analysis of
    Financial Condition and Results of Operations 
    Results of Operations of our strategies, beliefs, plans,
    expectations, anticipations and hopes with respect to Net Sales,
    Gross Profit, Selling, General and Administrative, Research and
    Development, Acquired In-Process Research and Development,
    Restructuring and Other Charges, Bad Debt (Recovery) Write-off,
    Other Income, net, Provision for Income Taxes, Deferred Tax
    Asset, Foreign Currency Accounting and Foreign Exchange
    Contracts including, without limitation, (1) our belief
    that an increase in demand for our products during the fourth
    quarter of 2003 could be an indication of the beginning of an
    industry recovery; (2) our plan to continue our R&D
    commitment to improvement of new products and enhancement of our
    current product lines; (3) our belief that significant
    investment in R&D is required to remain competitive;
    (4) our belief regarding an estimated cost savings of
    approximately $9.1 million in 2004 resulting from the
    restructuring plan implemented in 2003;
    (5) managements beliefs regarding the realization due
    to anticipated future taxable income of the benefits of the net
    operating loss and tax credit carryforwards;
    (6) managements beliefs regarding the realization of
    deferred tax assets; (7) the belief that our forward
    foreign exchange contracts do not subject us to speculative risk
    that would otherwise result from changes in currency exchange
    rates; and our strategies, beliefs, plans, expectations,
    anticipations and hopes with respect to Liquidity and Capital
    Resources set forth under Item 7. Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations  Liquidity and Capital Resources,
    including, without limitation, (1) our beliefs regarding
    the impact of the adoption of SFAS No. 150; (2) our
    belief that we will not be required to pay any amounts under
    standby letters of credit arrangements; (3) our belief that
    we will not be required to pay any amounts under additional
    guarantee arrangements on behalf of our consolidated
    subsidiaries; and (4) our belief that our current cash
    position, cash generated through operations and equity
    offerings, and available borrowings will be sufficient to meet
    our needs through at least the next twelve months, which
    statements are subject to numerous risks and uncertainties,
    including, without limitation, our inability to allocate
    substantial resources to R&D programs, the inaccuracy of our
    beliefs regarding taxes, foreign exchange contracts, the impact
    of certain accounting standards and our synthetic leases, that
    the semiconductor industry will continue to experience this or
    another periodic downturn, which could have a material adverse
    effect on the semiconductor industrys demand for
    semiconductor processing equipment, including equipment we
    manufacture and market, and our success in selecting,
    developing, manufacturing and marketing our new products, or
    enhancing our existing products;
|
| |  | The statements under the heading
    Item 7A. Quantitative and Qualitative Disclosures
    About Market Risk  Interest Rate Risk that we
    believe that an immediate change to interest rates to variable
    short-term borrowings will not have a material effect on our
    results, and under the heading Item 7A. Quantitative
    and Qualitative Disclosures About Market Risk 
    Foreign Currency Risk that we do not anticipate using
    options to hedge anticipated and uncommitted transactions to
    minimize the impact of foreign currency fluctuations on our
    results of operations, are subject to the risk, among other
    risks, that we have inaccurately assessed our future borrowing
    needs; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | The statements in Item 8. Financial
    Statements and Supplementary Data  Notes to
    Consolidated Financial Statements  Note 2.
    Significant Accounting Policies  Concentration of
    Credit and Other Risks that (1) we believe that the
    effects of applying SFAS No. 123 on pro forma disclosures
    are not likely to be representative of the effects on pro forma
    disclosures of future years; and (2) we do not believe that
    there is a significant risk of nonperformance by counterparties
    on foreign exchange contracts are subject to the risk, among
    other risks, that we may fail to continuously monitor our
    positions and the credit ratings of counterparties; and our
    statement in Item 8. Financial Statements and
    Supplementary Data  Notes to Consolidated Financial
    Statements  Note 6. Goodwill and Other
    Intangible Assets that we believe our estimated
    amortization expense for the identifiable intangible assets for
    each of the next five years will be approximately
    $2.9 million per year is subject to the risk that we have
    inaccurately assessed our amortization expense due to unforeseen
    future events or non-events.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

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Risk Factors

Set forth below and elsewhere in this Annual
Report on Form 10-K, including in Item 7.
Managements Discussion and Analysis, and in other
documents we file with the Securities and Exchange Commission,
are risks and uncertainties that could cause actual results to
differ materially from the results contemplated by the
forward-looking statements contained in this Annual Report.



| |                                                     
| | ----------------------------------------------------
| | Cyclical Downturns in the Semiconductor
    Industry

Our business depends predominantly on the capital
expenditures of semiconductor manufacturers, which in turn
depend on current and anticipated market demand for integrated
circuits and the products that use them. The semiconductor
industry has historically been very cyclical and has experienced
periodic downturns that have had a material adverse effect on
the demand for semiconductor processing equipment, including
equipment that we manufacture and market. During periods of
reduced and declining demand, we must be able to quickly and
effectively align our costs with prevailing market conditions,
as well as motivate and retain key employees. In particular, our
inventory levels during periods of reduced demand have at times
reached higher-than-necessary levels relative to the current
levels of production demand. We cannot provide any assurance
that we may not be required to make inventory valuation
adjustments in future periods. During periods of rapid growth,
we must be able to acquire and/or develop sufficient
manufacturing capacity to meet customer demand, and hire and
assimilate a sufficient number of qualified people. We cannot
give assurances that our net sales and operating results will
not be adversely affected if the current downturn in the
semiconductor industry continues, or if other downturns or
slowdowns in the rate of capital investment in the semiconductor
industry occur in the future.



| |                                                                              
| | -----------------------------------------------------------------------------
| | The Semiconductor Industry is Intensely
    Competitive and Capital-Intensive

We face substantial competition in the industry,
from both potential new market entrants as well as established
competitors. Some companies may have greater financial,
marketing, technical or other resources than we do, as well as
broader product lines, greater customer service capabilities, or
larger and more established sales organizations and customer
bases. Remaining competitive in the market depends in part upon
our ability to develop new and enhanced systems and to introduce
them at competitive prices on a timely basis. Our customers must
incur substantial expenditures to install and integrate capital
equipment into their semiconductor production lines. Once a
manufacturer has selected a vendors capital equipment for
a particular product line, the manufacturer is likely to
continue with the selected equipment vendor for that specific
application at that location. Accordingly, we may experience
difficulty in selling a product to a particular customer for a
significant period of time after that customer has selected a
competitors product. In addition, sales of our systems
depend in significant part upon a prospective customers
decision to increase or expand manufacturing
capacity  both of which typically involve a
significant capital commitment. From time to time, we have
experienced delays in finalizing system sales following initial
system qualification. Due to these and other factors, our
systems typically have a lengthy sales cycle, during which we
may expend substantial funds and management effort.



| |                            
| | ---------------------------
| | Rapidly Changing Technology

We devote a significant portion of our personnel
and financial resources to research and development programs,
and we seek to maintain close relationships with our customers
in order to remain responsive to their product needs. As is
typical in the semiconductor capital equipment market, we have
experienced delays from time to time in the introduction of and
certain technical and manufacturing difficulties with certain of
our products and product enhancements. In addition, we may
experience delays and technical and manufacturing difficulties
in future introductions or volume production of our new systems
or enhancements.

Our success in developing, introducing and
selling new and enhanced systems depends upon a variety of
factors, including product selection, timely and efficient
completion of product design and development and implementation
of manufacturing and assembly processes, product performance in
the field, and effective sales and marketing. There can be no
assurance that we will be successful in selecting, developing,
manufacturing

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and marketing new products, or in enhancing our
existing products. In addition, we could incur substantial
unanticipated costs to ensure the functionality and reliability
of our future product introductions early in their product life
cycles. If new products have reliability or quality problems,
reduced orders, or higher manufacturing costs, delays in
collecting accounts receivable and additional service and
warranty expenses may result. Any of these events could
materially adversely affect our business, financial condition or
results of operations.




| |                         
| | ------------------------
| | International Operations

Export sales currently account for a significant
portion of our net sales. This trend is expected to continue in
the foreseeable future. As a result, a significant portion of
our sales is subject to certain risks, including, but not
limited to:



| |   |                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Tariffs and other trade barriers;                                                                                                                                                                                                                                   
|
| |  | Challenges in staffing and managing foreign
    operations;                                                                                                                                                                                                         
|
| |  | Difficulties in managing foreign distributors;                                                                                                                                                                                                                      
|
| |  | Potentially adverse tax consequences;                                                                                                                                                                                                                               
|
| |  | Imposition of legislation and regulations
    relating to the import or export of semiconductor products,
    either by the United States or other countries;                                                                                                       
|
| |  | Periodic economic downturns;                                                                                                                                                                                                                                        
|
| |  | Political instability; and                                                                                                                                                                                                                                          
|
| |  | Fluctuations in interest and foreign currency
    exchange rates, creating the need to enter into forward foreign
    exchange contracts to hedge against the short-term impact of
    foreign currency fluctuations, specifically yen-denominated
    transactions.

There can be no assurance that any of these
factors or the adoption of restrictive policies will not have a
material adverse effect on our business, financial condition or
results of operations. In addition, each region in the global
semiconductor equipment market exhibits unique market
characteristics that can cause capital equipment investment
patterns to vary significantly from period to period. We derive
a substantial portion of our revenues from customers in Asia.
Any negative economic developments in Asia could result in the
cancellation or delay by Asian customers of orders for our
products, which could adversely affect our business, financial
condition or results of operations.



| |                                               
| | ----------------------------------------------
| | Variability of Quarterly Operating
    Results

We have experienced and expect to continue
experiencing significant fluctuations in our quarterly operating
results. These fluctuations are due to a number of factors that
include, but are not limited to:



| |   |                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Building our systems according to forecast, and
    not using limited backlog information, which hinders our ability
    to plan production and inventory levels;                                                                      
|
| |  | Failure to receive anticipated orders in time to
    permit shipment during the quarter;                                                                                                                                               
|
| |  | Customers rescheduling or canceling shipments;                                                                                                                                                                                         
|
| |  | Manufacturing difficulties;                                                                                                                                                                                                            
|
| |  | Customers deferring orders of our existing
    products due to new product announcements by us and/or our
    competitors;                                                                                                             
|
| |  | Overall business conditions in the semiconductor
    equipment industry; and                                                                                                                                                           
|
| |  | Variations in quarterly operating results or
    changes in analysts earnings estimates which may subject
    the price of our common stock to wide fluctuations and possible
    rapid increases or decreases in a short time period.

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| |             
| | ------------
| | Acquisitions

We have madeand may in the future
makeacquisitions of or significant investments in
businesses with complementary products, services and/or
technologies. Acquisitions involve numerous risks, including,
but not limited to:



| |   |                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Difficulties in integrating the operations,
    technologies, products and personnel of acquired companies;                                              
|
| |  | Lack of synergies or the inability to realize
    expected synergies;                                                                                    
|
| |  | Revenue and expense levels of acquired entities
    differing from those anticipated at the time of the acquisitions;                                    
|
| |  | Difficulties in managing geographically dispersed
    operations;                                                                                        
|
| |  | The potential loss of key employees, customers
    and strategic partners of acquired companies;                                                         
|
| |  | Diversion of managements attention from
    normal daily operations of the business; and                                                                
|
| |  | The impairment of acquired intangible assets as a
    result of technological advancements, or worse-than-expected
    performance of acquired companies.

Acquisitions are inherently risky, and we cannot
provide any assurance that our previous or future acquisitions
will be successful. The inability to effectively manage the
risks associated with previous or future acquisitions could
materially and adversely affect our business, financial
condition or results of operations.



| |                                                                          
| | -------------------------------------------------------------------------
| | A Large Portion of Net Sales is Derived
    from Sales to a Few Customers

We currently sell a significant proportion of our
systems in any particular period to a limited number of
customers, and we expect that sales of our products to
relatively few customers will continue to account for a high
percentage of our net sales in the foreseeable future. In
addition, we believe that sales to certain of our customers will
decrease in the near future as they complete current purchasing
requirements for new or expanded fabrication facilities.
Although the composition of the group comprising our largest
customers varies from year to year, the loss of a significant
customer or any reduction in orders from any significant
customer  including reductions due to customer
departures from recent buying patterns, as well as economic or
competitive conditions in the semiconductor
industry  could adversely affect our business,
financial condition or results of operations.



| |                      
| | ---------------------
| | Intellectual Property

We intend to continue to seek legal protection,
primarily through patents and trade secrets, for our proprietary
technology. There can be no assurance that patents will be
issued from any pending applications, or that any claims allowed
from existing or pending patents will be sufficiently broad to
protect our proprietary technology. There is also no guarantee
that any patents we hold will not be challenged, invalidated or
circumvented, or that the rights granted thereunder will provide
competitive advantages to us. We also cannot provide assurance
that the confidentiality agreements we enter into with
employees, consultants and other parties will not be breached.

We are currently involved in a number of legal
disputes regarding patent and other intellectual property
rights. Except as set forth in Part II: Other Information,
Item 1: Legal Proceedings in this document, we are not
aware of any significant claim of infringement by our products
of any patent or proprietary rights of others. Adverse outcomes
in current or future legal disputes could result in the loss of
our proprietary rights, subject the company to significant
liabilities to third parties, require us to seek licenses from
third parties, or prevent us from manufacturing or selling our
products. Any of these circumstances could have a material
adverse effect on our business, financial condition or results
of operations.

34



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| |                 
| | ----------------
| | Supply Shortages

We use numerous suppliers to obtain parts,
components and sub-assemblies for the manufacture and support of
our products. Although we make reasonable efforts to ensure that
such parts are available from multiple suppliers, certain key
parts may only be obtained from a single or limited sources.
These suppliers are in some cases thinly capitalized,
independent companies who derive a significant amount of their
business from us and/or a small group of other companies in the
semiconductor industry. We seek to reduce our dependence on this
limited group of suppliers. However, disruption or termination
of certain of these suppliers may occur. Such disruptions could
have an adverse effect on our operations. A prolonged inability
to obtain certain parts could have a material adverse effect on
our business, financial condition or results of operations, and
could result in our inability to meet customer demands on time.



| |                            
| | ---------------------------
| | Third-Party Indemnification

From time to time, in the normal course of
business, we indemnify third parties with whom we enter into
contractual relationships, including customers, lessors, and
parties to other transactions with us, with respect to certain
matters. We have agreed, under certain conditions, to hold these
third parties harmless against specified losses, such as those
arising from a breach of representations or covenants, other
third party claims that our products when used for their
intended purposes infringe the intellectual property rights of
such other third parties or other claims made against certain
parties. It is not possible to determine the maximum potential
amount of liability under these indemnification obligations due
to our limited history of prior indemnification claims and the
unique facts and circumstances that are likely to be involved in
each particular claim. Historically, payments made by us under
these obligations have not been material.




Item 7A.Quantitative
and Qualitative Disclosures About Market Risk

Interest Rate Risk

Our exposure to market risk for changes in
interest rates relates primarily to our investment portfolio and
short-term debt obligations. We do not use derivative financial
instruments in our investment portfolio. We place our
investments with high credit quality issuers and, by policy,
limit the amount of credit exposure with any one issuer.

We mitigate default risk by investing in only the
safest and highest credit quality securities and by monitoring
the credit rating of investment issuers. The portfolio includes
only marketable securities with active secondary or resale
markets to ensure portfolio liquidity. We have no material cash
flow exposure due to rate changes for cash equivalents and
short-term investments.

The majority of our short-term obligations have
fixed interest rates. Therefore, our results are only affected
by the interest rate changes to variable rate short-term
borrowings. Due to the short-term nature of these borrowings, an
immediate change to interest rates is not expected to have a
material effect on our results.

35



---



##### Table of Contents



The table below presents principal amounts and
related weighted average interest rates by year of maturity for
our investment portfolio and debt obligations and the fair value
of each as of December 31, 2003 and 2002. All of our
available-for-sale investments and debt securities mature within
two years from the original purchase or issuance date.

|             |                             |                        |   |         |       |              |   |        |       |  |   |           |       |  |   |           |  | 
|------------ | --------------------------- | ---------------------- | - | ------- | ----- | ------------ | - | ------ | ----- |  | - | --------- | ----- |  | - | --------- |  | 
|             |                             |                        |   |         |       |             
|             |                             | Periods of Maturity    |   |         |       | Fair Value  
|             |                             |                        |   |         |       | December 31,
|             |                             | 2004                   |   | 2005    |       | Total        |   | 2003  
|             |                             |                        |   |         |       |              |   |       
|             |                             |                       
|             |                             | (Dollars in thousands)
|Assets:      |                             |                        |   |         |       |              |   |        |       |  |   |           |       |  |   |          
|             | Cash equivalents            |                        | $ | 497,178 |       |              | $ |       |       |  | $ | 497,178   |       |  | $ | 497,178   | 
|             |                             | Average interest rate  |   |         | 1.05% |              |   |        |      |  |   |           | 1.05% |  |   |           |  | 
|             | Short-term investments      |                        | $ | 411,216 |       |              | $ | 93,738 |       |  | $ | 504,954   |       |  | $ | 504,954   | 
|             |                             | Average interest rate  |   |         | 1.35% |              |   |        | 1.71% |  |   |           | 1.42% |  |   |           |  | 
|             | Restricted investments      |                        | $ | 2,861   |       |              | $ |       |       |  | $ | 2,861     |       |  | $ | 2,861     | 
|             |                             | Average interest rate  |   |         | 1.03% |              |   |        |      |  |   |           | 1.03% |  |   |           |  | 
|             | Total investment securities |                        | $ | 911,255 |       |              | $ | 93,738 |       |  | $ | 1,004,993 |       |  | $ | 1,004,993 | 
|             |                             | Average interest rate  |   |         | 1.19% |              |   |        | 1.71% |  |   |           | 1.24% |  |   |           |  | 
|Liabilities: |                             |                        |   |         |       |              |   |        |       |  |   |           |       |  |   |          
|             | Short-term borrowings       |                        | $ | 13,023  |       |              | $ |       |       |  | $ | 13,023    |       |  | $ | 13,023    | 
|             |                             | Average interest rate  |   |         | 1.20% |              |   |        |      |  |   |           | 1.20% |  |   |           |  | 

|             |                             |                        |   |           |       |              |   |        |       |  |   |           |       |  |   |           |  | 
|------------ | --------------------------- | ---------------------- | - | --------- | ----- | ------------ | - | ------ | ----- |  | - | --------- | ----- |  | - | --------- |  | 
|             |                             |                        |   |           |       |             
|             |                             | Periods of Maturity    |   |           |       | Fair Value  
|             |                             |                        |   |           |       | December 31,
|             |                             | 2003                   |   | 2004      |       | Total        |   | 2002  
|             |                             |                        |   |           |       |              |   |       
|             |                             |                       
|             |                             | (Dollars in thousands)
|Assets:      |                             |                        |   |           |       |              |   |        |       |  |   |           |       |  |   |          
|             | Cash equivalents            |                        | $ | 615,844   |       |              | $ |       |       |  | $ | 615,844   |       |  | $ | 615,844   | 
|             |                             | Average interest rate  |   |           | 1.36% |              |   |        |      |  |   |           | 1.36% |  |   |           |  | 
|             | Short-term investments      |                        | $ | 385,793   |       |              | $ | 18,015 |       |  | $ | 403,808   |       |  | $ | 403,808   | 
|             |                             | Average interest rate  |   |           | 2.04% |              |   |        | 1.92% |  |   |           | 2.03% |  |   |           |  | 
|             | Restricted investments      |                        | $ | 58,995    |       |              | $ |       |       |  | $ | 58,995    |       |  | $ | 58,995    | 
|             |                             | Average interest rate  |   |           | 0.32% |              |   |        |      |  |   |           | 0.32% |  |   |           |  | 
|             | Total investment securities |                        | $ | 1,060,632 |       |              | $ | 18,016 |       |  | $ | 1,078,648 |       |  | $ | 1,078,648 | 
|             |                             | Average interest rate  |   |           | 1.55% |              |   |        | 1.92% |  |   |           | 1.55% |  |   |           |  | 
|Liabilities: |                             |                        |   |           |       |              |   |        |       |  |   |           |       |  |   |          
|             | Short-term borrowings       |                        | $ | 119,236   |       |              | $ |       |       |  | $ | 119,236   |       |  | $ | 119,236   | 
|             |                             | Average interest rate  |   |           | 6.14% |              |   |        |      |  |   |           | 6.14% |  |   |           |  | 

Foreign Currency Risk

We transact business in various foreign
countries. Our primary foreign currency cash flows are in Asia
and Europe. During 2003 and 2002, we utilized foreign currency
forward exchange contracts to hedge foreign currency-denominated
balance sheet positions. Under this program, increases or
decreases in currency commitments and balance sheet positions,
as translated into U.S. dollars, were primarily offset by
realized gains and losses on the hedging instruments. Our
subsidiary, SpeedFam-IPEC, used currency options contracts to
hedge a portion of the anticipated and uncommitted transactions
that were expected to be denominated in foreign currencies. Upon
the maturity of these contracts, we do not anticipate using
options to hedge anticipated and uncommitted transactions. The
goal of the hedging program is to minimize the impact of foreign
currency fluctuations on our results of operations. We do not
use foreign currency forward exchange contracts for speculative
or trading purposes.

36



---



##### Table of Contents



All of our unsettled foreign currency contracts
are marked-to-market, with unrealized gains and losses included
as a component of other income and expense. The following table
provides information as of December 31, 2003 and 2002 about
our derivative financial instruments, which are comprised of
predominantly foreign currency forward exchange contracts. The
information is provided in U.S. dollar equivalent amounts, as
presented in our consolidated financial statements. The table
below presents the notional amounts (at the contract exchange
rates), the weighted-average contractual foreign currency
exchange rates, and the estimated fair value of those contracts.

|                                             |                  |                                                  |        |               |   |                   |  |          |  |   |        |        |  
|-------------------------------------------- | ---------------- | ------------------------------------------------ | ------ | ------------- | - | ----------------- |  | -------- |  | - | ------ | ------ | -
|                                             |                  |                                                 
|                                             |                  | December 31, 2003                               
|                                             |                  |                                                 
|                                             |                  | Notional Amount                                  |        | Average       |   | Estimated Fair   
|                                             |                  | (Buy) Sell                                       |        | Contract Rate |   | Value-Gain (Loss)
|                                             |                  |                                                  |        |               |   |                  
|                                             |                  |                                                 
|                                             |                  | (In thousands, except for average contract rate)
|Foreign currency forward exchange contracts: |                  |                                                  |        |               |   |                   |  |          |  |   |        |       
|                                             | Japanese yen     |                                                  | $      | 34,991        |   |                   |  | 111.56   |  |   | $      | (3,026 | )
|                                             | British pound    |                                                  |        | (4,346        | ) |                   |  | 0.57     |  |   |        | 11     |  
|                                             | Euro             |                                                  |        | (8,136        | ) |                   |  | 0.81     |  |   |        | 8      |  
|                                             | Singapore dollar |                                                  |        | (7,410        | ) |                   |  | 1.71     |  |   |        | (4     | )
|                                             | Taiwanese dollar |                                                  |        | (10,868       | ) |                   |  | 33.95    |  |   |        | (23    | )
|                                             | Korean won       |                                                  |        | (9,627        | ) |                   |  | 1,193.30 |  |   |        | 38     |  
|                                             |                  |                                                  |        |               |   |                   |  |          |  |   |        |       
|                                             |                  | $                                                | (5,396 | )             |   |                   |  |          |  | $ | (2,996 | )     
|                                             |                  |                                                  |        |               |   |                   |  |          |  |   |        |       

|                                             |                  |                                                  |         |               |   |                   |  |          |  |   |     |     |  
|-------------------------------------------- | ---------------- | ------------------------------------------------ | ------- | ------------- | - | ----------------- |  | -------- |  | - | --- | --- | -
|                                             |                  |                                                 
|                                             |                  | December 31, 2002                               
|                                             |                  |                                                 
|                                             |                  | Notional Amount                                  |         | Average       |   | Estimated Fair   
|                                             |                  | (Buy) Sell                                       |         | Contract Rate |   | Value-Gain (Loss)
|                                             |                  |                                                  |         |               |   |                  
|                                             |                  |                                                 
|                                             |                  | (In thousands, except for average contract rate)
|Foreign currency forward exchange contracts: |                  |                                                  |         |               |   |                   |  |          |  |   |     |    
|                                             | Japanese yen     |                                                  | $       | 18,460        |   |                   |  | 118.33   |  |   | $   | 817 |  
|                                             | British pound    |                                                  |         | (4,140        | ) |                   |  | 0.64     |  |   |     | (8  | )
|                                             | Euro             |                                                  |         | (2,417        | ) |                   |  | 0.99     |  |   |     | 3   |  
|                                             | Singapore dollar |                                                  |         | (4,563        | ) |                   |  | 1.76     |  |   |     | (7  | )
|                                             | Taiwanese dollar |                                                  |         | (21,957       | ) |                   |  | 34.86    |  |   |     | 72  |  
|                                             | Korean won       |                                                  |         | (7,914        | ) |                   |  | 1,215.25 |  |   |     | 21  |  
|                                             | Chinese yuan     |                                                  |         | (493          | ) |                   |  | 8.27     |  |   |     |    |  
|                                             |                  |                                                  |         |               |   |                   |  |          |  |   |     |    
|                                             |                  | $                                                | (23,024 | )             |   |                   |  |          |  | $ | 898 |    
|                                             |                  |                                                  |         |               |   |                   |  |          |  |   |     |    

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

NOVELLUS SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |         |      |      | 
|--------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------------------------------------------------------------ | ----------------------------------- | ------- | ----- | ----- | ------- | ------- | ---- | ---- | --------- | ------- | ---- | ---- | 
|                                                                                                                            |                                              |                                                                               
|                                                                                                                            |                                              | Years Ended December 31,                                                      
|                                                                                                                            |                                              |                                                                               
|                                                                                                                            |                                              | 2003                                                                           |                                     | 2002    |       | 2001 
|                                                                                                                            |                                              |                                                                                |                                     |         |       |      
|                                                                                                                            |                                              |                                                                               
|                                                                                                                            |                                              | (In thousands, except per share data)                                         
|Net sales                                                                                                                   |                                              | $                                                                              | 925,070                             |         |       | $     | 839,958 |         |      | $    | 1,339,322 |        
|Cost of sales                                                                                                               |                                              |                                                                                | 545,070                             |         |       |       | 461,435 |         |      |      | 647,971   |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Gross profit                                                                                                                |                                              |                                                                                | 380,000                             |         |       |       | 378,523 |         |      |      | 691,351   |        
|Operating expenses:                                                                                                         |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|                                                                                                                            | Selling, general and administrative          |                                                                                |                                     | 165,618 |       |       |         | 154,172 |      |      |           | 198,567 |     
|                                                                                                                            | Research and development                     |                                                                                |                                     | 227,439 |       |       |         | 222,344 |      |      |           | 272,032 |     
|                                                                                                                            | Acquired in-process research and development |                                                                                |                                     |        |       |       |         | 9,003   |      |      |           |        |     
|                                                                                                                            | Restructuring and other charges              |                                                                                |                                     | 18,529  |       |       |         | 6,467   |      |      |           | 61,106  |     
|                                                                                                                            | Bad debt write-off (recovery)                |                                                                                |                                     |        |       |       |         | (7,662  | )    |      |           | 7,662   |     
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Total operating expenses                                                                                                    |                                              |                                                                                | 411,586                             |         |       |       | 384,324 |         |      |      | 539,367   |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Operating income (loss), net                                                                                                |                                              |                                                                                | (31,586                             | )       |       |       | (5,801  | )       |      |      | 151,984   |        
|Other income (expense):                                                                                                     |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|                                                                                                                            | Interest income                              |                                                                                |                                     | 17,272  |       |       |         | 41,851  |      |      |           | 64,297  |     
|                                                                                                                            | Interest expense                             |                                                                                |                                     | (909    | )     |       |         | (1,020  | )    |      |           | (1,146  | )   
|                                                                                                                            | Other, net                                   |                                                                                |                                     | (97     | )     |       |         | (12,110 | )    |      |           | (5,758  | )   
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Other income, net                                                                                                           |                                              |                                                                                | 16,266                              |         |       |       | 28,721  |         |      |      | 57,393    |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Income (loss) before provision
    (benefit) for income taxes and cumulative effect of a
    change in accounting principle |                                              |                                                                                | (15,320                             | )       |       |       | 22,920  |         |      |      | 209,377   |        
|Provision (benefit) for income taxes                                                                                        |                                              |                                                                                | (10,286                             | )       |       |       |        |         |      |      | 64,907    |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Income (loss) before cumulative effect of a
    change in accounting principle                                              |                                              |                                                                                | (5,034                              | )       |       |       | 22,920  |         |      |      | 144,470   |        
|Cumulative effect of a change in accounting
    principle, net of tax                                                       |                                              |                                                                                | (62,780                             | )       |       |       |        |         |      |      |          |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Net income (loss)                                                                                                           |                                              | $                                                                              | (67,814                             | )       |       | $     | 22,920  |         |      | $    | 144,470   |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Net income (loss) per share:                                                                                                |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|                                                                                                                            | Basic                                        |                                                                                |                                     |         |       |       |         |         |      |      |           |         |     
|                                                                                                                            |                                              | Income (loss) before cumulative effect of a
    change in accounting principle |                                     | $       | (0.03 | )     |         | $       | 0.16 |      |           | $       | 1.01 |     
|                                                                                                                            |                                              | Cumulative effect of a change in accounting
    principle                      |                                     |         | (0.42 | )     |         |         |     |      |           |         |     |     
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|                                                                                                                            |                                              |                                                                                | Basic net income (loss) per share   |         | $     | (0.45 | )       |         | $    | 0.16 |           |         | $    | 1.01 | 
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|                                                                                                                            | Diluted                                      |                                                                                |                                     |         |       |       |         |         |      |      |           |         |     
|                                                                                                                            |                                              | Income (loss) before cumulative effect of a
    change in accounting principle |                                     | $       | (0.03 | )     |         | $       | 0.15 |      |           | $       | 0.97 |     
|                                                                                                                            |                                              | Cumulative effect of a change in accounting
    principle                      |                                     |         | (0.42 | )     |         |         |     |      |           |         |     |     
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|                                                                                                                            |                                              |                                                                                | Diluted net income (loss) per share |         | $     | (0.45 | )       |         | $    | 0.15 |           |         | $    | 0.97 | 
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Shares used in basic per share calculations                                                                                 |                                              |                                                                                | 150,680                             |         |       |       | 144,371 |         |      |      | 142,462   |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        
|Shares used in diluted per share calculations                                                                               |                                              |                                                                                | 150,680                             |         |       |       | 148,748 |         |      |      | 148,924   |        
|                                                                                                                            |                                              |                                                                                |                                     |         |       |       |         |         |      |      |           |        

See accompanying Notes to the Consolidated
Financial Statements.

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NOVELLUS SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                           |                                                                                                                                      |                           |           |           |           |   |           |           |           | 
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------ | ------------------------- | --------- | --------- | --------- | - | --------- | --------- | --------- | 
|                                           |                                                                                                                                      |                          
|                                           |                                                                                                                                      | December 31,             
|                                           |                                                                                                                                      |                          
|                                           |                                                                                                                                      | 2003                      |           | 2002     
|                                           |                                                                                                                                      |                           |           |          
|                                           |                                                                                                                                      |                          
|                                           |                                                                                                                                      | (In thousands)           
|ASSETS                                    
|Current assets:                            |                                                                                                                                      |                           |           |           |           |   |           |          
|                                           | Cash and cash equivalents                                                                                                            |                           | $         | 497,178   |           |   | $         | 615,844   |          
|                                           | Short-term investments                                                                                                               |                           |           | 504,954   |           |   |           | 403,808   |          
|                                           | Accounts receivable, net of allowance for
    doubtful
    accounts                 of
    $7,655 in 2003 and $7,339 in 2002         |                           |           | 231,760   |           |   |           | 192,862   |          
|                                           | Inventories                                                                                                                          |                           |           | 199,100   |           |   |           | 257,358   |          
|                                           | Deferred tax assets, net                                                                                                             |                           |           | 126,901   |           |   |           | 119,699   |          
|                                           | Prepaid and other current assets                                                                                                     |                           |           | 12,095    |           |   |           | 44,363    |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|                                           |                                                                                                                                      | Total current assets      |           |           | 1,571,988 |   |           |           | 1,633,934 | 
|Property and equipment, net                |                                                                                                                                      |                           | 506,567   |           |           |   | 179,926   |          
|Notes receivable                           |                                                                                                                                      |                           |          |           |           |   | 397,429   |          
|Goodwill                                   |                                                                                                                                      |                           | 173,267   |           |           |   | 163,136   |          
|Intangible and other assets                |                                                                                                                                      |                           | 87,078    |           |           |   | 119,569   |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|Total assets                               |                                                                                                                                      | $                         | 2,338,900 |           |           | $ | 2,493,994 |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|LIABILITIES AND SHAREHOLDERS
    EQUITY  
|Current liabilities:                       |                                                                                                                                      |                           |           |           |           |   |           |          
|                                           | Accounts payable                                                                                                                     |                           | $         | 53,537    |           |   | $         | 71,218    |          
|                                           | Accrued payroll and related expenses                                                                                                 |                           |           | 25,197    |           |   |           | 36,748    |          
|                                           | Accrued warranty                                                                                                                     |                           |           | 28,805    |           |   |           | 31,002    |          
|                                           | Other accrued liabilities                                                                                                            |                           |           | 43,406    |           |   |           | 53,723    |          
|                                           | Income taxes payable                                                                                                                 |                           |           | 10,293    |           |   |           | 14,070    |          
|                                           | Deferred profit                                                                                                                      |                           |           | 46,821    |           |   |           | 55,613    |          
|                                           | Current obligations under lines of credit                                                                                            |                           |           | 13,023    |           |   |           | 2,799     |          
|                                           | Convertible subordinated debentures                                                                                                  |                           |           |          |           |   |           | 116,437   |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|                                           |                                                                                                                                      | Total current liabilities |           |           | 221,082   |   |           |           | 381,610   | 
|Deferred income tax liabilities            |                                                                                                                                      |                           |          |           |           |   | 19,502    |          
|Other liabilities                          |                                                                                                                                      |                           | 45,958    |           |           |   | 37,194    |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|Total liabilities                          |                                                                                                                                      |                           | 267,040   |           |           |   | 438,306   |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|Commitments and contingencies              |                                                                                                                                      |                           |           |           |           |   |           |          
|Shareholders equity:                      |                                                                                                                                      |                           |           |           |           |   |           |          
|                                           | Preferred stock, no par value; authorized
    shares  10,000; issued and outstanding
    shares  none                              |                           |           |          |           |   |           |          |          
|                                           | Common stock, no par value; authorized
    shares  240,000; issued and outstanding
    shares  152,899 in 2003 and 149,119 in 2002 |                           |           | 1,565,926 |           |   |           | 1,487,281 |          
|                                           | Retained earnings                                                                                                                    |                           |           | 501,362   |           |   |           | 570,153   |          
|                                           | Accumulated other comprehensive income (loss)                                                                                        |                           |           | 4,572     |           |   |           | (1,746    | )        
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|Total shareholders equity                 |                                                                                                                                      |                           | 2,071,860 |           |           |   | 2,055,688 |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          
|Total liabilities and shareholders equity |                                                                                                                                      | $                         | 2,338,900 |           |           | $ | 2,493,994 |          
|                                           |                                                                                                                                      |                           |           |           |           |   |           |          

See accompanying Notes to the Consolidated
Financial Statements.

39



---



##### Table of Contents



NOVELLUS SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |   |        |        |          |  
|------------------------------------------------------------------ | ------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------- | -------------------------------------------- | ----- | ------ | ---------- | - | ------- | ------ | ---------- | - | ------ | ------ | -------- | -
|                                                                   |                                                                                             |                                                                                                                                
|                                                                   |                                                                                             | Years Ended December 31,                                                                                                       
|                                                                   |                                                                                             |                                                                                                                                
|                                                                   |                                                                                             | 2003                                                                                                                            |                                                           | 2002                                         |       | 2001  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |       
|                                                                   |                                                                                             |                                                                                                                                
|                                                                   |                                                                                             | (In thousands)                                                                                                                 
|Cash flows from operating
    activities:                          |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Net income (loss)                                                  |                                                                                             | $                                                                                                                               | (67,814                                                   | )                                            |       | $      | 22,920     |   |         | $      | 144,470    |  
|                                                                   | Adjustment to reconcile net income (loss) to
    net cash provided by operating activities: |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |   |       
|                                                                   |                                                                                             |                                                                                                                                 | Write-off of debt issuance costs                          |                                              |       | 616    |            |   |         | 17,047 |            |   |        |       |         
|                                                                   |                                                                                             |                                                                                                                                 | (Gain) loss on sale/impairment of equity
    investments  |                                              |       |       |            |   |         | (4,602 | )          |   |        | 8,556  |         
|                                                                   |                                                                                             |                                                                                                                                 | Cumulative effect of a change in accounting
    principle |                                              |       | 62,780 |            |   |         |       |            |   |        |       |         
|                                                                   |                                                                                             |                                                                                                                                 | Non-cash portion of restructuring and other
    charges   |                                              |       | 51,895 |            |   |         |       |            |   |        | 25,501 |         
|                                                                   |                                                                                             |                                                                                                                                 | Bad debt write-off (recovery)                             |                                              |       |       |            |   |         | (7,662 | )          |   |        | 7,662  |         
|                                                                   |                                                                                             |                                                                                                                                 | Adjustment to conform fiscal year end of GaSonics         |                                              |       |       |            |   |         |       |            |   |        | 1,714  |         
|                                                                   |                                                                                             |                                                                                                                                 | Depreciation and amortization                             |                                              |       | 69,570 |            |   |         | 44,310 |            |   |        | 51,934 |         
|                                                                   |                                                                                             |                                                                                                                                 | Amortization of deferred compensation                     |                                              |       | 3,329  |            |   |         | 1,626  |            |   |        | 1,451  |         
|                                                                   |                                                                                             |                                                                                                                                 | Acquired in-process research and development              |                                              |       |       |            |   |         | 9,003  |            |   |        |       |         
|                                                                   |                                                                                             |                                                                                                                                 | Income tax benefits from employee stock plans             |                                              |       |       |            |   |         | 19,427 |            |   |        | 25,037 |         
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Changes in operating assets and liabilities: |       |        |            |   |         |        |            |   |        |        |          |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Accounts receivable                          |       |        | (38,898    | ) |         |        | 58,341     |   |        |        | 167,713  |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Inventories                                  |       |        | 9,824      |   |         |        | 19,912     |   |        |        | (50,079  | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Deferred income taxes                        |       |        | (14,677    | ) |         |        | 3,346      |   |        |        | 55,860   |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Prepaid and other current assets             |       |        | 22,535     |   |         |        | 42,706     |   |        |        | (66,511  | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Accounts payable                             |       |        | (17,588    | ) |         |        | (4,021     | ) |        |        | (55,706  | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Accrued payroll and related expenses         |       |        | (11,551    | ) |         |        | (2,809     | ) |        |        | (36,000  | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Accrued warranty                             |       |        | (2,197     | ) |         |        | (13,599    | ) |        |        | (8,006   | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Other accrued liabilities                    |       |        | (12,772    | ) |         |        | (11,995    | ) |        |        | 11,073   |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Income taxes payable                         |       |        | (3,116     | ) |         |        | 6,186      |   |        |        | (54,502  | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           | Deferred profit                              |       |        | (8,792     | ) |         |        | 14,778     |   |        |        | (153,078 | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Net cash provided by operating activities                          |                                                                                             |                                                                                                                                 | 43,144                                                    |                                              |       |        | 214,914    |   |         |        | 77,089     |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Cash flows from investing
    activities:                          |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Purchases of short-term investments                                |                                                                                             |                                                                                                                                 | (1,600,519                                                | )                                            |       |        | (2,028,463 | ) |         |        | (2,293,771 | )
|Proceeds from sales and maturities of short-term
    investments   |                                                                                             |                                                                                                                                 | 1,498,644                                                 |                                              |       |        | 2,956,991  |   |         |        | 1,599,183  |  
|Capital expenditures                                               |                                                                                             |                                                                                                                                 | (31,135                                                   | )                                            |       |        | (26,776    | ) |         |        | (79,965    | )
|Decrease (increase) in intangible and other
    assets             |                                                                                             |                                                                                                                                 | 3,690                                                     |                                              |       |        | 9,407      |   |         |        | (7,443     | )
|Increase in synthetic lease collateral                             |                                                                                             |                                                                                                                                 |                                                          |                                              |       |        | (177,458   | ) |         |        | (244,673   | )
|Cash acquired from SpeedFam-IPEC acquisition, net                  |                                                                                             |                                                                                                                                 |                                                          |                                              |       |        | 43,462     |   |         |        |           |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Net cash provided (used in) by investing
    activities            |                                                                                             |                                                                                                                                 | (129,320                                                  | )                                            |       |        | 777,163    |   |         |        | (1,026,669 | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Cash flows from financing
    activities:                          |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Proceeds (repayments) from convertible
    subordinated debentures |                                                                                             |                                                                                                                                 | (117,053                                                  | )                                            |       |        | (879,750   | ) |         |        | 862,400    |  
|Proceeds from employee stock compensation plans                    |                                                                                             |                                                                                                                                 | 75,651                                                    |                                              |       |        | 54,434     |   |         |        | 45,469     |  
|Proceeds (repayments) from lines of credit,
    net                |                                                                                             |                                                                                                                                 | 10,224                                                    |                                              |       |        | (23,380    | ) |         |        | 4,577      |  
|Repurchases of common stock                                        |                                                                                             |                                                                                                                                 | (1,312                                                    | )                                            |       |        | (78,177    | ) |         |        | (1,641     | )
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Net cash provided (used in) by financing
    activities            |                                                                                             |                                                                                                                                 | (32,490                                                   | )                                            |       |        | (926,873   | ) |         |        | 910,805    |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Net increase (decrease) in cash and cash
    equivalents           |                                                                                             |                                                                                                                                 | (118,666                                                  | )                                            |       |        | 65,204     |   |         |        | (38,775    | )
|Cash and cash equivalents at the beginning of the
    year         |                                                                                             |                                                                                                                                 | 615,844                                                   |                                              |       |        | 550,640    |   |         |        | 589,415    |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Cash and cash equivalents at the end of the year                   |                                                                                             | $                                                                                                                               | 497,178                                                   |                                              |       | $      | 615,844    |   |         | $      | 550,640    |  
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|Supplemental disclosures:                                          |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|                                                                   | Cash paid (received) during the year for:                                                   |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |   |       
|                                                                   |                                                                                             | Interest                                                                                                                        |                                                           | $                                            | 909   |        |            | $ | 204     |        |            | $ | 1,146  |       
|                                                                   |                                                                                             | Income taxes, net                                                                                                               |                                                           | $                                            | 6,321 |        |            | $ | (63,329 | )      |            | $ | 63,201 |       
|                                                                   | Non-cash financing activities:                                                              |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |   |       
|                                                                   |                                                                                             | Issuance of common stock and stock options
    related to SpeedFam-IPEC acquisition, net of deferred
    compensation of $3,104 |                                                           | $                                            |      |        |            | $ | 166,736 |        |            | $ |       |       
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  
|                                                                   |                                                                                             | Subordinated debt assumed from SpeedFam-IPEC
    acquisition                                                                    |                                                           | $                                            |      |        |            | $ | 116,437 |        |            | $ |       |       
|                                                                   |                                                                                             |                                                                                                                                 |                                                           |                                              |       |        |            |   |         |        |            |  

See accompanying Notes to the Consolidated
Financial Statements.

40



---



##### Table of Contents



NOVELLUS SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |         |         |         | 
|---------------------------- | ---------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------- | ---------------------------------------------------------------- | -------------------- | - | ------------- | --------- | ------------- | - | ------ | ------- | ------- | ------- | - | ------- | - | ------ | ----- | --------- | ------- | ------- | ------- | ------- | 
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           | Accumulated   |   |       
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   | Other         |           |              
|                             |                                                                                                                  | Common Stock                                                         |                                                                  |                      |   | Comprehensive |           | Total        
|                             |                                                                                                                  |                                                                      |                                                                  | Retained             |   | Income        |           | Shareholders
|                             |                                                                                                                  | Shares                                                               |                                                                  | Amount               |   | Earnings      |           | (Loss)        |   | Equity
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |       
|                             |                                                                                                                  |                                                                     
|                             |                                                                                                                  | (In thousands)                                                      
|Balance at December 31, 2000 |                                                                                                                  |                                                                      | 140,601                                                          |                      |   | $             | 1,200,718 |               |   | $      | 453,250 |         |         | $ | (12,493 | ) |        | $     | 1,641,475 |        
|                             | Components of comprehensive income:                                                                              |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |        
|                             |                                                                                                                  | Net income                                                           |                                                                  |                      |  |               |           |               |  |        |         |         | 144,470 |   |         |   |       |       |           |         | 144,470 |        
|                             |                                                                                                                  | Net change in unrealized gains on
    available-for-sale securities  |                                                                  |                      |  |               |           |               |  |        |         |         |        |   |         |   | 7,988  |       |           |         | 7,988   |        
|                             |                                                                                                                  |                                                                      | Foreign currency translation adjustments                         |                      |   |              |           |               |   |       |         |         |         |  |         |   |        | 127   |           |         |         | 127     |        
|                             |                                                                                                                  |                                                                      | Other than temporary loss included in net income,
    net of tax |                      |   |              |           |               |   |       |         |         |         |  |         |   |        | 5,904 |           |         |         | 5,904   |        
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|                             |                                                                                                                  |                                                                      |                                                                  | Comprehensive income |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |         |         | 158,489 | 
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|                             | Issuance of common stock under employee
    compensation plans                                                   |                                                                      |                                                                  | 2,954                |   |               |           | 45,469        |   |        |         |        |         |   |         |  |        |       |           | 45,469  |        
|                             | Adjustment to conform to fiscal year end of
    GaSonics                                                         |                                                                      |                                                                  | 57                   |   |               |           | 851           |   |        |         | 863     |         |   |         |  |        |       |           | 1,714   |        
|                             | Issuance of restricted common stock                                                                              |                                                                      |                                                                  | 31                   |   |               |           |              |   |        |         |        |         |   |         |  |        |       |           |        |        
|                             | Amortization of deferred compensation                                                                            |                                                                      |                                                                  |                     |   |               |           | 1,451         |   |        |         |        |         |   |         |  |        |       |           | 1,451   |        
|                             | Income tax benefits realized from activity in
    employee stock plans                                           |                                                                      |                                                                  |                     |   |               |           | 25,037        |   |        |         |        |         |   |         |  |        |       |           | 25,037  |        
|                             | Repurchases of common stock                                                                                      |                                                                      |                                                                  | (37                  | ) |               |           | (325          | ) |        |         | (1,316  | )       |   |         |  |        |       |           | (1,641  | )      
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|Balance at December 31, 2001 |                                                                                                                  |                                                                      | 143,606                                                          |                      |   |               | 1,273,201 |               |   |        | 597,267 |         |         |   | 1,526   |   |        |       | 1,871,994 |        
|                             | Components of comprehensive income:                                                                              |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |        
|                             |                                                                                                                  | Net income                                                           |                                                                  |                      |  |               |           |               |  |        |         |         | 22,920  |   |         |   |       |       |           |         | 22,920  |        
|                             |                                                                                                                  | Net change in unrealized losses on
    available-for-sale securities |                                                                  |                      |  |               |           |               |  |        |         |         |        |   |         |   | (350   | )     |           |         | (350    | )      
|                             |                                                                                                                  | Foreign currency translation adjustments                             |                                                                  |                      |  |               |           |               |  |        |         |         |        |   |         |   | 714    |       |           |         | 714     |        
|                             |                                                                                                                  | Gain on sale of an equity investment, net of tax                     |                                                                  |                      |  |               |           |               |  |        |         |         |        |   |         |   | (3,636 | )     |           |         | (3,636  | )      
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|                             |                                                                                                                  |                                                                      | Comprehensive income                                             |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |         | 19,648  |        
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|                             | Issuance of common stock under employee
    compensation plans                                                   |                                                                      |                                                                  | 2,870                |   |               |           | 54,434        |   |        |         |        |         |   |         |  |        |       |           | 54,434  |        
|                             | Issuance of common stock and assumption of stock
    options in connection with the acquisition of SpeedFam-IPEC |                                                                      |                                                                  | 5,733                |   |               |           | 166,736       |   |        |         |        |         |   |         |  |        |       |           | 166,736 |        
|                             | Issuance of restricted common stock                                                                              |                                                                      |                                                                  | 100                  |   |               |           |              |   |        |         |        |         |   |         |  |        |       |           |        |        
|                             | Amortization of deferred compensation                                                                            |                                                                      |                                                                  |                     |   |               |           | 1,626         |   |        |         |        |         |   |         |  |        |       |           | 1,626   |        
|                             | Income tax benefits realized from activity in
    employee stock plans                                           |                                                                      |                                                                  |                     |   |               |           | 19,427        |   |        |         |        |         |   |         |  |        |       |           | 19,427  |        
|                             | Repurchases of common stock                                                                                      |                                                                      |                                                                  | (3,190               | ) |               |           | (28,143       | ) |        |         | (50,034 | )       |   |         |  |        |       |           | (78,177 | )      
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|Balance at December 31, 2002 |                                                                                                                  |                                                                      | 149,119                                                          |                      |   |               | 1,487,281 |               |   |        | 570,153 |         |         |   | (1,746  | ) |        |       | 2,055,688 |        
|                             | Components of comprehensive loss:                                                                                |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |        
|                             |                                                                                                                  | Net loss                                                             |                                                                  |                      |  |               |           |               |  |        |         |         | (67,814 | ) |         |   |       |       |           |         | (67,814 | )      
|                             |                                                                                                                  | Net change in unrealized gains on
    available-for-sale securities  |                                                                  |                      |  |               |           |               |  |        |         |         |        |   |         |   | 172    |       |           |         | 172     |        
|                             |                                                                                                                  | Foreign currency translation adjustments                             |                                                                  |                      |  |               |           |               |  |        |         |         |        |   |         |   | 6,146  |       |           |         | 6,146   |        
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|                             |                                                                                                                  |                                                                      | Comprehensive loss                                               |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |         |         | (61,496 | )      
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|                             | Issuance of common stock under employee
    compensation plans and other                                         |                                                                      |                                                                  | 3,696                |   |               |           | 75,651        |   |        |         |        |         |   |         |  |        |       |           | 75,651  |        
|                             | Issuance of restricted common stock, net                                                                         |                                                                      |                                                                  | 116                  |   |               |           |              |   |        |         |        |         |   |         |  |        |       |           |        |        
|                             | Amortization of deferred compensation                                                                            |                                                                      |                                                                  |                     |   |               |           | 3,329         |   |        |         |        |         |   |         |  |        |       |           | 3,329   |        
|                             | Repurchases of common stock                                                                                      |                                                                      |                                                                  | (32                  | ) |               |           | (335          | ) |        |         | (977    | )       |   |         |  |        |       |           | (1,312  | )      
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        
|Balance at December 31, 2003 |                                                                                                                  |                                                                      | 152,899                                                          |                      |   | $             | 1,565,926 |               |   | $      | 501,362 |         |         | $ | 4,572   |   |        | $     | 2,071,860 |        
|                             |                                                                                                                  |                                                                      |                                                                  |                      |   |               |           |               |   |        |         |         |         |   |         |   |        |       |           |        

See accompanying Notes to the Consolidated
Financial Statements.

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##### Table of Contents



NOVELLUS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|        |                            
|------- | ---------------------------
|Note 1. | Description of the Business

Novellus Systems, Inc. is a supplier of
semiconductor manufacturing equipment used in the fabrication of
integrated circuits. We are focused on delivering innovative
interconnect products and technologies that meet the
increasingly complex and demanding needs of the worlds
largest semiconductor manufacturers. The semiconductor
manufacturing equipment that we build, market and service
provides todays chipmakers with high productivity and low
cost of ownership.

As part of our growth strategy, from time to time
we make acquisitions. On December 6, 2002, we acquired
SpeedFam-IPEC, Inc., a global supplier of chemical
mechanical planarization (CMP) systems used in the
fabrication of advanced copper interconnects. The acquisition
was accounted for as a purchase business combination and
qualified as a tax-free reorganization under IRS regulations.
Our consolidated financial statements for fiscal 2002 include
the financial position, results of operations and cash flows of
SpeedFam-IPEC from date of acquisition.

On January 10, 2001, we acquired GaSonics
International Corporation, a developer and supplier of
photoresist and residue removal technologies. The transaction
was accounted for as a pooling-of-interests. Our financial
statements include the operations of GaSonics for all periods
presented. There were no transactions between GaSonics and
Novellus prior to the acquisition.



|        |                                
|------- | -------------------------------
|Note 2. | Significant Accounting Policies

Basis of
Presentation The
accompanying consolidated financial statements include our
accounts and the accounts of our wholly-owned subsidiaries after
elimination of all significant intercompany account balances and
transactions. Certain prior year amounts in the consolidated
financial statements and the notes thereto have been
reclassified to conform to the 2003 presentation.

Stock-Based
Compensation We account
for stock-based employee compensation using the intrinsic value
method under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, or APB
No. 25, and have adopted the disclosure-only provisions of
Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation, or
SFAS No. 123, as amended by SFAS No. 148,
Accounting for Stock-Based Compensation 
Transition and Disclosures. Accordingly, no expense has
been recognized for options granted to employees at fair value.
We amortize deferred stock-based compensation on the graded
vesting method over the vesting periods of the applicable stock
purchase rights and stock options, generally four years. The
graded vesting method provides for vesting of portions of the
overall awards at interim dates and results in greater expense
recorded in earlier years than the straight-line method.

SFAS No. 123 requires the use of option
pricing models that were not developed for use in valuing
employee stock options. The Black-Scholes option-pricing model
was developed for use in estimating the fair value of
short-lived exchange-traded options that have no vesting
restrictions and are fully transferable. In addition,
option-pricing models require the input of highly subjective
assumptions, including the options expected life and the
price volatility of the underlying stock. Since our employee
stock options have characteristics significantly different from
those of traded options and changes in the subjective input
assumptions can materially affect the fair value estimate, in
our opinion, the existing models do not necessarily provide a
reliable single measure of the fair value of employee stock
options.

42



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Had compensation expense been determined based on
the fair value at the grant date for awards, consistent with the
provisions of SFAS No. 123, we would have reported pro
forma net income (loss) and net income (loss) per share as
follows (in thousands, except per share data):

|                                              |                                                                                       |                          |          |         |   |      |         |         |   |   |         |         |  
|--------------------------------------------- | ------------------------------------------------------------------------------------- | ------------------------ | -------- | ------- | - | ---- | ------- | ------- | - | - | ------- | ------- | -
|                                              |                                                                                       |                         
|                                              |                                                                                       | Years Ended December 31,
|                                              |                                                                                       |                         
|                                              |                                                                                       | 2003                     |          | 2002    |   | 2001
|                                              |                                                                                       |                          |          |         |   |     
|Net income (loss) as reported                 |                                                                                       | $                        | (67,814  | )       |   | $    | 22,920  |         |   | $ | 144,470 |        
|Add back:                                     |                                                                                       |                          |          |         |   |      |         |         |   |   |         |        
|                                              | Intrinsic value method expense included in
    reported net income (loss), net of tax |                          |          | 2,186   |   |      |         | 1,178   |   |   |         | 1,175   |  
|Less:                                         |                                                                                       |                          |          |         |   |      |         |         |   |   |         |        
|                                              | Fair value method expense, net of tax                                                 |                          |          | (66,063 | ) |      |         | (70,232 | ) |   |         | (68,478 | )
|                                              |                                                                                       |                          |          |         |   |      |         |         |   |   |         |        
|Pro-forma net income (loss)                   |                                                                                       | $                        | (131,691 | )       |   | $    | (46,134 | )       |   | $ | 77,167  |        
|                                              |                                                                                       |                          |          |         |   |      |         |         |   |   |         |        
|Pro-forma basic net income (loss) per share   |                                                                                       | $                        | (0.87    | )       |   | $    | (0.32   | )       |   | $ | 0.53    |        
|Pro-forma diluted net income (loss) per share |                                                                                       | $                        | (0.87    | )       |   | $    | (0.32   | )       |   | $ | 0.49    |        

The fair value of each option grant is estimated
on the date of grant using the Black-Scholes option-pricing
model, with the following weighted-average assumptions for
grants made in 2003, 2002 and 2001:

|                        |  |      |            |      |  |      |            |  |  |  |            | 
|----------------------- |  | ---- | ---------- | ---- |  | ---- | ---------- |  |  |  | ---------- | 
|                        |  | 2003 |            | 2002 |  | 2001
|                        |  |      |            |      |  |     
|Dividend yield          |  |      | None       |      |  |      | None       |  |  |  | None       | 
|Expected volatility     |  |      | 78%        |      |  |      | 85%        |  |  |  | 85%        | 
|Risk free interest rate |  |      | 2.1%       |      |  |      | 3.1%       |  |  |  | 4.1%       | 
|Expected lives          |  |      | 3.6  years |      |  |      | 3.1  years |  |  |  | 3.3  years | 

The weighted-average fair value of options
granted during the year was $21.56, $17.67 and $22.85 for 2003,
2002 and 2001, respectively. The effects of applying
SFAS 123 on pro forma disclosures are not likely to be
representative of the effects on pro forma disclosures of future
years.

The pro forma net income (loss) and net income
(loss) per share listed above include expense related to our
employee stock purchase plans. The fair value of issuances under
the employee stock purchase plans is estimated on the date of
issuance using the Black-Scholes option-pricing model, with the
following weighted-average assumptions for issuances made in
2003, 2002 and 2001:

|                        |  |      |           |      |  |      |           |  |  |  |           | 
|----------------------- |  | ---- | --------- | ---- |  | ---- | --------- |  |  |  | --------- | 
|                        |  | 2003 |           | 2002 |  | 2001
|                        |  |      |           |      |  |     
|Dividend yield          |  |      | None      |      |  |      | None      |  |  |  | None      | 
|Expected volatility     |  |      | 47%       |      |  |      | 72%       |  |  |  | 81%       | 
|Risk free interest rate |  |      | 1.3%      |      |  |      | 2.0%      |  |  |  | 4.2%      | 
|Expected lives          |  |      | 1/2  year |      |  |      | 1/2  year |  |  |  | 1/2  year | 

The weighted average fair value of purchase
rights granted during the year was $9.52, $12.88 and $16.76 for
2003, 2002 and 2001, respectively.

Use of
Estimates The preparation
of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us
to make estimates and judgments that affect the reported amounts
of assets, liabilities, revenues and expenses and the related
disclosure of contingent assets and liabilities. We evaluate our
estimates on an ongoing basis, including those related to
revenue recognition, cash and investments, allowance for
doubtful accounts, inventory valuation, deferred tax assets,
property and equipment, goodwill and other intangible assets,
warranty obligations, restructuring and impairment charges,
contingencies and litigation and stock-based compensation. We
base our estimates on

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

historical experience and on various other
assumptions that are believed to be reasonable under the current
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. Our intent is
to accurately state our assets and liabilities given facts known
at the time of valuation. Our assumptions may prove incorrect as
facts change in the future. Actual results may differ materially
from these estimates under different assumptions or conditions.

Revenue
Recognition We recognize
revenue in accordance with SEC Staff Accounting Bulletin
No. 104, Revenue Recognition, or SAB 104,
which superseded the earlier related guidance in SAB
No. 101, Revenue Recognition in Financial
Statements, or SAB 101. We recognize revenue when
persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the sellers price
is fixed or determinable, and collectibility is reasonably
assured.

Certain of our product sales are accounted for as
multiple-element arrangements. A multiple-element arrangement is
a transaction which may involve the delivery or performance of
multiple products, services, or rights to use assets, and
performance may occur at different points in time or over
different periods of time. If we have met defined customer
acceptance experience levels with both the customer and the
specific type of equipment, we recognize equipment revenue upon
shipment and transfer of title, with the remainder generally
recognized at the later of completion of the installation
services or customer acceptance.

Installation services are not essential to the
functionality of the delivered equipment. We allocate revenue
based on the residual method as a fair value has been
established for installation services. However, since final
payment is not typically due until customer acceptance, we defer
revenue for the final payment, which is in excess of the fair
value of the installation services. All other equipment sales
are recognized upon customer acceptance.

Revenue related to sales of spare parts is
recognized upon shipment. Revenue related to maintenance and
service contracts is recognized ratably over the duration of the
contracts. Unearned maintenance and service contract revenue is
included in other accrued liabilities.

Cash, Cash Equivalents and Short-Term
Investments We consider
all highly liquid debt instruments with insignificant interest
rate risk and original maturities of ninety days or less to be
cash equivalents. Investments with original maturities greater
than three months and that mature within one year from the
balance sheet date are considered to be short-term investments.
Our short-term investments are classified as available-for-sale
and are reported at fair value, with unrealized gains and
losses, net of tax, recorded in shareholders equity. The
fair value of short-term investments is based on quoted market
prices. Realized gains and losses and declines in fair value
that are other than temporary are recorded in earnings when
realized. The cost of securities sold is based on the specific
identification method.

Allowance for Doubtful
Accounts We evaluate our
allowance for doubtful accounts based on a combination of
factors. In circumstances where we are aware of a specific
customers inability to meet its financial obligations, we
provide a specific allowance for bad debt against the amount due
to reduce the net recognized receivable to the amount we
reasonably believe will be collected. For all other customers,
we recognize an allowance for doubtful accounts based on a
certain percentage of total revenues, which is based on our
historical experience over the past five years. If circumstances
change (e.g. higher than expected defaults or an unexpected
material adverse change in a major customers ability to
meet its financial obligations), we may amend our estimates of
the recoverability of the outstanding balance.

Inventories and Inventory
Valuation Inventories are
stated at the lower of cost (first-in, first-out) or market. We
periodically assess the recoverability of all inventories,
including raw materials, work-in-process, finished goods, and
spare parts, to determine whether adjustments for impairment are
required. Inventory that is obsolete or in excess of our
forecasted usage is written down to its estimated realizable
value based on assumptions about future demand and market
conditions. If actual demand is lower than our forecast,
additional inventory write-downs may be required.

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Deferred Tax
Assets We record a
valuation allowance to reduce our deferred tax assets to the
amount that is more likely than not to be realized. The
valuation allowance at December 31, 2003 relates primarily
to acquired net operating loss carryforwards and foreign tax
credits that are not realizable until 2006 and beyond. The
valuation allowance includes $38.0 million related to
acquired deferred tax assets of SpeedFam-IPEC which will be
credited to goodwill when realized, and $26.5 million
related to stock option deductions which will be credited to
equity when realized. We have considered future taxable income
and ongoing prudent and feasible tax planning strategies in
assessing the need for the valuation allowance. If in the future
we determine that we would not be able to realize all or part of
our net deferred tax assets, an increase to the valuation
allowance for deferred tax assets would decrease income in the
period in which such determination was made.

Property and
Equipment Property and
equipment are stated at cost. Depreciation and amortization are
computed on the straight-line method over the following
estimated useful lives:

|                        |  |                                               
|----------------------- |  | ----------------------------------------------
|Machinery and equipment |  | 2 - 7 years                                   
|Furniture and fixtures  |  | 3 - 5 years                                   
|Buildings               |  | 30 - 40 years                                 
|Leasehold improvements  |  | Shorter of useful life or remaining lease term

Goodwill and Other Intangible
Assets We account for
goodwill and other intangible assets in accordance with
SFAS No. 142, Goodwill and Other Intangible
Assets, or SFAS No. 142. SFAS No. 142
requires that goodwill and identifiable intangible assets with
indefinite useful lives no longer be amortized, but instead be
tested for impairment at least annually. SFAS No. 142
also requires that intangible assets with estimable useful lives
be amortized over their respective estimated useful lives to
their estimated residual values, and reviewed for impairment in
accordance with SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets.

We review our long-lived assets, including
goodwill and other intangible assets, for impairment at least
annually or whenever events or changes in circumstances indicate
that the carrying amount of these assets may not be recoverable.
According to our policy, we completed goodwill impairment tests
in the third and fourth quarters of 2003. The test performed in
the third quarter was completed in connection with our
restructuring plan implemented in that quarter. Our annual
goodwill impairment test was completed in the fourth quarter.
The first step of the test identifies when impairment may have
occurred, while the second step of the test measures the amount
of the impairment, if any. The results of our impairment tests
did not indicate impairment. For further discussion, see
Note 6 to the Consolidated Financial Statements.

Warranty
Our warranty policy generally states that we will provide
warranty coverage for a predetermined amount of time on systems
and modules for material and labor to repair and service the
equipment. We record the estimated cost of warranty coverage to
cost of sales upon system shipment. The estimated cost of
warranty is determined by the warranty term as well as the
average historical labor and material costs for a specific
product. Should actual product failure rates or material usage
differ from our estimates, revisions to the estimated warranty
liability may be required. These revisions could have a positive
or negative impact on gross profit. We review the actual product
failure rates and material usage rates on a quarterly basis and
adjust our warranty liability as necessary.

Restructuring and Impairment
Charges Restructuring
activities initiated prior to December 31, 2002 were
recorded in accordance with Emerging Issues Task Force Issue
No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity
(Including Certain Costs Incurred in a Restructuring), and
restructuring activities after December 31, 2002 were
recorded under the provisions of SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities, or SFAS No. 146;
SFAS No. 112, Employers Accounting for
Postemployment Benefits; and SAB 100,
Restructuring and Impairment Charges.
SFAS No. 146 requires that a liability for costs
associated with an

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

exit or disposal activity be recognized when the
liability is incurred, rather than when the exit or disposal
plan is approved.

Certain restructuring charges related to asset
impairments are recorded in accordance with
SFAS No. 144 and SAB 100. Accordingly,
restructuring accruals are recorded when management initiates an
exit plan that will cause us to incur costs that have no future
economic benefit. The restructuring accrual related to vacated
facilities is calculated net of estimated sublease income.
Sublease income is estimated based on current market quotes for
similar properties. If we are unable to sublet the vacated
properties on a timely basis or if we are forced to sublet them
at lower rates due to changes in market conditions, we would
adjust the accruals accordingly.

Contingencies and
Litigation We assess the
probability of adverse judgments in connection with current and
threatened litigation. We would accrue the cost of an adverse
judgment if, in our estimation, the adverse outcome is probable
and we can reasonably estimate the ultimate cost. We have made
no such accruals as of December 31, 2003.

Foreign Currency
Translation For all of our
foreign subsidiaries, the local currency is the functional
currency. Accordingly, translation gains or losses related to
these foreign subsidiaries are included as a component of
accumulated other comprehensive income (loss).

Forward Foreign Exchange
Contracts Forward foreign
exchange contracts are used to hedge against the short-term
impact of foreign currency fluctuations on intercompany accounts
payable denominated in U.S. dollars recorded by our
Japanese subsidiary. We also enter into forward foreign exchange
contracts to buy and sell foreign currencies to hedge the
parents intercompany balances denominated in a currency
other than the U.S. dollar. In 2003 and 2002, these hedging
contracts were denominated primarily in the Japanese Yen, the
Taiwanese dollar, and the Korean Won. The forward foreign
exchange contracts we use are generally short-term in nature.
The effect of exchange rate changes on forward exchange
contracts is expected to offset the effect of exchange rate
changes on the underlying hedged items. We believe these
financial instruments do not subject us to speculative risk that
would otherwise result from changes in currency exchange rates.
All unsettled foreign currency contracts are marked-to-market,
with unrealized gains and losses included as a component of
other income and expense. Net foreign currency gains and losses
for effective and ineffective hedges have not been material to
our results of operations.

Advertising
Expenses We expense
advertising costs as incurred. Advertising expenses for 2003,
2002 and 2001 were $1.9 million, $2.7 million and
$4.7 million, respectively.

Concentration of Credit and Other
Risks We use financial
instruments that potentially subject us to concentrations of
credit risk. Such instruments include cash equivalents,
short-term investments, accounts receivable and financial
instruments used in hedging activities. We invest our cash in
cash deposits, money market funds, commercial paper,
certificates of deposit, readily marketable debt securities, or
medium-term notes. We place our investments with high-credit
quality financial institutions, which limits the credit exposure
from any one financial institution or instrument. To date, we
have not experienced significant losses on these investments.

We sell a significant portion of our systems to a
limited number of customers. System sales to our ten largest
customers in 2003, 2002 and 2001 accounted for 76%, 79% and 61%
of our total net sales, respectively. No customer accounted for
more than 10% of our accounts receivable as of December 31,
2003. One customer accounted for 18% of receivables at
December 31, 2002. We expect sales of our products to
relatively few customers will continue to account for a high
percentage of our total net sales in the foreseeable future.
None of our customers has entered into a long-term purchase
agreement that would require them to purchase our products. If
the financial condition or operations of these customers
deteriorate substantially, our operating results could be
adversely affected.

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

We perform ongoing credit evaluations of our
customers financial condition and generally require no
collateral. We have an exposure to nonperformance by
counterparties on the foreign exchange contracts used in hedging
activities. These counterparties are large international
financial institutions and to date, no such counterparty has
failed to meet its financial obligations to us. We do not
believe there is a significant risk of nonperformance by these
counterparties because we continuously monitor our positions,
the credit ratings of such counterparties, and the amount of
contracts we enter into with any one party. However, there can
be no assurance that there will be no significant nonperformance
by these counterparties and that this would not materially
adversely affect our business, financial condition, and results
of operations.



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In May 2003, the Financial Accounting Standards
Board, or FASB, issued SFAS No. 150, Accounting for
Certain Financial Instruments with Characteristics of both
Liabilities and Equity, or SFAS No. 150.
SFAS No. 150 establishes standards for the
classification and measurement of financial instruments with
characteristics of both liabilities and equity.
SFAS No. 150 became effective for three types of
financial instruments entered into or modified after
May 31, 2003. The adoption of SFAS No. 150 does
not have a material impact on our results of operations or
financial condition.



|        |                      
|------- | ---------------------
|Note 3. | Financial Instruments



| |                                                      
| | -----------------------------------------------------
| | Cash, Cash Equivalents and Short-term
    Investments

The following table presents the estimated fair
value of our short-term investments by investment grade (in
thousands):

|                                 |                                               |                                                             |         |         |           |   |         |         |           | 
|-------------------------------- | --------------------------------------------- | ----------------------------------------------------------- | ------- | ------- | --------- | - | ------- | ------- | --------- | 
|                                 |                                               |                                                            
|                                 |                                               | December 31,                                               
|                                 |                                               |                                                            
|                                 |                                               | 2003                                                        |         | 2002   
|                                 |                                               |                                                             |         |        
|Cash                             |                                               | $                                                           | (21,390 | )       |           | $ | 7,727   |        
|Institutional money market funds |                                               |                                                             | 477,500 |         |           |   | 565,694 |        
|Commercial paper                 |                                               |                                                             | 37,370  |         |           |   | 42,423  |        
|Agency securities                |                                               |                                                             | 3,698   |         |           |   |        |        
|                                 |                                               |                                                             |         |         |           |   |         |        
|                                 | Amounts included in cash and cash equivalents |                                                             |         | 497,178 |           |   |         | 615,844 |          
|U.S. Government agencies         |                                               |                                                             | 287,428 |         |           |   | 314,545 |        
|Municipal securities             |                                               |                                                             | 53,046  |         |           |   | 27,532  |        
|Commercial paper                 |                                               |                                                             | 6,980   |         |           |   | 25,783  |        
|Corporate securities             |                                               |                                                             | 52,534  |         |           |   | 18,653  |        
|Tax-exempt auction rate notes    |                                               |                                                             | 102,125 |         |           |   | 14,700  |        
|Mutual funds                     |                                               |                                                             | 2,841   |         |           |   | 2,595   |        
|                                 |                                               |                                                             |         |         |           |   |         |        
|                                 | Amounts included in short-term investments    |                                                             |         | 504,954 |           |   |         | 403,808 |          
|                                 |                                               |                                                             |         |         |           |   |         |        
|                                 |                                               | Total cash, cash equivalents and short-term
    investments |         | $       | 1,002,132 |   |         | $       | 1,019,652 | 
|                                 |                                               |                                                             |         |         |           |   |         |        

Unrealized gains (losses) on all securities were
not significant as of December 31, 2003 and 2002. All debt
securities held at December 31, 2003 are due in less than
two years.

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                                              
| | ---------------------------------------------
| | Fair Value of Other Financial
    Instruments

The carrying and estimated fair values of our
other financial instruments are as follows (in thousands):

|                                          |  |              |        |                |  |          |        |                |  |   |         |  |  |   |         | 
|----------------------------------------- |  | ------------ | ------ | -------------- |  | -------- | ------ | -------------- |  | - | ------- |  |  | - | ------- | 
|                                          |  |             
|                                          |  | December 31,
|                                          |  |             
|                                          |  |              |        |               
|                                          |  | 2003         |        | 2002          
|                                          |  |              |        |               
|                                          |  | Carrying     |        | Estimated Fair |  | Carrying |        | Estimated Fair
|                                          |  | Value        |        | Value          |  | Value    |        | Value         
|                                          |  |              |        |                |  |          |        |               
|Restricted investment  non-current       |  | $            | 2,861  |                |  | $        | 2,861  |                |  | $ | 58,995  |  |  | $ | 58,995  | 
|Notes receivable                          |  |              |       |                |  |          |       |                |  |   | 397,429 |  |  |   | 397,429 | 
|Current obligations under lines of credit |  |              | 13,023 |                |  |          | 13,023 |                |  |   | 2,799   |  |  |   | 2,799   | 
|Convertible subordinated debentures       |  |              |       |                |  |          |       |                |  |   | 116,437 |  |  |   | 116,437 | 

The fair values of our restricted investments are
based on quoted market prices as of December 31, 2003 and
2002, respectively. The fair value of our obligations under
lines of credit is based on current rates offered to us for
similar debt instruments of the same remaining maturities.



| |                                                      
| | -----------------------------------------------------
| | Financial Instruments with Off-Balance
    Sheet Risk

As part of our asset and liability management, we
enter into various types of transactions that involve financial
instruments with off-balance sheet risk. We enter into foreign
forward exchange contracts in order to manage foreign exchange
risk. The notional amounts, carrying amounts and estimated fair
values of our foreign currency forward exchange contracts are as
follows (in thousands):

|                              |  |              |        |          |  |            |        |          |  |          |        |            |  |   |         |   |  |   |     |  |  |   |     | 
|----------------------------- |  | ------------ | ------ | -------- |  | ---------- | ------ | -------- |  | -------- | ------ | ---------- |  | - | ------- | - |  | - | --- |  |  | - | --- | 
|                              |  |             
|                              |  | December 31,
|                              |  |             
|                              |  |              |        |         
|                              |  | 2003         |        | 2002    
|                              |  |              |        |         
|                              |  | Notional     |        | Carrying |  | Estimated  |        | Notional |  | Carrying |        | Estimated 
|                              |  | Amount       |        | Amount   |  | Fair Value |        | Amount   |  | Amount   |        | Fair Value
|                              |  |              |        |          |  |            |        |          |  |          |        |           
|Sell (buy) foreign currencies |  | $            | (5,396 | )        |  | $          | (2,996 | )        |  | $        | (2,996 | )          |  | $ | (23,024 | ) |  | $ | 898 |  |  | $ | 898 | 

The fair value of our foreign forward exchange
contracts is calculated based on quoted market prices or pricing
models using current market rates as of December 31, 2003
and 2002, respectively.



|        |                      
|------- | ---------------------
|Note 4. | Balance Sheet Details



| |            
| | -----------
| | Inventories

|                          |                   |                |         |         |  |   |         |         | 
|------------------------- | ----------------- | -------------- | ------- | ------- |  | - | ------- | ------- | 
|                          |                   |               
|                          |                   | December 31,  
|                          |                   |               
|                          |                   | 2003           |         | 2002   
|                          |                   |                |         |        
|                          |                   |               
|                          |                   | (In thousands)
|Purchased and spare parts |                   | $              | 146,399 |         |  | $ | 205,341 |        
|Work-in-process           |                   |                | 37,502  |         |  |   | 45,487  |        
|Finished goods            |                   |                | 15,199  |         |  |   | 6,530   |        
|                          |                   |                |         |         |  |   |         |        
|                          | Total inventories |                | $       | 199,100 |  |   | $       | 257,358 | 
|                          |                   |                |         |         |  |   |         |        

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                            
| | ---------------------------
| | Property and equipment, net

|                              |                              |                |         |         |  |  |         |         | 
|----------------------------- | ---------------------------- | -------------- | ------- | ------- |  |  | ------- | ------- | 
|                              |                              |               
|                              |                              | December 31,  
|                              |                              |               
|                              |                              | 2003           |         | 2002   
|                              |                              |                |         |        
|                              |                              |               
|                              |                              | (In thousands)
|Property and equipment:       |                              |                |         |         |  |  |         |        
|                              | Machinery and equipment      |                | $       | 530,925 |  |  | $       | 290,273 | 
|                              | Buildings and land           |                |         | 235,304 |  |  |         | 8,983   | 
|                              | Leasehold improvements       |                |         | 84,720  |  |  |         | 87,740  | 
|                              | Furniture and fixtures       |                |         | 19,628  |  |  |         | 19,725  | 
|                              |                              |                |         |         |  |  |         |        
|                              |                              |                | 870,577 |         |  |  | 406,721 |        
|Less accumulated depreciation |                              |                | 364,010 |         |  |  | 226,795 |        
|                              |                              |                |         |         |  |  |         |        
|                              | Total property and equipment |                | $       | 506,567 |  |  | $       | 179,926 | 
|                              |                              |                |         |         |  |  |         |        



| |                 
| | ----------------
| | Accrued warranty

Changes in our accrued warranty liability were as
follows (in thousands):

|                             |                                                                             |              |        |         |   |   |        |         |  
|---------------------------- | --------------------------------------------------------------------------- | ------------ | ------ | ------- | - | - | ------ | ------- | -
|                             |                                                                             |             
|                             |                                                                             | Years Ended 
|                             |                                                                             | December 31,
|                             |                                                                             |             
|                             |                                                                             | 2003         |        | 2002   
|                             |                                                                             |              |        |        
|Balance, beginning of period |                                                                             | $            | 31,002 |         |   | $ | 43,337 |        
|                             | Warranties issued                                                           |              |        | 42,229  |   |   |        | 38,908  |  
|                             | Settlements                                                                 |              |        | (47,270 | ) |   |        | (56,322 | )
|                             | SpeedFam-IPEC balance at acquisition                                        |              |        |        |   |   |        | 1,264   |  
|                             | Changes in liability for pre-existing warranties,
    including expirations |              |        | 2,844   |   |   |        | 3,815   |  
|                             |                                                                             |              |        |         |   |   |        |        
|Balance, end of period       |                                                                             | $            | 28,805 |         |   | $ | 31,002 |        
|                             |                                                                             |              |        |         |   |   |        |        



|        |                          
|------- | -------------------------
|Note 5. | Earnings (Loss) Per Share

Basic net income (loss) per share is computed by
dividing net income (loss) by the weighted-average number of
common shares outstanding during the period. For purposes of
computing net income (loss) per share, the weighted-average
number of outstanding shares of common stock excludes shares of
restricted stock subject to repurchase.

Diluted net income per share is computed using
the weighted-average number of shares of common stock
outstanding, including shares of restricted common stock subject
to repurchase and, when dilutive, potential shares from stock
options to purchase common stock using the treasury stock method
and from convertible securities on an as-if-converted basis.

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The following table provides a reconciliation of
the numerators and denominators of the basic and diluted per
share computations (in thousands, except for per share amounts):

|                                    |                                             |                          |       |         |   |      |      |         |  |   |      |         | 
|----------------------------------- | ------------------------------------------- | ------------------------ | ----- | ------- | - | ---- | ---- | ------- |  | - | ---- | ------- | 
|                                    |                                             |                         
|                                    |                                             | Years Ended December 31,
|                                    |                                             |                         
|                                    |                                             | 2003                     |       | 2002    |   | 2001
|                                    |                                             |                          |       |         |   |     
|Numerator:                          |                                             |                          |       |         |   |      |      |         |  |   |      |        
|                                    | Net income (loss)                           |                          | $     | (67,814 | ) |      | $    | 22,920  |  |   | $    | 144,470 | 
|Denominator:                        |                                             |                          |       |         |   |      |      |         |  |   |      |        
|                                    | Basic weighted-average shares outstanding   |                          |       | 150,680 |   |      |      | 144,371 |  |   |      | 142,462 | 
|                                    | Employee stock options                      |                          |       |        |   |      |      | 4,179   |  |   |      | 6,342   | 
|                                    | Restricted stock                            |                          |       |        |   |      |      | 198     |  |   |      | 120     | 
|                                    |                                             |                          |       |         |   |      |      |         |  |   |      |        
|                                    | Diluted weighted-average shares outstanding |                          |       | 150,680 |   |      |      | 148,748 |  |   |      | 148,924 | 
|                                    |                                             |                          |       |         |   |      |      |         |  |   |      |        
|Basic net income (loss) per share   |                                             | $                        | (0.45 | )       |   | $    | 0.16 |         |  | $ | 1.01 |        
|Diluted net income (loss) per share |                                             | $                        | (0.45 | )       |   | $    | 0.15 |         |  | $ | 0.97 |        

For the year ended December 31, 2003, all
3.5 million shares of stock options to purchase common
stock were excluded from the computation of net loss per share
as it would be anti-dilutive during the period. Options to
purchase 8.7 million and 3.6 million shares of common
stock at weighted-average prices of $42.60 and $46.77 per
share were outstanding during 2002 and 2001, respectively, but
were not included in the computation of diluted net income per
common share because the exercise price of the options was
greater than the average market price of the common shares and,
therefore, the effect would be anti-dilutive.



|        |                                     
|------- | ------------------------------------
|Note 6. | Goodwill and Other Intangible Assets



| |         
| | --------
| | Goodwill

As of December 31, 2003 and 2002, we had
goodwill of approximately $173.3 million and
$163.1 million, respectively. We completed a goodwill
impairment test in the third quarter of 2003 in conjunction with
our restructuring activities. In addition, we completed the
annual goodwill impairment test in the fourth quarters of 2003
and 2002 in accordance with our policy. The first step of the
test identifies when impairment may have occurred, while the
second step of the test measures the amount of the impairment,
if any. The results of our impairment tests did not indicate
impairment.

As a result of the acquisition of SpeedFam-IPEC
in December 2002, we recorded goodwill of $143.0 million.
In 2003, we recorded a net increase to goodwill of approximately
$10.1 million. The adjustment to goodwill is a result of
the reallocation of the initial estimated purchase price
allocation for the acquisition of SpeedFam-IPEC and additional
purchase price. The following table represents the 2003
adjustments to goodwill, assets acquired and liabilities assumed
(in thousands):

|                                      |                           |   |        |        | 
|------------------------------------- | ------------------------- | - | ------ | ------ | 
|Directors and officers insurance      |                           | $ | 1,293  |       
|Revisions to assigned inventory value |                           |   | 3,083  |       
|Restructuring accrual                 |                           |   | 11,032 |       
|Deferred tax assets  non-current     |                           |   | (6,108 | )     
|Other adjustments                     |                           |   | 831    |       
|                                      |                           |   |        |       
|                                      | Total goodwill adjustment |   | $      | 10,131 | 
|                                      |                           |   |        |       

The directors and officers (D&O) insurance
covers the former directors and officers of SpeedFam-IPEC. As
part of our acquisition of SpeedFam-IPEC, we agreed to purchase
D&O insurance for these directors and officers; however, the
cost of the D&O insurance was not included in our initial
purchase price.

50



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The revisions assigned to inventory value of
$3.1 million primarily relates to inventory not properly
valued as of the acquisition date. The adjustment to the
restructuring accrual of $11.0 million is due to a decrease
in our estimated future sublease income on facilities leased by
SpeedFam-IPEC. This revised sublease income estimate is based on
subsequent knowledge obtained about real estate conditions that
existed as of the acquisition date. These facilities were
abandoned as a result of the acquisition. The deferred tax asset
adjustment of $6.1 million is a result of the additional
purchase price allocation adjustments.

The following table reconciles the reported net
income (loss) and net income (loss) per share for 2001 to their
respective pro forma balances, adjusted to exclude goodwill
amortization expense, as a result of the adoption of
SFAS No. 142 in January 2002. Fiscal 2003 and 2002 results
are presented for comparative purposes (in thousands, except for
net income (loss) per share):

|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |       | 
|------------------------------------------ | -------------------------------------------- | ------------------------ | ------- | ----- | - | ---- | ------ | ---- |  | - | ------- | ----- | 
|                                           |                                              |                         
|                                           |                                              | Years Ended December 31,
|                                           |                                              |                         
|                                           |                                              | 2003                     |         | 2002  |   | 2001
|                                           |                                              |                          |         |       |   |     
|Reported net income (loss)                 |                                              | $                        | (67,814 | )     |   | $    | 22,920 |      |  | $ | 144,470 |      
|                                           | Add back goodwill amortization, net of tax   |                          |         |      |   |      |        |     |  |   |         | 2,232 | 
|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |      
|Adjusted net income (loss)                 |                                              | $                        | (67,814 | )     |   | $    | 22,920 |      |  | $ | 146,702 |      
|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |      
|Basic and diluted income (loss) per share: |                                              |                          |         |       |   |      |        |      |  |   |         |      
|                                           | Reported basic net income (loss) per share   |                          | $       | (0.45 | ) |      | $      | 0.16 |  |   | $       | 1.01  | 
|                                           | Add back goodwill amortization, net of tax   |                          |         |      |   |      |        |     |  |   |         | 0.02  | 
|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |      
|                                           | Adjusted basic income (loss) per share       |                          | $       | (0.45 | ) |      | $      | 0.16 |  |   | $       | 1.03  | 
|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |      
|                                           | Reported diluted net income (loss) per share |                          | $       | (0.45 | ) |      | $      | 0.15 |  |   | $       | 0.97  | 
|                                           | Add back goodwill amortization, net of tax   |                          |         |      |   |      |        |     |  |   |         | 0.02  | 
|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |      
|                                           | Adjusted diluted income (loss) per share     |                          | $       | (0.45 | ) |      | $      | 0.15 |  |   | $       | 0.99  | 
|                                           |                                              |                          |         |       |   |      |        |      |  |   |         |      



| |                  
| | -----------------
| | Intangible Assets

Intangible assets consist primarily of purchased
technology. Intangible assets amounted to $15.1 million,
net of accumulated amortization of $4.2 million, and
$25.6 million, net of accumulated amortization of
$2.4 million, as of December 31, 2003 and 2002,
respectively. During 2003, we wroteoff $5.5 million of
purchased technology. For further discussion, see Note 8 to
the Consolidated Financial Statements. The amortization expense
for the identifiable intangible assets was approximately
$3.6 million, $1.4 million and $1.0 million for
the years ended December 31, 2003, 2002 and 2001,
respectively. Our estimated amortization expense for the
identifiable intangible assets for each of the next five years
will be approximately $2.9 million per year. As of
December 31, 2003, we have no identifiable intangible
assets with indefinite lives.



|        |                      
|------- | ---------------------
|Note 7. | Business Combinations



| |                             
| | ----------------------------
| | Acquisition of SpeedFam-IPEC

On December 6, 2002, we acquired all of the
outstanding stock of SpeedFam-IPEC in exchange for 0.1818 of a
share of Novellus common stock for each outstanding share of
SpeedFam-IPEC common stock. We assumed options to purchase
SpeedFam-IPEC common stock based on the same ratio. In addition,
we assumed all $115.0 million of SpeedFam-IPECs
6.25% Convertible Subordinated Notes due in 2004. The Notes
were adjusted to a fair value of $116.4 million as of the
acquisition date. The acquisition was accounted for as a
purchase business combination and qualified as a tax-free
reorganization under Internal Revenue Service regulations. The
results of SpeedFam-IPECs operations have been included in
the consolidated financial statements since December 6,
2002. The total purchase price of approximately
$175.7 million

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

includes Novellus common stock valued at
$153.4 million, assumed options and warrants with a fair
value of $16.4 million and estimated direct transaction
costs of $5.9 million. The fair value of Novellus
common stock was derived using an average market price per share
of $26.77, which was based on an average of the closing prices
for a range of five trading days around August 12, 2002,
the announcement date of the acquisition. The fair value of the
stock options was determined using the Black-Scholes option
pricing model with the following assumptions: no dividend yield,
expected volatility of 85%, expected life of 3.3 years and
a risk-free interest rate of 2.49%. The model assumed an
expected life of 3.3 years for assumed options and
0.5 years for assumed warrants. The purchase price was
allocated to the fair market value of assets acquired and
liabilities assumed.



|        |                                
|------- | -------------------------------
|Note 8. | Restructuring and Other Charges

The following table summarizes activity related
to restructuring charges we recorded in the three years ended
December 31, 2003 (in thousands):

|                                     |  |            |        |            |  |           |         |             |  |       |        |           |  |   |         |   |  |   |         |   |  |   |         |  
|------------------------------------ |  | ---------- | ------ | ---------- |  | --------- | ------- | ----------- |  | ----- | ------ | --------- |  | - | ------- | - |  | - | ------- | - |  | - | ------- | -
|                                     |  |            |        |            |  |           |         |             |  |       |        | Inventory
|                                     |  |            |        | Asset      |  |           |         | Acquisition |  |       |        | Write-   
|                                     |  | Facilities |        | Impairment |  | Severance |         | Expense     |  | Total |        | down     
|                                     |  |            |        |            |  |           |         |             |  |       |        |          
|Restructuring charges for 2001       |  | $          | 33,818 |            |  | $         | 14,127  |             |  | $     |       |           |  | $ | 13,161  |   |  | $ | 61,106  |   |  | $ | 7,102   |  
|Cash payments                        |  |            | (952   | )          |  |           | (1,745  | )           |  |       |       |           |  |   | (13,161 | ) |  |   | (15,858 | ) |  |   |        |  
|Non-cash charges                     |  |            | (6,017 | )          |  |           | (12,382 | )           |  |       |       |           |  |   |        |   |  |   | (18,399 | ) |  |   | (7,102  | )
|                                     |  |            |        |            |  |           |         |             |  |       |        |           |  |   |         |   |  |   |         |   |  |   |         |  
|Balance at December 31, 2001         |  |            | 26,849 |            |  |           |        |             |  |       |       |           |  |   |        |   |  |   | 26,849  |   |  |   |        |  
|Restructuring charges for 2002       |  |            | 1,478  |            |  |           |        |             |  |       | 4,989  |           |  |   |        |   |  |   | 6,467   |   |  |   |        |  
|SpeedFam-IPEC restructuring charges  |  |            | 27,024 |            |  |           |        |             |  |       | 251    |           |  |   | 1,253   |   |  |   | 28,528  |   |  |   |        |  
|Cash payments                        |  |            | (9,783 | )          |  |           |        |             |  |       | (4,989 | )         |  |   |        |   |  |   | (14,772 | ) |  |   |        |  
|                                     |  |            |        |            |  |           |         |             |  |       |        |           |  |   |         |   |  |   |         |   |  |   |         |  
|Balance at December 31, 2002         |  |            | 45,568 |            |  |           |        |             |  |       | 251    |           |  |   | 1,253   |   |  | $ | 47,072  |   |  |   |        |  
|Restructuring charges for 2003       |  |            | 4,088  |            |  |           | 7,943   |             |  |       | 3,807  |           |  |   |        |   |  |   | 15,838  |   |  |   | 43,952  |  
|SpeedFam-IPEC acquisition adjustment |  |            | 11,032 |            |  |           |        |             |  |       |       |           |  |   |        |   |  |   | 11,032  |   |  |   |        |  
|Cash payments                        |  |            | (9,828 | )          |  |           |        |             |  |       | (3,466 | )         |  |   | (138    | ) |  |   | (13,432 | ) |  |   |        |  
|Non-cash charges                     |  |            | (347   | )          |  |           | (7,943  | )           |  |       |       |           |  |   |        |   |  |   | (8,290  | ) |  |   | (43,952 | )
|                                     |  |            |        |            |  |           |         |             |  |       |        |           |  |   |         |   |  |   |         |   |  |   |         |  
|Balance at December 31, 2003         |  | $          | 50,513 |            |  | $         |        |             |  | $     | 592    |           |  | $ | 1,115   |   |  | $ | 52,220  |   |  | $ |        |  
|                                     |  |            |        |            |  |           |         |             |  |       |        |           |  |   |         |   |  |   |         |   |  |   |         |  

In September 2001, we implemented a restructuring
plan that was driven by the decline in net orders due to the
contraction of the semiconductor capital equipment market from
calendar year 2000 levels and the need to improve our cost
structure by consolidating excess facilities. As a result, we
recorded restructuring and asset impairment charges totaling
$55.0 million, of which $47.9 million is included in
operating expense and $7.1 million is included in cost of
sales. The restructuring charges consisted of $33.8 million
related to vacated facilities, $14.1 million of asset
impairment charges and $7.1 million of discontinued
inventory write-downs. Of the $14.1 million asset
impairment charge, $9.5 million related to abandoned assets
associated with the discontinuation of certain projects and
$4.6 million related to the write-off of purchased
technology.

52



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The restructuring charges in 2002 include
approximately $28.5 million incurred in connection with
exiting activities of SpeedFam-IPEC that were recognized as
liabilities assumed in the purchase business combination. These
activities relate primarily to facility-related charges of
$27.0 million, severance-related charges of
$0.3 million and other costs associated with exiting
activities of SpeedFam-IPEC of $1.2 million.

In the third quarter of 2003, we announced a
restructuring plan to align our cost structure with current
business conditions. The restructuring plan resulted in pre-tax
charges of $59.8 million in the third quarter, which is
comprised of $44.0 million for the write-down of inventory,
$7.9 million for asset write-offs (including fixed assets
and purchased technology), $4.1 million for vacated
facilities, and $3.8 million for severance. The inventory
charge, which is also discussed further below, is included in
cost of sales and the other charges are included in
restructuring and other charges in the consolidated statement of
operations.



| |           
| | ----------
| | Facilities

The 2001 vacated facilities charge of
$33.8 million relates to rent obligations after the
abandonment of five corporate facilities in California,
primarily San Jose, and eleven field offices located in
Arizona, California, Florida, Washington, the Netherlands,
Germany, Israel, Singapore and Japan, which were under
long-term operating lease agreements. The abandoned corporate
facilities were redundant facilities from the GaSonics
acquisition. The closure of the field offices was due to a
slowdown in the semiconductor capital equipment market. As of
December 31, 2001, we estimated anticipated future sublease
income of $4.5 million relating to the vacated facilities
and offset the amount against the remaining lease payments.
During 2002 and 2003, additional charges of $1.5 million
and $3.0 million, respectively, were recorded due to a
decrease in our future sublease income estimate.

The facility-related charges of
$27.0 million in 2002 were attributable to the closure
and/or subletting of excess SpeedFam-IPEC office space,
primarily in the U.S. and Asia. The majority of the
facility-related charges consisted of remaining rent obligations
and restoration costs offset by estimated sublease income of
approximately $44.1 million. The estimated costs of
abandoning these leased facilities, including estimated sublease
income, were based primarily on market information analyses
provided by a commercial real estate brokerage firm we retained.
In the third quarter of 2003, we lowered the estimated sublease
income related to the SpeedFam-IPEC facilities by
$11.0 million, as discussed below.

The facilities restructuring charge in the third
quarter of 2003 primarily relates to abandoned corporate
facilities from our January 2001 acquisition of GaSonics
International Corporation. The charge consists of
$1.1 million of repair and restoration costs and
$3.0 million related to the decrease in our future sublease
income estimate noted above. In addition to the restructuring
charge, we further lowered our estimate of future sublease
income on abandoned facilities from the SpeedFam-IPEC
acquisition by $11.0 million. The SpeedFam-IPEC facilities
adjustment resulted in an increase to goodwill due to a
reallocation of our purchase price. For further discussion on
the goodwill increase, see Note 6 to the consolidated
financial statements.



| |                 
| | ----------------
| | Asset Impairment

In 2001, we abandoned assets and wrote off
purchased technology of $14.1 million. The charge for
abandoned assets of $9.5 million relates to the write-off
of evaluation tools of $6.1 million, with the remaining
balance pertaining to the write-off of certain assets related to
two abandoned product lines and certain previous generation lab
equipment. These items have been written off as we do not expect
future cash flows from them. The write-off of purchased
technology of $4.6 million relates to technology purchased
from a third party vendor for use in certain research and
development projects. The purchased technology has been written
off as these research and development projects have been
cancelled and there is no future economic benefit pertaining to
the purchased technology. The results of operations relating to
these product lines were not material to our consolidated
results of operations.

53



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

In the third quarter of 2003, we abandoned assets
and wrote off purchased technology of $7.9 million. The
charge for abandoned assets of $2.4 million primarily
relates to previous generation lab equipment. These assets have
been abandoned as we do not expect to recover the carrying value
through future cash flows. The write-off of purchased technology
of $5.5 million relates to technology previously purchased
from a third party vendor for use in certain research and
development projects. The purchased technology has been written
off as these research and development projects have been
cancelled and there is no estimated future economic benefit for
the purchased technology.



| |          
| | ---------
| | Severance

In the first and fourth quarters of 2002, we
reduced our workforce by approximately 13.1% and 8.0%,
respectively, in response to market conditions, and accordingly
recorded charges of $3.3 million and $1.7 million,
respectively, primarily for the cost of severance compensation.
These employee reductions affected approximately 500 people
across all business functions, operating units and major
geographic regions. As of December 31, 2002, substantially
all severance benefits related to these reductions in workforce
had been paid. SpeedFam-IPECs severance-related charges of
$0.3 million were attributable to workforce reductions in
the U.S. and various international locations across many
business functions and job classes. The charges include
severance, payroll taxes and COBRA benefits. All of these
severance-related charges had been paid as of December 31,
2003.

In the third quarter of 2003, we reduced our
workforce by approximately 7% in response to market conditions
and recorded charges of $3.8 million, primarily for the
cost of severance compensation. This workforce reduction
affected approximately 200 people across all business functions,
operating units and major geographic regions. Substantially all
of these severance-related charges had been paid as of
December 31, 2003.



| |                  
| | -----------------
| | Acquisition Costs

In addition to the restructuring charges, we also
incurred acquisition costs of $13.2 million related to the
acquisition of GaSonics in the first quarter of fiscal 2001.
These costs included professional fees, financial printing and
other related costs. Additionally, these costs included charges
related to the cancellation of various contracts and the
write-off of certain redundant assets. At December 31,
2001, all expenses related to these accruals had been paid.

Other costs of $1.2 million recorded in 2002
primarily relate to legal and other professional fees as well as
other exit costs associated with the closing of
SpeedFam-IPECs foreign entities.



| |                      
| | ---------------------
| | Inventory Write-downs

The write-down of inventory of $7.1 million
in 2001 relates to the abandonment of two product lines. One
product line was not part of our core business strategy and the
other, a PECVD product, has been replaced by a next-generation
product. The results of operations relating to these product
lines were not material to our consolidated results of
operations.

The inventory charge in the third quarter of 2003
was a result of a sustained shift in our customers order
patterns from 200mm to 300mm equipment, which resulted in
reduced demand for our 200mm equipment. Furthermore, the levels
of required spares inventory were reduced due to a streamlining
of our worldwide spares distribution system. These changes
resulted in a portion of our inventory becoming excess or
obsolete and led to a $44.0 million write-down of inventory.

As of December 31, 2003, substantially all
actions under the 2003, 2002 and 2001 restructuring plans have
been completed, except for payments of future rent obligations
of $50.5 million, which are to be paid in cash through year
2017.

54



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|        |                                    
|------- | -----------------------------------
|Note 9. | Convertible Subordinated Debentures

In connection with our acquisition of
SpeedFam-IPEC, we assumed $115.0 million of convertible
subordinated notes due in 2004. The notes were adjusted to their
fair value of $116.4 million as of the acquisition date.
The notes accrued interest at a rate of 6.25%, which was payable
semi-annually in March and September. The notes were
subordinated to all existing and future senior Novellus
indebtedness and could have been converted into
3.3096 shares of Novellus common stock at a
conversion price of $302.15 per $1,000 principal amount. We
exercised our right to redeem the notes on January 8, 2003
at a redemption price of $117.1 million. The redemption
price represented 101.786% of par value. As a result, we
recognized approximately $0.6 million in other expense in
2003 for the difference between the carrying value as of the
acquisition date and the redemption price.

On July 26, 2001, we issued
$880.0 million of Liquid Yield Option NotesTM
(LYONs) due July 26, 2031. The net proceeds after issuance
costs (which were being amortized over 30 years) from the
LYONs offering were $862.4 million. The LYONs were zero
coupon, zero-yield subordinated debentures convertible into
shares of Novellus common stock or redeemable for cash by
the security holder, subject to specified conditions as set
forth in the indenture. On July 26, 2002, the holders of
the LYONs exercised their option to require us to repurchase
each LYON for $1,000 in cash on such date, or approximately
$880.0 million for substantially all of the outstanding
LYONs. We used restricted short-term investments, which had
matured to $880.0 million, to repurchase the LYONs. We
recorded a charge of approximately $17.0 million in other
expense in 2002 for the remaining unamortized issuance costs
related to the LYONs.



|         |                           
|-------- | --------------------------
|Note 10. | Commitments and Guarantees



| |                           
| | --------------------------
| | Variable Interest Entities

In January 2003, the FASB issued FASB
Interpretation No. 46, Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51,
or FIN 46. FIN 46 requires variable interest entities
to be consolidated by the primary beneficiary of the entity. An
entity is considered a variable interest entity if the equity
investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity
at risk for the entity to finance its activities without
additional subordinated financial support from other parties.
FIN 46 is effective for all new variable interest entities
created or acquired after January 31, 2003. For variable
interest entities created or acquired prior to February 1,
2003, the provisions of FIN 46 were to be applied at the
end of periods ending after June 15, 2003. In October 2003,
the FASB issued a FASB Draft Position on FIN 46, delaying
the effective date of FIN 46 to periods ending after
December 15, 2003, but encouraging early adoption. We
early-adopted FIN 46 on June 29, 2003.

Pursuant to the guidelines of FIN 46, we
concluded that the lessor in our synthetic leases was a variable
interest entity and that we were the primary beneficiary of the
variable interest entity. As such, we were required to
consolidate the variable interest lessor beginning on
June 29, 2003. Additionally, since each of the other
lessees involved with this lessor had a variable interest in
specified assets and liabilities of the variable interest
lessor, we were only required to consolidate the specific
assets, liabilities, and operating results associated with our
synthetic leases. As a result of the early adoption of
FIN 46, we recorded a non-cash charge of approximately
$62.8 million, net of tax, in the third quarter of fiscal
2003 as a cumulative effect of a change in accounting principle
in accordance with APB Opinion No. 20, Accounting
Changes. The gross charge represents approximately
$95.8 million of pre-tax depreciation that would have been
recorded had we consolidated these assets from inception of the
leases. As a result of the adoption of FIN 46 and the
exercise of our option to purchase the properties subject to the
synthetic leases in September 2003, property and equipment
increased on a net basis by approximately $360.6 million
and notes receivable and other non-current assets decreased by
$456.4 million. The purchase of these properties in
September 2003 eliminated our interest in the variable interest
entity.

55



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The consolidation and subsequent purchase of the
facilities previously accounted for as synthetic leases
increased our depreciation expense by approximately
$8.5 million per quarter and decreased both our rent
expense and interest income by approximately $3.0 million
per quarter from historical levels, which decreased our
quarterly earnings per share by approximately $0.04. The
adoption of FIN 46 and the exercise of our purchase option
had no impact on our liquidity.



| |                          
| | -------------------------
| | Standby Letters of Credit

We provide standby letters of credit to certain
parties as required for certain transactions we initiated during
the ordinary course of business. As of December 31, 2003,
the maximum potential amount of future payments that we could be
required to make under these letters of credit was approximately
$4.8 million. We have not recorded any liability in
connection with these arrangements beyond that required to
appropriately account for the underlying transaction being
guaranteed. We do not believe, based on historical experience
and information currently available, that it is probable that
any amounts will be required to be paid under these arrangements.



| |                       
| | ----------------------
| | Guarantee Arrangements

We have guarantee arrangements on behalf of
certain of our consolidated subsidiaries. These guarantee
arrangements are for line-of-credit borrowings, overdrafts and
operating leases. The available credit facilities with various
financial institutions total $31.3 million. These credit
facilities bear interest at various rates, expire on various
dates through December 2004 and are used for general corporate
purposes. As of December 31, 2003, our subsidiaries had
$13.0 million outstanding under the lines of credit at an
annual weighted-average interest rate of 1.2%, which, on a
consolidated basis, we will be required to repay. In the event
of default of these facilities by our subsidiaries, such
arrangements would be guaranteed by us to a maximum exposure of
$29.9 million as of December 31, 2003. As of
December 31, 2002, amounts outstanding under these lines of
credit were $2.8 million, at an annual weighted-average
interest rate of 1.4%.

Certain of our subsidiaries have lease
arrangements, which we guarantee. These leases will expire
between 2004 and 2010. In the event that our subsidiaries do not
make the required payments, we could be required to pay the
leases on their behalf. The annual lease obligations under these
arrangements are included in our consolidated minimum lease
payments table below. As of December 31, 2003, we have not
recorded any liability related to guarantees of subsidiary
obligations. Based on historical experience and information
currently available to us, we do not expect that it is probable
any amounts will be required to be paid under these guarantee
arrangements.



| |                  
| | -----------------
| | Lease Commitments

We have non-cancelable operating leases for
various facilities. Rent expense was approximately
$13.1 million, $10.4 million and $16.9 million
for the years ended December 31, 2003, 2002 and 2001,
respectively, net of sublease income of $7.9 million,
$7.4 million and $7.2 million, respectively. Certain
of the operating leases contain renewal options, at our
discretion, at the end of the lease terms.

The following is a table summarizing future
minimum lease payments under all non-cancelable operating
leases, with initial or remaining terms in excess of one year.
We had no other significant commitments as of December 31,
2003 (in thousands):

|                                |  |                           |        |      |  |          |        |      |  |      |        |            |  |        |       |       |  |   |       |  |  |   |        |  |  |   |         |   |  |   |        | 
|------------------------------- |  | ------------------------- | ------ | ---- |  | -------- | ------ | ---- |  | ---- | ------ | ---------- |  | ------ | ----- | ----- |  | - | ----- |  |  | - | ------ |  |  | - | ------- | - |  | - | ------ | 
|                                |  |                           |        |      |  |          |        |     
|                                |  | Years Ending December 31, |        |      |  |          |        |     
|                                |  |                           |        |      |  | Sublease |        | Net 
|                                |  | 2004                      |        | 2005 |  | 2006     |        | 2007 |  | 2008 |        | Thereafter |  | Income |       | Total
|                                |  |                           |        |      |  |          |        |      |  |      |        |            |  |        |       |      
|Non-cancelable operating leases |  | $                         | 14,042 |      |  | $        | 13,188 |      |  | $    | 11,644 |            |  | $      | 6,982 |       |  | $ | 7,082 |  |  | $ | 46,781 |  |  | $ | (21,147 | ) |  | $ | 78,572 | 

56



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|         |           
|-------- | ----------
|Note 11. | Litigation



| |                        
| | -----------------------
| | Applied Materials, Inc.

On June 13, 1997, we agreed to purchase the
Thin Film Systems (TFS) business of Varian Associates, Inc. On
the same day, Applied Materials, Inc. sued Varian in the United
States District Court for the Northern District of California
for alleged patent infringement concerning several of its
physical vapor deposition (PVD) patents (the Applied Patents).

On June 23, 1997, we sued Applied in the
United States District Court for the Northern District of
California, claiming infringement by Applied of several of our
PVD patents acquired from Varian in the TFS purchase. Applied
has filed counterclaims in this suit, alleging that we infringed
the Applied Patents. We are seeking an injunction against future
infringement by Applied, damages for past infringement and
treble damages for alleged willful infringement.

On July 7, 1997, Applied amended its
complaint in its suit against Varian to add Novellus as a
defendant. We have requested that the Court dismiss us as a
defendant in this suit. The Court has not yet ruled on the
request or required us to file an answer in this lawsuit.

The relief requested by Applied in both suits
includes a permanent injunction against future infringement,
damages for alleged past infringement and treble damages for
alleged willful infringement. Trial is currently set to commence
on May 24, 2004. Applied has recently indicated, however,
that it will not be seeking any relief against us in this trial.

We believe that we have meritorious claims
against Applied. We also believe that there are meritorious
defenses to Applieds allegations, including the defense
that our operations and products (including TFS products and
systems) do not infringe the Applied Patents, and that the
Applied Patents are invalid, unenforceable or both. As a result
of court rulings adverse to Applied, and in light of certain
indemnity obligations undertaken by Varian, which include
reimbursement of certain legal expenses and a portion of any
losses incurred from this litigation, we do not believe that
Applieds claims will have a material adverse effect on our
business, financial condition or results of operations.



| |               
| | --------------
| | Semitool, Inc.

On June 11, 2001, Semitool, Inc. sued
Novellus for patent infringement in the United States District
Court for the District of Oregon. In this lawsuit, Semitool
alleges that Novellus infringes one of Semitools patents
related to copper electroplating. Semitool seeks an injunction
against future infringement by Novellus, damages for past
infringement, and treble damages for alleged willful
infringement.

On November 13, 2001, we countersued
Semitool for patent infringement in the United States District
Court for the District of Oregon. We allege that Semitool
infringes certain Novellus patents related to copper
electroplating. We seek an injunction against Semitool, damages
for past infringement, and treble damages for willful
infringement by Semitool.

The Court has issued claim construction orders
regarding all of the patents-in-suit, and discovery has closed.
The Court has not yet ruled on any of the motions for summary
judgment submitted by Semitool against the Novellus patents. The
case is presently scheduled to proceed to trial in November of
2004. We believe that we have meritorious claims against
Semitool and meritorious defenses to Semitools claims
against us, and that this litigation will not have a material
adverse impact on our business, financial condition, or results
of operations. However, the outcome of patent disputes is often
affected by uncertainty in the resolution of complex issues of
fact and law. If Semitool were to prevail against us, the
adverse effect on our business, financial condition, or results
of operations could be material.

57



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                                                             
| | ------------------------------------------------------------
| | Plasma Physics Corporation and Solar
    Physics Corporation

On June 14, 2002, certain of our present and
former customers  including Agilent
Technologies, Inc., Micron Technology, Inc., Agere
Systems, Inc., National Semiconductor Corporation,
Koninklijke Philips Electronics N.V., Texas
Instruments, Inc., ST Microelectronics, Inc., LSI
Logic Corporation, International Business Machines
Corporation, Conexant Systems, Inc., Motorola, Inc.,
Advanced Micro Devices, Inc. and Analog Devices
Inc.  were sued for patent infringement by Plasma
Physics Corporation and Solar Physics Corporation. We have not
been sued by Plasma Physics, Solar Physics, or any other party
for infringement of any Plasma Physics or Solar Physics patent.
Certain defendants in the case, however, contend that we
allegedly have indemnification obligations and liability
relating to these lawsuits. We believe that these matters will
not have a material adverse impact on our business, financial
condition, or results of operations. There can be no assurance,
however, that we will prevail in the above lawsuit or in any
other lawsuit filed in connection with the alleged
indemnification obligations. If one or more parties were to
prevail against us in such a suit and damages were awarded, the
adverse impact on our business, financial condition, or results
of operations could be material.



| |                              
| | -----------------------------
| | Linear Technology Corporation

On March 12, 2002, Linear Technology
Corporation filed a complaint against Novellus, among other
parties, in the Superior Court of the State of California for
the County of Santa Clara. The complaint sought damages
(including punitive damages) and injunctions for causes of
actions involving alleged breach of contract, fraud, unfair
competition, breach of warranty, and declaratory relief. We
filed a demurrer to Linears complaint, which the court
granted on April 11, 2003, with leave to amend. On
May 2, 2003, Linear filed a second amended complaint. We
filed a demurrer to Linears second amended complaint,
which the court granted on August 14, 2003, with leave to
amend. On September 15, 2003, Linear filed a third amended
complaint. We filed a demurrer to Linears third amended
complaint, which the court granted on January 15, 2004,
with leave to amend. Linear has not yet filed another complaint.

This litigation is in its early stages and is
therefore inherently difficult to assess. We believe that this
litigation will not have a material adverse impact on our
business, financial condition, or results of operations.
However, the outcome of patent disputes is often affected by
uncertainty in the resolution of complex issues of fact and law.
If Linear were to prevail against us, the adverse effect on our
business, financial condition, or results of operations could be
material.



| |                      
| | ---------------------
| | Employment Litigation

On April 4, 2003, Thomas Graziani, et al. filed a
class action lawsuit against Novellus in the United States
District Court for the District of Oregon. On August 1, 2003,
David Robinson, et al. filed a class action lawsuit against
Novellus in the United States District Court for the Northern
District of California, San Jose Division. Both lawsuits seek
collective and/or class action status for field service
engineers who work for Novellus and both lawsuits allege that
field service engineers are entitled to compensatory damages in
the form of overtime pay, liquidated damages, interest and
attorneys fees and costs. We are currently engaged in
mediation with the plaintiffs in these actions. At a mediation
held on March 1, 2004, the parties to both lawsuits agreed to a
settlement to be documented on or before April 2, 2004. As of
the date of this Annual Report on Form 10-K, there is no written
agreement binding the parties. Moreover, the settlement requires
court approval, which may or may not be received. Approval is
expected to be sought in the second quarter of 2004. Because the
settlement has not yet been documented or approved and because
members of the class may be permitted to opt out of the class
and file individual claims, we are unable to determine the total
amount or a range of amounts for the settlement at this time. If
efforts to settle these lawsuits are not successful, we intend
to vigorously defend against them.

58



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##### Table of Contents



NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                 
| | ----------------
| | Other Litigation

We are a defendant or plaintiff in various other
actions that arose in the normal course of business. We believe
that the ultimate disposition of these matters will not have a
material adverse effect on our business, financial condition or
results of operations.



|         |             
|-------- | ------------
|Note 12. | Income Taxes

Significant components of the provision (benefit)
for income taxes attributable to income (loss) before income
taxes and cumulative effect of a change in accounting principle
are as follows (in thousands):

|                                                                                                       |          |                                            |         |         |         |      |         |         |   |  |        |         |        | 
|------------------------------------------------------------------------------------------------------ | -------- | ------------------------------------------ | ------- | ------- | ------- | ---- | ------- | ------- | - |  | ------ | ------- | ------ | 
|                                                                                                       |          |                                           
|                                                                                                       |          | Years Ended December 31,                  
|                                                                                                       |          |                                           
|                                                                                                       |          | 2003                                       |         | 2002    |         | 2001
|                                                                                                       |          |                                            |         |         |         |     
|Federal                                                                                                |          |                                            |         |         |         |      |         |         |   |  |        |        
|                                                                                                       | Current  |                                            | $       | 7,270   |         |      | $       | (41,842 | ) |  | $      | (40,645 | )     
|                                                                                                       | Deferred |                                            |         | (30,046 | )       |      |         | 19,346  |   |  |        | 72,765  |       
|                                                                                                       |          |                                            |         |         |         |      |         |         |   |  |        |        
|                                                                                                       |          |                                            | (22,776 | )       |         |      | (22,496 | )       |   |  | 32,120 |        
|State                                                                                                  |          |                                            |         |         |         |      |         |         |   |  |        |        
|                                                                                                       | Current  |                                            |         | 405     |         |      |         | 377     |   |  |        | 864     |       
|                                                                                                       | Deferred |                                            |         | (5,230  | )       |      |         | (8,853  | ) |  |        | 70      |       
|                                                                                                       |          |                                            |         |         |         |      |         |         |   |  |        |        
|                                                                                                       |          |                                            | (4,825  | )       |         |      | (8,476  | )       |   |  | 934    |        
|Foreign                                                                                                |          |                                            |         |         |         |      |         |         |   |  |        |        
|                                                                                                       | Current  |                                            |         | 17,315  |         |      |         | 11,544  |   |  |        | 6,816   |       
|Income tax benefits attributable to employee
    stock plan activity allocated to shareholders equity |          |                                            |        |         |         |      | 19,428  |         |   |  | 25,037 |        
|                                                                                                       |          |                                            |         |         |         |      |         |         |   |  |        |        
|                                                                                                       |          | Total provision (benefit) for income taxes |         | $       | (10,286 | )    |         | $       |  |  |        | $       | 64,907 | 
|                                                                                                       |          |                                            |         |         |         |      |         |         |   |  |        |        

Pre-tax income from foreign operations was
approximately $51.7 million, $18.0 million and
$15.0 million in 2003, 2002 and 2001, respectively.

59



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##### Table of Contents



NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Deferred income taxes reflect the net tax effects
of temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts
used for income tax purposes. Significant components of our
deferred tax assets and liabilities are as follows (in
thousands):

|                          |                                                 |                                                 |   |         |         |  |   |         |         | 
|------------------------- | ----------------------------------------------- | ----------------------------------------------- | - | ------- | ------- |  | - | ------- | ------- | 
|                          |                                                 |                                                
|                          |                                                 | December 31,                                   
|                          |                                                 |                                                
|                          |                                                 | 2003                                            |   | 2002   
|                          |                                                 |                                                 |   |        
|Deferred tax assets:      |                                                 |                                                 |   |         |         |  |   |        
|                          | Reserves and accruals                           |                                                 | $ | 50,022  |         |  | $ | 42,716  |        
|                          | Expenses not currently deductible               |                                                 |   | 37,836  |         |  |   | 27,869  |        
|                          | Capitalized in-process research and development |                                                 |   | 26,577  |         |  |   | 29,826  |        
|                          | Deferred profit                                 |                                                 |   | 19,937  |         |  |   | 25,527  |        
|                          | Net operating loss carryforwards                |                                                 |   | 108,413 |         |  |   | 71,374  |        
|                          | Credits                                         |                                                 |   | 47,026  |         |  |   | 29,188  |        
|                          | Other                                           |                                                 |   | 10,678  |         |  |   |        |        
|                          |                                                 |                                                 |   |         |         |  |   |        
|                          |                                                 | Total deferred tax assets                       |   |         | 300,489 |  |   |         | 226,500 | 
|                          | Valuation allowance                             |                                                 |   | (76,510 | )       |  |   | (57,028 | )      
|                          |                                                 |                                                 |   |         |         |  |   |        
|                          |                                                 | Deferred tax assets, net of valuation allowance |   |         | 223,979 |  |   |         | 169,472 | 
|Deferred tax liabilities: |                                                 |                                                 |   |         |         |  |   |        
|                          | Depreciation                                    |                                                 |   | (55,440 | )       |  |   | (69,246 | )      
|                          | Other                                           |                                                 |   |        |         |  |   | (29     | )      
|                          |                                                 |                                                 |   |         |         |  |   |        
|                          |                                                 | Total net deferred tax assets                   |   | $       | 168,539 |  |   | $       | 100,197 | 
|                          |                                                 |                                                 |   |         |         |  |   |        

The net increase (decrease) in the valuation
allowance was $19.5 million, $49.4 million and
($3.1) million during the years ended December 31,
2003, 2002 and 2001, respectively. The valuation allowance
balance at December 31, 2003 includes $38.0 million
related to the acquired deferred tax assets of SpeedFam-IPEC
which will be credited to goodwill when realized and
$26.5 million related to stock option benefits that will be
credited to equity when realized.

As of December 31, 2003, we had federal and
state tax credit carryforwards of approximately $27.5 and
$19.5 million, respectively. These credits include foreign
tax credits for which a valuation allowance has been provided to
the extent that they may not be utilized. The federal tax credit
carryforwards expire in years 2006 through 2023. Of the state
tax credit carryforwards, $16.8 million carries forward
indefinitely and $2.7 million expires in years 2009 through
2011.

As of December 31, 2003, our federal net
operating losses for tax return purposes were
$298.4 million. A valuation allowance has been provided to
the extent that we believe that the losses may not be utilized
in future periods due to the limitations of Internal Revenue
Code Section 382. If not utilized, these carryforwards will
start to expire in 2020.

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The provision (benefit) for income taxes differs
from the provision calculated by applying the federal statutory
tax rate to income (loss) before income taxes and cumulative
effect of a change in accounting principle because of the
following (in thousands):

|                                        |                                            |                          |        |         |   |      |        |   |  |   |        |        | 
|--------------------------------------- | ------------------------------------------ | ------------------------ | ------ | ------- | - | ---- | ------ | - |  | - | ------ | ------ | 
|                                        |                                            |                         
|                                        |                                            | Years Ended December 31,
|                                        |                                            |                         
|                                        |                                            | 2003                     |        | 2002    |   | 2001
|                                        |                                            |                          |        |         |   |     
|Expected provision at 35%               |                                            | $                        | (5,362 | )       |   | $    | 8,022  |   |  | $ | 73,282 |       
|State tax, net of federal benefit       |                                            |                          | (3,136 | )       |   |      | (3,975 | ) |  |   | 2,886  |       
|Research and development credits        |                                            |                          | (2,000 | )       |   |      | (5,144 | ) |  |   | (6,783 | )     
|Export sales incentive                  |                                            |                          |       |         |   |      | (1,199 | ) |  |   | (7,328 | )     
|Valuation allowance increase (decrease) |                                            |                          | 322    |         |   |      | (3,100 | ) |  |   | (3,100 | )     
|Write-off of acquired IPR&D             |                                            |                          |       |         |   |      | 3,151  |   |  |   |       |       
|Other                                   |                                            |                          | (110   | )       |   |      | 2,245  |   |  |   | 5,950  |       
|                                        |                                            |                          |        |         |   |      |        |   |  |   |        |       
|                                        | Total provision (benefit) for income taxes |                          | $      | (10,286 | ) |      | $      |  |  |   | $      | 64,907 | 
|                                        |                                            |                          |        |         |   |      |        |   |  |   |        |       



|         |                     
|-------- | --------------------
|Note 13. | Shareholders Equity



| |                                      
| | -------------------------------------
| | Other Comprehensive Income
    (Loss)

The components of accumulated other comprehensive
income (loss), net of related taxes are as follows (in
thousands):

|                                                                 |                                               |              |       |       |  |   |        |        |  
|---------------------------------------------------------------- | --------------------------------------------- | ------------ | ----- | ----- |  | - | ------ | ------ | -
|                                                                 |                                               |             
|                                                                 |                                               | December 31,
|                                                                 |                                               |             
|                                                                 |                                               | 2003         |       | 2002 
|                                                                 |                                               |              |       |      
|Foreign currency translation adjustments                         |                                               | $            | 4,685 |       |  | $ | (1,461 | )     
|Unrealized loss on available-for-sale securities,
    net of tax |                                               |              | (113  | )     |  |   | (285   | )     
|                                                                 |                                               |              |       |       |  |   |        |       
|                                                                 | Accumulated other comprehensive income (loss) |              | $     | 4,572 |  |   | $      | (1,746 | )
|                                                                 |                                               |              |       |       |  |   |        |       



| |                                    
| | -----------------------------------
| | Common Stock Repurchase
    Program

On September 19, 2001, our Board of
Directors authorized a stock repurchase program of up to
$500 million over the next two years. As of
September 19, 2003, the end of the repurchase program,
3.2 million shares, or $79.5 million of common stock,
had been repurchased.



| |                            
| | ---------------------------
| | Employee Stock Option Plans

We grant options to employees under several stock
option plans. Under the 1992 Stock Option Plan, which expired in
fiscal 2002, options to purchase up to 33,300,000 shares of
Novellus common stock were made available for grant at not
less than fair market value. In May 2001, our shareholders
approved the 2001 Stock Incentive Plan, the terms of which
reserve 6,360,000 shares of common stock for future
issuance. In December 2001, the Board of Directors approved the
reservation of 6,000,000 shares of common stock for future
issuance under the 2001 Non-Qualified Option Plan. In fiscal
2002, an additional 4,500,000 shares of common stock were
reserved for future issuance under the 2001 Non-Qualified Option
Plan. Options generally vest ratably over a four-year period on
the anniversary of the date of grant or as determined by the
Board of Directors. Stock options expire ten years after the
date of grant.

Pursuant to the terms of the SpeedFam-IPEC
acquisition agreement, we assumed SpeedFam-IPECs 1991
Employee Incentive Stock Option Plan, 1992 Stock Option Plan,
1995 Stock Plan, 2001 Non-statutory Stock Option Plan and
Stand-Alone Non-statutory Stock Option Agreement. These plans
accounted for approximately 1,675,000 shares of common
stock, of which 530,000 had not been granted as of the
acquisition

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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

date of December 6, 2002. These shares have
been included in the stock option rollforward table presented
below.

Information with respect to stock option activity
is as follows (share data in thousands):

|                              |                                     |           |       |                     |   |                |        |        |   |   |       |       | 
|----------------------------- | ----------------------------------- | --------- | ----- | ------------------- | - | -------------- | ------ | ------ | - | - | ----- | ----- | 
|                              |                                     |           |       |                    
|                              |                                     |           |       | Options Outstanding
|                              |                                     |           |       |                    
|                              |                                     | Shares    |       |                     |   | Weighted-     
|                              |                                     | Available |       | Number of           |   | Average       
|                              |                                     | for Grant |       | Shares              |   | Exercise Price
|                              |                                     |           |       |                     |   |               
|Balances at December 31, 2000 |                                     |           | 4,123 |                     |   |                | 17,994 |        |   | $ | 22.47 |      
|                              | Additional authorization            |           |       | 12,122              |   |                |        |       |   |   |       |      | 
|                              | Options granted                     |           |       | (7,614              | ) |                |        | 7,614  |   |   | $     | 39.85 | 
|                              | Options exercised                   |           |       |                    |   |                |        | (2,506 | ) |   | $     | 14.04 | 
|                              | Options canceled                    |           |       | 543                 |   |                |        | (543   | ) |   | $     | 32.64 | 
|                              |                                     |           |       |                     |   |                |        |        |   |   |       |      
|Balances at December 31, 2001 |                                     |           | 9,174 |                     |   |                | 22,559 |        |   | $ | 29.04 |      
|                              | Additional authorization            |           |       | 4,500               |   |                |        |       |   |   |       |      | 
|                              | Assumption of SpeedFam-IPEC options |           |       | 530                 |   |                |        | 1,145  |   |   | $     | 42.85 | 
|                              | Options granted                     |           |       | (6,292              | ) |                |        | 6,292  |   |   | $     | 33.34 | 
|                              | Options exercised                   |           |       |                    |   |                |        | (2,485 | ) |   | $     | 15.23 | 
|                              | Options expired                     |           |       | (513                | ) |                |        |       |   |   | $     | 35.71 | 
|                              | Options canceled                    |           |       | 1,455               |   |                |        | (1,455 | ) |   | $     | 36.58 | 
|                              |                                     |           |       |                     |   |                |        |        |   |   |       |      
|Balances at December 31, 2002 |                                     |           | 8,854 |                     |   |                | 26,056 |        |   | $ | 31.16 |      
|                              | Options granted                     |           |       | (3,966              | ) |                |        | 3,966  |   |   | $     | 38.94 | 
|                              | Options exercised                   |           |       |                    |   |                |        | (3,073 | ) |   | $     | 18.70 | 
|                              | Options expired                     |           |       | (503                | ) |                |        |       |   |   | $     | 45.82 | 
|                              | Options canceled                    |           |       | 1,651               |   |                |        | (1,651 | ) |   | $     | 45.82 | 
|                              |                                     |           |       |                     |   |                |        |        |   |   |       |      
|Balances at December 31, 2003 |                                     |           | 6,036 |                     |   |                | 25,298 |        |   | $ | 32.80 |      
|                              |                                     |           |       |                     |   |                |        |        |   |   |       |      

The following table summarizes information about
stock options outstanding as of December 31, 2003 (share
data in thousands):

|                    |                |                     |  |                  |        |                  |  |                   |      |                  |  |   |       |  |  |  |        |  |  |   |       | 
|------------------- | -------------- | ------------------- |  | ---------------- | ------ | ---------------- |  | ----------------- | ---- | ---------------- |  | - | ----- |  |  |  | ------ |  |  | - | ----- | 
|                    |                |                    
|Options Outstanding |                | Options Exercisable
|                    |                |                    
|                    |                | Weighted-Average    |  |                  |        |                 
|                    |                | Options Outstanding |  | Remaining        |        |                  |  | Options           |      |                 
|Range of            |                | at December 31,     |  | Contractual Life |        | Weighted-Average |  | Exercisable at    |      | Weighted-Average
|Exercise Prices     |                | 2003                |  | (years)          |        | Exercise Price   |  | December 31, 2003 |      | Exercise Price  
|                    |                |                     |  |                  |        |                  |  |                   |      |                 
|                    | $4.69-$25.55   |                     |  |                  | 6,041  |                  |  |                   | 5.09 |                  |  | $ | 19.62 |  |  |  | 5,814  |  |  | $ | 19.60 | 
|                    | $25.56-$30.05  |                     |  |                  | 5,111  |                  |  |                   | 8.69 |                  |  | $ | 29.10 |  |  |  | 1,544  |  |  | $ | 28.89 | 
|                    | $30.06-$35.89  |                     |  |                  | 2,920  |                  |  |                   | 7.21 |                  |  | $ | 30.85 |  |  |  | 1,899  |  |  | $ | 30.52 | 
|                    | $36.50-$38.70  |                     |  |                  | 5,283  |                  |  |                   | 8.03 |                  |  | $ | 38.60 |  |  |  | 2,613  |  |  | $ | 38.69 | 
|                    | $38.87-$253.71 |                     |  |                  | 5,943  |                  |  |                   | 8.48 |                  |  | $ | 45.32 |  |  |  | 1,606  |  |  | $ | 51.09 | 
|                    |                |                     |  |                  |        |                  |  |                   |      |                  |  |   |       |  |  |  |        |  |  |   |       | 
|                    | $4.69-$253.71  |                     |  |                  | 25,298 |                  |  |                   | 7.47 |                  |  | $ | 32.80 |  |  |  | 13,476 |  |  | $ | 29.66 | 
|                    |                |                     |  |                  |        |                  |  |                   |      |                  |  |   |       |  |  |  |        |  |  |   |       | 

The range of option exercise prices for options
outstanding at December 31, 2003 is wide, primarily due to
the impact of assumed options of acquired companies that had
experienced significant price fluctuations.

62



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                                               
| | ----------------------------------------------
| | Restricted Stock and Deferred
    Compensation

We award restricted stock to our employees,
primarily vice presidents and senior executives, from our 1992
Stock Option Plan and our 2001 Stock Incentive Plan,
collectively referred to as the Plans. We have awarded a total
of 477,100 shares of common stock under the Plans, of which
249,100 shares of common stock remain outstanding as of
December 31, 2003. Our restricted stock normally vests
ratably or on a cliff basis over four or five years and is
subject to forfeiture if employment terminates prior to vesting.
Deferred compensation is recorded based on the market value of
the restricted shares at grant and is presented as a reduction
of shareholders equity in our consolidated balance sheets.
Deferred compensation is amortized as compensation expense over
the vesting period, using the graded-vesting method. For the
years ended December 31, 2003, 2002 and 2001, approximately
$1.9 million, $1.7 million, and $1.5 million,
respectively, was recorded as amortization expense related to
restricted stock issuances.

In connection with the acquisition of
SpeedFam-IPEC on December 6, 2002, we recorded deferred
compensation of $3.1 million for the intrinsic value of
unvested stock options we assumed. Approximately
328,000 shares of unvested stock options were assumed at
the acquisition date. These stock options had exercise prices
ranging from $11.22 to $324.53 per share, a
weighted-average exercise price of $42.85, and a
weighted-average contractual life of five years. The deferred
compensation is presented as a reduction of shareholders
equity in our consolidated balance sheets and is being amortized
as compensation expense over the remaining vesting period, using
the graded-vesting method. For the years ended December 31,
2003 and 2002, approximately $1.4 million and
$0.2 million, respectively, was recorded as amortization
expense related to these stock options.



| |                              
| | -----------------------------
| | Employee Stock Purchase Plans

In December 1988 and May 1992, we adopted
qualified Employee Stock Purchase Plans, referred to herein as
the Purchase Plans, under Sections 421 and 423 of the
Internal Revenue Code, and reserved 1,200,000 and
900,000 shares of common stock for issuance under the
respective Purchase Plans. In April 1998, the Board of Directors
approved amendments to the Purchase Plans, which were
subsequently ratified by shareholders, increasing the number of
shares available for issuance thereunder from
2,100,000 shares to 2,850,000 shares. In April 1999,
the Board of Directors approved amendments to the Purchase
Plans, which were subsequently ratified by shareholders,
increasing the number of shares available for issuance
thereunder from 2,850,000 shares to 3,900,000 shares.
Under the Purchase Plans, qualified employees are entitled to
purchase shares at 85% of the fair market value on specified
dates. There were approximately 557,000, 366,000 and
309,000 shares issued under the Purchase Plans in 2003,
2002 and 2001, respectively. In fiscal 2002, an additional
1,000,000 shares of common stock were reserved for future
issuance under the Purchase Plans. As of December 31, 2003,
approximately 706,000 shares were reserved for future
issuance under the Purchase Plans.



| |                                         
| | ----------------------------------------
| | Employee Savings and Retirement
    Plan

We maintain a 401(k) retirement savings plan for
our full-time employees. Participants in the 401(k) plan may
contribute up to 20% of their annual salary, limited by the
maximum dollar amount allowed by the Internal Revenue Code. In
January 2000, we announced that we would contribute a percentage
of each participating employees salary deferral
contributions or 50% of the first 6% of an employees
annual compensation, up to a maximum of $2,000. Our matching
contributions are invested in Novellus common stock and,
beginning on January 1, 2000, become fully vested at the
end of the employees third year of service. We recorded
$3.5 million, $3.6 million and $4.7 million of
expense in connection with matching contributions under the
401(k) plan for the years ended December 31, 2003, 2002 and
2001, respectively.

63



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|         |                                                         
|-------- | --------------------------------------------------------
|Note 14. | Geographic Information Reporting and Major
    Customers

We operate primarily in one segment, the
manufacturing, marketing and servicing of semiconductor
equipment for thin film deposition, surface preparation and
chemical mechanical planarization. In accordance with
SFAS No. 131, Disclosures About Segments of an
Enterprise and Related Information, our chief operating
decision-maker is the Chairman and Chief Executive Officer, who
reviews operating results to make decisions about allocating
resources and assessing performance for the entire company. All
material operating units qualify for aggregation under
SFAS No. 131, due to their identical customer base and
similarities in economic characteristics, nature of products and
services, and process for procurement, manufacturing and
distribution processes. Since we primarily operate in one
segment and in one group of similar products and services, all
financial segment and product line information required by
SFAS No. 131 can be found in the consolidated
financial statements.

For the year ended December 31, 2003, two
customers accounted for 27% and 12% of our net sales,
respectively. For the year ended December 31, 2002, four
customers accounted for 17%, 11%, 11% and 10% of our net sales,
respectively. For the year ended December 31, 2001, one
customer accounted for 16% of our total net sales.

For geographical reporting, revenues are
attributed to the geographic location in which our subsidiaries
are located. Long-lived property, plant and equipment, goodwill
and other intangible assets are attributed to the geographic
location in which the assets are located.

The following is a summary of operations by
geographic area (in thousands):

|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |           | 
|-------------------------------------- | --------------- | ------------- | --------- | --------- |  | ---- | ------ | ----------- |  | ------------ | ------- | ------- |  | - | ------- | ------- | - | - | --------- | --------- | 
|                                       |                 | North America |           | Europe    |  | Asia |        | Elimination |  | Consolidated
|                                       |                 |               |           |           |  |      |        |             |  |             
|2003                                   |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|Sales to unaffiliated customers        |                 | $             | 729,998   |           |  | $    | 24,965 |             |  | $            | 170,107 |         |  | $ |        |         |   | $ | 925,070   |          
|Transfers between geographic locations |                 |               | 42,217    |           |  |      | 17,828 |             |  |              | 39,312  |         |  |   | (99,357 | )       |   |   |          |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|                                       | Total net sales |               |           | 772,215   |  |      |        | 42,793      |  |              |         | 209,419 |  |   |         | (99,357 | ) |   |           | 925,070   | 
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|Operating income (loss)                |                 | $             | (81,960   | )         |  | $    | 3,608  |             |  | $            | 46,766  |         |  | $ |        |         |   | $ | (31,586   | )        
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|Long-lived assets                      |                 |               | 503,952   |           |  |      | 915    |             |  |              | 1,700   |         |  |   |        |         |   |   | 506,567   |          
|All other identifiable assets          |                 |               | 1,690,927 |           |  |      | 24,081 |             |  |              | 117,325 |         |  |   |        |         |   |   | 1,832,333 |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|                                       | Total assets    |               | $         | 2,194,879 |  |      | $      | 24,996      |  |              | $       | 119,025 |  |   | $       |        |   |   | $         | 2,338,900 | 
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          

|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |           | 
|-------------------------------------- | --------------- | ------------- | --------- | --------- |  | ---- | ------ | ----------- |  | ------------ | ------- | ------- |  | - | ------- | ------- | - | - | --------- | --------- | 
|                                       |                 | North America |           | Europe    |  | Asia |        | Elimination |  | Consolidated
|                                       |                 |               |           |           |  |      |        |             |  |             
|2002                                   |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|Sales to unaffiliated customers        |                 | $             | 719,957   |           |  | $    | 8,031  |             |  | $            | 111,970 |         |  | $ |        |         |   | $ | 839,958   |          
|Transfers between geographic locations |                 |               | 14,349    |           |  |      | 13,898 |             |  |              | 33,665  |         |  |   | (61,912 | )       |   |   |          |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|                                       | Total net sales |               |           | 734,306   |  |      |        | 21,929      |  |              |         | 145,635 |  |   |         | (61,912 | ) |   |           | 839,958   | 
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|Operating income (loss)                |                 | $             | (47,548   | )         |  | $    | 37,017 |             |  | $            | 4,730   |         |  | $ |        |         |   | $ | (5,801    | )        
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|Long-lived assets                      |                 |               | 175,095   |           |  |      | 3,815  |             |  |              | 1,016   |         |  |   |        |         |   |   | 179,926   |          
|All other identifiable assets          |                 |               | 2,190,365 |           |  |      | 15,717 |             |  |              | 107,986 |         |  |   |        |         |   |   | 2,314,068 |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          
|                                       | Total assets    |               | $         | 2,365,460 |  |      | $      | 19,532      |  |              | $       | 109,002 |  |   | $       |        |   |   | $         | 2,493,994 | 
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |         |         |   |   |           |          

64



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##### Table of Contents



NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |           | 
|-------------------------------------- | --------------- | ------------- | --------- | --------- |  | ---- | ------ | ----------- |  | ------------ | ------- | ------- |  | - | -------- | -------- | - | - | --------- | --------- | 
|                                       |                 | North America |           | Europe    |  | Asia |        | Elimination |  | Consolidated
|                                       |                 |               |           |           |  |      |        |             |  |             
|2001                                   |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |          
|Sales to unaffiliated customers        |                 | $             | 1,165,923 |           |  | $    | 7,425  |             |  | $            | 165,974 |         |  | $ |         |          |   | $ | 1,339,322 |          
|Transfers between geographic locations |                 |               | 84,257    |           |  |      | 16,185 |             |  |              | 33,347  |         |  |   | (133,789 | )        |   |   |          |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |          
|                                       | Total net sales |               |           | 1,250,180 |  |      |        | 23,610      |  |              |         | 199,321 |  |   |          | (133,789 | ) |   |           | 1,339,322 | 
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |          
|Operating income                       |                 | $             | 135,137   |           |  | $    | 2,170  |             |  | $            | 14,677  |         |  | $ |         |          |   | $ | 151,984   |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |          
|Long-lived assets                      |                 |               | 172,494   |           |  |      | 608    |             |  |              | 4,499   |         |  |   |         |          |   |   | 177,601   |          
|All other identifiable assets          |                 |               | 2,758,827 |           |  |      | 5,475  |             |  |              | 89,221  |         |  |   |         |          |   |   | 2,853,523 |          
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |          
|                                       | Total assets    |               | $         | 2,931,321 |  |      | $      | 6,083       |  |              | $       | 93,720  |  |   | $        |         |   |   | $         | 3,031,124 | 
|                                       |                 |               |           |           |  |      |        |             |  |              |         |         |  |   |          |          |   |   |           |          

Revenue for each geographic area is recognized
from the locations within a designated geographic region in
accordance with SAB 104, which superseded the earlier
related guidance in SAB 101. Transfers and commission
arrangements between geographic areas are at prices sufficient
to recover a reasonable profit.



|         |                              
|-------- | -----------------------------
|Note 15. | Bad Debt Write-off (Recovery)

In September 2001, we determined that due to the
financial difficulties facing one of our customers, an
outstanding accounts receivable balance was at risk for
collection. Accordingly, we recorded a write-off of
$7.7 million. In the first quarter of 2002, all amounts
under this accounts receivable balance were paid, resulting in a
recovery of $7.7 million.



|         |                           
|-------- | --------------------------
|Note 16. | Related Party Transactions

In March 2002, we began leasing an aircraft from
NVLS I, LLC, a third-party entity wholly-owned by
Richard S. Hill, our Chairman and Chief Executive Officer.
Under the aircraft lease agreement, we incurred lease expense of
approximately $0.8 and $0.2 million for the years ended
December 31, 2003 and 2002.

A member of our Board of Directors, D. James
Guzy, is also a member of the Board of Directors of Intel
Corporation, one of our significant customers. Intel Corporation
represented approximately 12%, 11% and 16% of net sales for the
years ended December 31, 2003, 2002 and 2001, respectively.
Intel Corporation also accounted for 6% and 18% of our accounts
receivable as of December 31, 2003 and 2002, respectively.

From time to time we have made secured and
unsecured relocation loans to our executive officers, vice
presidents and key personnel. As of December 31, 2003, we
do not have any outstanding loans to our executive officers as
defined by the Securities and Exchange Commission. However, we
do have outstanding loans to certain non-executive
vice-presidents and key personnel. As of December 31, 2003
and 2002, the total outstanding balance of loans to
non-executive vice presidents and key personnel was
approximately $5.7 million and $6.0 million,
respectively. Of the amount outstanding at December 31,
2003, $4.8 million was secured by collateral. Excluding
relocation loans, all other loans bear interest.

65



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NOVELLUS SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|         |                                     
|-------- | ------------------------------------
|Note 17. | Quarterly Financial Data (Unaudited)

|                                                                                                               |                   |                                       |         |         |  |            |         |         |  |   |         |         |   |   |         |        | 
|-------------------------------------------------------------------------------------------------------------- | ----------------- | ------------------------------------- | ------- | ------- |  | ---------- | ------- | ------- |  | - | ------- | ------- | - | - | ------- | ------ | 
|                                                                                                               |                   |                                      
|                                                                                                               |                   | Year Ended December 31, 2003         
|                                                                                                               |                   |                                      
|                                                                                                               |                   | First                                 |         | Second  |  | Third      |         | Fourth 
|                                                                                                               |                   | Quarter                               |         | Quarter |  | Quarter(1) |         | Quarter
|                                                                                                               |                   |                                       |         |         |  |            |         |        
|                                                                                                               |                   |                                      
|                                                                                                               |                   | (In thousands, except per share data)
|Net sales                                                                                                      |                   | $                                     | 238,410 |         |  | $          | 239,050 |         |  | $ | 221,099 |         |   | $ | 226,511 |       
|Gross profit                                                                                                   |                   | $                                     | 109,814 |         |  | $          | 105,322 |         |  | $ | 58,776  |         |   | $ | 106,088 |       
|Net income (loss) before cumulative effect of a
    change in accounting principle                             |                   | $                                     | 11,872  |         |  | $          | 7,430   |         |  | $ | (34,788 | )       |   | $ | 10,452  |       
|Cumulative effect of change in accounting
    principle                                                        |                   |                                       |        |         |  |            |        |         |  | $ | (62,780 | )       |   |   |        |       
|                                                                                                               | Net income (loss) |                                       | $       | 11,872  |  |            | $       | 7,430   |  |   | $       | (97,568 | ) |   | $       | 10,452 | 
|Basic and diluted net income (loss) per share
    before cumulative effect of a change in accounting principle |                   | $                                     | 0.08    |         |  | $          | 0.05    |         |  | $ | (0.22   | )       |   | $ | 0.07    |       
|Cumulative effect of change in accounting
    principle                                                        |                   |                                       |        |         |  |            |        |         |  | $ | (0.42   | )       |   |   |        |       
|Basic and diluted net income (loss) per share                                                                  |                   | $                                     | 0.08    |         |  | $          | 0.05    |         |  | $ | (0.64   | )       |   | $ | 0.07    |       
|Shares used in basic per share calculations                                                                    |                   |                                       | 149,434 |         |  |            | 149,950 |         |  |   | 151,280 |         |   |   | 152,057 |       
|Shares used in diluted per share calculations                                                                  |                   |                                       | 152,229 |         |  |            | 153,034 |         |  |   | 151,280 |         |   |   | 156,580 |       

|                                              |  |                                       |         |         |  |            |         |            |  |   |         |  |  |   |         | 
|--------------------------------------------- |  | ------------------------------------- | ------- | ------- |  | ---------- | ------- | ---------- |  | - | ------- |  |  | - | ------- | 
|                                              |  |                                      
|                                              |  | Year Ended December 31, 2002         
|                                              |  |                                      
|                                              |  | First                                 |         | Second  |  | Third      |         | Fourth    
|                                              |  | Quarter(2)                            |         | Quarter |  | Quarter(3) |         | Quarter(4)
|                                              |  |                                       |         |         |  |            |         |           
|                                              |  |                                      
|                                              |  | (In thousands, except per share data)
|Net sales                                     |  | $                                     | 169,679 |         |  | $          | 222,147 |            |  | $ | 230,495 |  |  | $ | 217,637 | 
|Gross profit                                  |  | $                                     | 71,530  |         |  | $          | 101,564 |            |  | $ | 109,382 |  |  | $ | 96,047  | 
|Net income                                    |  | $                                     | 3,836   |         |  | $          | 12,013  |            |  | $ | 4,083   |  |  | $ | 2,988   | 
|Basic and diluted net income per share        |  | $                                     | 0.03    |         |  | $          | 0.08    |            |  | $ | 0.03    |  |  | $ | 0.02    | 
|Shares used in basic per share calculations   |  |                                       | 144,255 |         |  |            | 145,120 |            |  |   | 143,691 |  |  |   | 144,416 | 
|Shares used in diluted per share calculations |  |                                       | 150,624 |         |  |            | 151,053 |            |  |   | 146,094 |  |  |   | 147,219 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The third quarter 2003 results include
    restructuring and other charges of $62.5 million and a
    non-cash charge of $62.8 million, net of tax, as a
    cumulative effect of a change in accounting principle from the
    consolidation of properties previously accounted for as
    synthetic leases.                                                                         
|   
|(2) | The first quarter 2002 results include
    $9.0 million of pre-tax net benefit, which reflects the
    combined effect of a benefit of $7.7 million for recovery
    of an account receivable previously written-off and a
    $4.6 million gain on sale of an equity investment,
    partially offset by $3.3 million of severance charges.                                          
|   
|(3) | The third quarter 2002 results include a
    $17.0 million pre-tax charge for the write-off of debt
    issuance costs related to the retirement of the
    $880.0 million Liquid Yield Option Notes.                                                                                                                                                                                 
|   
|(4) | The fourth quarter 2002 results include
    $3.2 million of pre-tax restructuring charges and an
    $11.5 million net loss from SpeedFam-IPEC operations
    subsequent to the close of the acquisition on December 6,
    2002 to December 31, 2002. The $11.5 million loss
    contributed by SpeedFam-IPEC includes a $9.0 million
    in-process research and development charge.

66



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REPORT OF ERNST & YOUNG
LLP, INDEPENDENT AUDITORS

The Board of Directors and Shareholders

Novellus Systems, Inc.

We have audited the accompanying consolidated
balance sheets of Novellus Systems, Inc. as of
December 31, 2003 and 2002, and the related consolidated
statements of operations, shareholders equity, and cash
flows for each of the three years in the period ended
December 31, 2003. Our audits also included the financial
statement schedule listed in the index at Item 15(a)(2).
These financial statements and schedule are the responsibility
of the Companys management. Our responsibility is to
express an opinion on these financial statements and schedule
based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of Novellus Systems, Inc.
as of December 31, 2003 and 2002 and the consolidated
results of its operations and its cash flows for each of the
three years in the period ended December 31, 2003, in
conformity with accounting principles generally accepted in the
United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.

As discussed in Note 6 to the consolidated
financial statements, in 2002, Novellus changed its method of
accounting for goodwill and other intangible assets in
accordance with guidance provided in Statement of Financial
Accounting Standards No. 142, Goodwill and Other
Intangible Assets.

As discussed in Note 10 to the consolidated
financial statements, in 2003 Novellus changed its method of
accounting for synthetic leases in accordance with FASB
Interpretation No. 46, Consolidation of Variable
Interest Entities, an Interpretation of Accounting Research
Bulletin No. 51.



| |                  
| | -----------------
| | ERNST & YOUNG LLP

San Jose, California

January 23, 2004


67



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##### Table of Contents








|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

Not applicable.






|         |                        
|-------- | -----------------------
|Item 9a. | Controls and Procedures

Evaluation of Our Disclosure Controls and
Internal Controls

As of the end of the period covered by this
Annual Report on Form 10-K, we evaluated the effectiveness
of the design and operation of our disclosure controls and
procedures and our internal controls and procedures for
financial reporting. This controls evaluation was performed
under the supervision and with the participation of management,
including our Chief Executive Officer (CEO) and Chief
Financial Officer (CFO). Rules adopted by the Securities and
Exchange Commission, or the SEC, require that in this section of
the Annual Report on Form 10-K, we present the conclusions
of the CEO and the CFO about the effectiveness of our disclosure
controls and internal controls for financial reporting based on
and as of the date of the controls evaluation.

CEO and CFO Certifications

The certifications of the CEO and the CFO
required in accordance with Section 302 of the
Sarbanes-Oxley Act of 2002 are filed as exhibits to this Annual
Report on Form 10-K. This section of the Annual Report on
Form 10-K contains the information concerning the controls
evaluation referred to in the Section 302 certifications.
This information should be read in conjunction with the
Section 302 certifications for a more complete
understanding of the topics presented.

Disclosure Controls and Internal Controls for
Financial Reporting

Disclosure controls are procedures that are
designed with the objective of ensuring that information
required to be disclosed in our reports filed under the
Securities Exchange Act of 1934, or the Exchange Act, such as
this Annual Report on Form 10-K, is recorded, processed,
summarized and reported within the time periods specified in the
SECs rules and forms. Disclosure controls are also
designed with the objective of ensuring that such information is
accumulated and communicated to our management, including the
CEO and CFO, as appropriate to allow timely decisions regarding
required disclosure. Internal controls for financial reporting
are procedures which are designed with the objective of
providing reasonable assurance that our transactions are
properly authorized, our assets are safeguarded against
unauthorized or improper use and our transactions are properly
recorded and reported, all to permit the preparation of our
financial statements in conformity with accounting principles
generally accepted in the United States of America.

Limitations on the Effectiveness of
Controls

The companys management, including the CEO
and CFO, do not expect that our disclosure controls or our
internal controls for financial reporting will prevent all error
and all fraud. A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of
the inherent limitations in all control systems, no evaluation
of controls can provide absolute assurance that all control
issues and instances of fraud, if any, within the company have
been detected. These inherent limitations include the realities
that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or mistake.
Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by
management override of the controls. The design of any system of
controls also is based in part upon certain assumptions about
the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under
all potential future conditions; over time, controls may become
inadequate because of changes in conditions, or the degree of
compliance with the policies or procedures may deteriorate.
Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be
detected.

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##### Table of Contents



Scope of the Controls Evaluation

The evaluation of our disclosure controls and our
internal controls for financial reporting by our CEO and CFO
included a review of the controls implemented by the company and
the effect of the controls on the information generated for use
in this Annual Report on Form 10-K. In the course of the
controls evaluation, we sought to identify data errors, controls
problems or acts of fraud and to confirm that appropriate
corrective action, including process improvements, were being
undertaken. This type of evaluation will be performed on a
quarterly basis so that the conclusions concerning our controls
effectiveness can be reported in our Quarterly Reports on
Form 10-Q and our Annual Report on Form 10-K. Our
internal controls for financial reporting are also evaluated on
an ongoing basis by our outsourced internal audit department and
by other personnel in our finance department. The overall goal
of these various evaluation activities is to monitor our
disclosure controls and our internal controls for financial
reporting and to make modifications as necessary; our intent in
this regard is that the disclosure controls and the internal
controls for financial reporting will be maintained as dynamic
systems that change (including improvements and corrections) as
conditions warrant.

Among other matters, we sought in our evaluation
to determine whether there were any significant
deficiencies or material weaknesses in the
companys internal controls for financial reporting, or
whether the company had identified any acts of fraud involving
personnel who have a significant role in the companys
internal controls for financial reporting. This information was
important both for the controls evaluation generally and because
items 5 and 6 in the Section 302 certifications of the CEO
and CFO require that the CEO and CFO disclose that information
to our Boards Audit Committee and to our independent
auditors and report on related matters in this section of the
Annual Report on Form 10-K. In the professional auditing
literature, significant deficiencies are referred to
as reportable conditions. These are control issues
that could have a significant adverse effect on the ability to
record, process, summarize and report financial data in the
financial statements. A material weakness is defined
in the auditing literature as a particularly serious reportable
condition where the internal control for financial reporting
does not reduce to a relatively low level the risk that
misstatements caused by error or fraud may occur in amounts that
would be material in relation to the financial statements and
not be detected within a timely period by employees in the
normal course of performing their assigned functions. We also
sought to deal with other controls matters in the controls
evaluation, and in each case if a problem was identified, we
considered what revision, improvement and/or correction to make
in accordance with our ongoing procedures. In accordance with
SEC requirements, the CEO and CFO note that, during our most
recent fiscal quarter, there have been no changes in internal
controls for financial reporting that have actually affected or
are reasonably likely to materially affect our internal controls
for financial reporting.

Conclusions

Based upon the controls evaluation, our CEO and
CFO have concluded that, subject to the limitations noted above,
our disclosure controls are effective to ensure that material
information relating to the company is made known to management,
including the CEO and CFO, particularly during the period when
our periodic reports are being prepared, and that our internal
controls for financial reporting are effective to provide
reasonable assurance that our financial statements are fairly
presented in conformity with accounting principles generally
accepted in the United States of America.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

The information required by this item is included
under Proposal No. 1: Election of Directors,
Other Information  Executive Officers and
Compliance with Section 16(a) of the Exchange
Act in our Proxy Statement, to be filed in connection with
our 2004 Annual Meeting of Shareholders, and is incorporated
herein by reference.

Novellus has adopted a Code of Conduct that is
designed to qualify as a code of ethics within the
meaning of Section 406 of the Sarbanes-Oxley Act of 2002
and the rules promulgated thereunder. The Code

69



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##### Table of Contents



of Conduct is available on our website at
www.novellus.com. To the extent required by law, any
amendments to, or waivers from, any provision of the Code of
Conduct will promptly disclosed to the public. To the extent
permitted by such legal requirements, Novellus intends to make
such public disclosure by posting the relevant material on our
website in accordance with SEC rules.







|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this item is included
under Other Information  Executive
Compensation in our Proxy Statement, to be filed in
connection with our 2004 Annual Meeting of Shareholders, and is
incorporated herein by reference.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The information required by this item is included
under Other Information  Security Ownership of
Certain Beneficial Owners and Management in our Proxy
Statement, to be filed in connection with our 2004 Annual
Meeting of Shareholders, and is incorporated herein by reference.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this item is included
under Other Information  Certain
Transactions in our Proxy Statement, to be filed in
connection with our 2004 Annual Meeting of Shareholders, and is
incorporated herein by reference.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

Information concerning principal accountant fees
and services and the audit committees pre-approval
policies and procedures appears in our 2003 Proxy Statement
under the headings, Audit Fees and All Other
Fees, and is incorporated herein by reference.




PART IV






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules,
    and Reports on Form 8-K



| |     |                                                              
| | --- | -------------------------------------------------------------
| | (a) | The following documents are filed as part of this
    report:



|    |                                                                               
|--- | ------------------------------------------------------------------------------
|(1) | Financial Statements and Report of
    Ernst & Young LLP, Independent Auditors

Consolidated Statements of Operations 
Years Ended December 31, 2003, 2002, and 2001.


Consolidated Balance Sheets at December 31,
2003 and 2002.


Consolidated Statements of Cash Flows 
Years Ended December 31, 2003, 2002, and 2001.


Consolidated Statement of Shareholders
Equity  Years Ended December 31, 2003, 2002 and
2001.


Notes to Consolidated Financial Statements.


Report of Ernst & Young
LLP, Independent Auditors.




| |     |                              
| | --- | -----------------------------
| | (2) | Financial Statement Schedules

The following financial statement schedule is
filed as part of this Report on Form 10-K and should be
read in conjunction with the financial statements:


Schedule II 
Valuation and Qualifying Accounts.


| |                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| | All other schedules are omitted because they are
    not required or the required information is included in the
    financial statements or notes thereto.



| |     |                                                                      
| | --- | ---------------------------------------------------------------------
| | (3) | Exhibits (numbered in accordance with
    Item 601 of Regulation S-K)

| |   |       |  |                                                                
| | - | ----- |  | ---------------------------------------------------------------
| | 3 | .1(1) |  | Amended and Restated Articles of Incorporation of
    Novellus.
| | 3 | .2    |  | Amended and Restated Bylaws of Novellus.                       

70



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| |     |         |  |                                                                                                                                                                                                                                                                    
| | --- | ------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10  | .3(2)   |  | Assignment and Assumption of Lessees
    Interest in Lease (Units 8 and 9, Palo Alto) and Covenants,
    Conditions and Restrictions on Leasehold Interests (Units 1-12,
    Palo Alto) by and between Varian Associates, Inc. and
    Novellus dated May 7, 1997.
| | 10  | .5(3)   |  | Environmental Agreement by and between Varian
    Associates, Inc. and Novellus dated May 7, 1997.                                                                                                                                                                 
| | 10  | .8(4)   |  | Settlement Agreement by and between Applied
    Materials, Inc. and Novellus dated May 4, 1997.
    Confidential treatment has been granted with respect to portions
    of this Exhibit.                                                                          
| | *10 | .9(5)   |  | Novellus 1992 Stock Option Plan, together
    with forms of agreements thereunder.                                                                                                                                                                                
| | *10 | .10(6)  |  | Form of Restated Stock Purchase Agreement between
    Novellus and Jeff Benzing, Wilbert van den Hoek and certain
    other employees of Novellus dated December 16, 1999.                                                                                         
| | *10 | .11(7)  |  | Novellus 1992 Employee Stock Purchase Plan.                                                                                                                                                                                                                       
| | *10 | .12(8)  |  | Form of Directors and Officers Indemnification
    Agreement.                                                                                                                                                                                                      
| | *10 | .13(9)  |  | Employment Agreement between Novellus and Peter
    Hanley dated June 15, 1992.                                                                                                                                                                                    
| | *10 | .14(10) |  | Offer Letter Agreement between Novellus and
    Richard S. Hill dated November 1, 1993.                                                                                                                                                                            
| | *10 | .15(11) |  | Employment Agreement between Novellus and Richard
    S. Hill dated October 1, 1998.                                                                                                                                                                               
| | *10 | .16(12) |  | Amendment to Employment Agreement between
    Novellus and Richard S. Hill dated December 16, 1999.                                                                                                                                                                
| | *10 | .18(13) |  | GaSonics International Corporation Amended and
    Restated 1994 Stock Option/Stock Issuance Plan, together with
    forms of agreements thereunder, as assumed by Novellus.                                                                                       
| | *10 | .19(14) |  | Gamma Precision Technology, Inc. 1998 Stock
    Option Plan, together with forms of agreements thereunder, as
    assumed by Novellus.                                                                                                                             
| | *10 | .20(15) |  | GaSonics International Corporation Supplemental
    Stock Option Plan, as assumed by Novellus.                                                                                                                                                                     
| | 10  | .21(16) |  | Form of Light Industrial Lease between Teachers
    Insurance and Annuity Association of America and
    GaSonics, Inc. for office space at 2730 Junction Avenue,
    San Jose, California.                                                                        
| | 10  | .22(17) |  | Participation Agreement among Novellus
    Systems, Inc., ABN AMRO Leasing, Inc., the
    participants named therein and ABN AMRO Bank N.V. dated
    April 18, 2001.                                                                                              
| | *10 | .23(18) |  | Novellus Systems, Inc. 2001 Stock Incentive
    Plan dated May 11, 2001, together with forms of agreement
    thereunder.                                                                                                                                          
| | 10  | .24(19) |  | Participation Agreement among Novellus
    Systems, Inc., ABN AMRO Leasing, Inc., Novellus
    Investment I, LLC and ABN AMRO Bank N.V. dated
    September 21, 2001.                                                                                              
| | 10  | .25(20) |  | Amended and Restated Ground Lease Agreement
    between Novellus Systems, Inc. and ABN AMRO
    Leasing, Inc. dated September 21, 2001.                                                                                                                            
| | *10 | .26(21) |  | SpeedFam-IPEC, Inc. Amended and Restated
    1995 Stock Plan, as assumed by Novellus.                                                                                                                                                                              
| | *10 | .27(22) |  | SpeedFam-IPEC, Inc. 2001 Nonstatutory Stock
    Option Plan, together with forms of agreements thereunder, as
    assumed by Novellus.                                                                                                                             
| | *10 | .28(23) |  | Integrated Process Equipment Corporation 1992
    Stock Option Plan, as assumed by Novellus.                                                                                                                                                                       
| | *10 | .29(24) |  | SpeedFam International, Inc. Amended and
    Restated 1991 Employee Incentive Stock Option Plan, as assumed
    by Novellus.                                                                                                                                       
| | *10 | .30(25) |  | SpeedFam-IPEC, Inc. Stand-Alone Stock Option
    Agreement dated June 14, 2001 between
    SpeedFam-IPEC, Inc. and Peter Simone, as assumed by
    Novellus.                                                                                                       
| | 10  | .31(26) |  | Lease Agreement between Seldin Properties and
    Integrated Process Equipment Corp. dated December 26, 1996.                                                                                                                                                      
| | 10  | .32(27) |  | Purchase and Sale Agreement between Glen Una
    Management Company, Inc. and SpeedFam-IPEC, Inc. dated
    May 31, 2002.                                                                                                                                          
| | 10  | .33(28) |  | Lease Agreement between Phoenix Industrial
    Investment Partners, L.P. and SpeedFam-IPEC, Inc. dated
    June 21, 2002.                                                                                                                                          
| | 10  | .34(29) |  | First Amendment to Lease Agreement between
    Phoenix Industrial Investment Partners, L.P. and
    SpeedFam-IPEC, Inc. dated January 21, 2003.                                                                                                                    

71



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##### Table of Contents



| |     |         |  |                                                                                                                                                                                                                                                                        
| | --- | ------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10  | .35(30) |  | Lease Guaranty between Novellus and Phoenix
    Industrial Investment Partners, L.P. dated January 21, 2002.                                                                                                                                                           
| | 10  | .36(31) |  | Separation Agreement between Novellus and Asuri
    Raghavan dated February 5, 2003.                                                                                                                                                                                   
| | *10 | .37     |  | Amendment to Employment Agreement between
    Novellus and Richard S. Hill dated January 14, 2004.                                                                                                                                                                     
| | *10 | .38     |  | Letter Agreement between Novellus and Peter
    Hanley dated December 11, 2003.                                                                                                                                                                                        
| | *10 | .39     |  | Letter Agreement between Novellus and Sasson
    Somekh dated January 23, 2004.                                                                                                                                                                                        
| | *10 | .40     |  | Letter Agreement between Novellus and Thomas St.
    Dennis dated June 27, 2003.                                                                                                                                                                                       
| | *10 | .41     |  | Restricted Stock Purchase Agreement between
    Novellus and Richard S. Hill dated December 13, 2002.                                                                                                                                                                  
| | *10 | .42     |  | Stand-Alone Stock Option Agreement dated
    January 23, 2004, between Novellus and Sasson Somekh.                                                                                                                                                                     
| | *10 | .43     |  | Stand-Alone Restricted Stock Award dated
    January 23, 2004, between Novellus and Sasson Somekh.                                                                                                                                                                     
| | 21  | .1      |  | Subsidiaries of Novellus.                                                                                                                                                                                                                                              
| | 23  | .1      |  | Consent of Ernst & Young
    LLP, Independent Auditors.                                                                                                                                                                                                                
| | 24  | .1      |  | Power of Attorney (see page 75).                                                                                                                                                                                                                                       
| | 31  | .1      |  | Certification of Richard S. Hill, Chairman of the
    Board of Directors and Chief Executive Officer of Novellus
    Systems, Inc. dated March 5, 2004 in accordance with
    18 U.S.C. 1350, as adopted pursuant to Section 302 of
    the Sarbanes-Oxley Act of 2002.
| | 31  | .2      |  | Certification of Kevin S. Royal, Vice President
    and Chief Financial Officer of Novellus Systems, Inc. dated
    March 5, 2004 in accordance with 18 U.S.C. 1350, as
    adopted pursuant to Section 302 of the Sarbanes-Oxley Act
    of 2002.                     
| | 32  | .1      |  | Certification of Richard S. Hill, Chairman of the
    Board of Directors and Chief Executive Officer of Novellus
    Systems, Inc. dated March 5, 2004 in accordance with
    18 U.S.C. 1350, as adopted pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.
| | 32  | .2      |  | Certification of Kevin S. Royal, Vice President
    and Chief Financial Officer of Novellus Systems, Inc. dated
    March 5, 2004 in accordance with 18 U.S.C. 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002.                     



---



| |     |                                                                                                                                                                                                 
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the exhibit with the
    corresponding exhibit number in Novellus Report on
    Form 10-K filed with the Securities and Exchange Commission
    on March 30, 2000.
|
| | (2) | Incorporated by reference to Exhibit 2.3 to
    Novellus Report on Form 8-K filed with the Securities
    and Exchange Commission on July 7, 1997.                                             
|
| | (3) | Incorporated by reference to Exhibit 2.6 to
    Novellus Report on Form 8-K filed with the Securities
    and Exchange Commission on July 7, 1997.                                             
|
| | (4) | Incorporated by reference to Exhibit 10.1 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on August 11, 1997.                                        
|
| | (5) | Incorporated by reference to Exhibit 10.30
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 26, 1993.                             
|
| | (6) | Incorporated by reference to Exhibit 10.21
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 30, 2000.                                        
|
| | (7) | Incorporated by reference to Exhibit 10.31
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 26, 1993.                             
|
| | (8) | Incorporated by reference to Exhibit 10.1
    filed with Novellus Report on Form 10-Q filed with
    the Securities and Exchange Commission on August 13, 2002.                                
|
| | (9) | Incorporated by reference to Exhibit 10.34
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 26, 1993.                             

72



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|     |                                                                                                                                                                    
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to Exhibit 10.41
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 18, 1994.
|    
|(11) | Incorporated by reference to Exhibit 10.27
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 10, 1999.           
|    
|(12) | Incorporated by reference to Exhibit 10.27
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 30, 2000.           
|    
|(13) | Incorporated by reference to Exhibit 10.31
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(14) | Incorporated by reference to Exhibit 10.32
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(15) | Incorporated by reference to Exhibit 10.33
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(16) | Incorporated by reference to Exhibit 10.34
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(17) | Incorporated by reference to Exhibit 10.6 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on May 15, 2001.              
|    
|(18) | Incorporated by reference to Exhibit 10.7 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on May 15, 2001.              
|    
|(19) | Incorporated by reference to Exhibit 10.1 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on November 13, 2001.         
|    
|(20) | Incorporated by reference to Exhibit 10.2 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on November 13, 2001.         
|    
|(21) | Incorporated by reference to Exhibit 10.30
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(22) | Incorporated by reference to Exhibit 10.31
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(23) | Incorporated by reference to Exhibit 10.32
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(24) | Incorporated by reference to Exhibit 10.33
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(25) | Incorporated by reference to Exhibit 10.34
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(26) | Incorporated by reference to Exhibit 10.35
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(27) | Incorporated by reference to Exhibit 10.36
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(28) | Incorporated by reference to Exhibit 10.37
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(29) | Incorporated by reference to Exhibit 10.38
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(30) | Incorporated by reference to Exhibit 10.39
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(31) | Incorporated by reference to Exhibit 10.29
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 21, 2002.           

73



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---



|    |  |                                                                                                                                                                                    
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*   |  | Management contracts or compensatory plans or
    arrangements.                                                                                                                    
|   
|(b) |  | Reports on Form 8-K:                                                                                                                                                               
|   
|    |  | On October 14, 2003, Novellus furnished a
    report on Form 8-K under Items 7 and 12 announcing our
    results of operations for the fiscal quarter ended
    September 27, 2003.

74



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities and Exchange Act of 1934, the
Registrant has duly caused this Report on Form 10-K to be
signed on its behalf by the undersigned, thereunto duly
authorized, in the City of San Jose, State of California on
this 12th day of March, 2004.



| |                       
| | ----------------------
| | NOVELLUS SYSTEMS, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ RICHARD S. HILL

| |                                   
| | ----------------------------------
| |                                   
| | Richard S. Hill                   
| | Chairman of the Board of Directors
| | and Chief Executive Officer       

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints
Richard S. Hill and Kevin S. Royal, and each of them, his
attorneys-in-fact, each with the power of substitution, for him
in any and all capacities, to sign any amendments to this Annual
Report on Form 10-K and to file the same, with exhibits
thereto and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his
substitute or substitutes, may do or cause to be done by virtue
hereof.

Pursuant to the requirements of the Securities
Exchange Act of 1934, this Annual Report on Form 10-K has
been signed by the following persons on behalf of the Registrant
in the capacities and on the date indicated.

|                                           |  |                                                                                                                  |  |                |  | 
|------------------------------------------ |  | ---------------------------------------------------------------------------------------------------------------- |  | -------------- |  | 
|                                           |  |                                                                                                                  |  |               
|Signature                                  |  | Title                                                                                                            |  | Date          
|                                           |  |                                                                                                                  |  |               
|                                          
|/s/ RICHARD S. HILLRichard S. Hill         |  | Chairman of the Board of Directors and Chief
    Executive Officer (Principal Executive Officer)                 |  | March 12, 2004
|                                          
|/s/ KEVIN S. ROYALKevin S. Royal           |  | Vice President and Chief Financial
    Officer(Principal Financial Officer and Principal Accounting
    Officer) |  | March 12, 2004
|                                          
|/s/ D. JAMES GUZYD. James Guzy             |  | Director                                                                                                         |  | March 12, 2004
|                                          
|/s/ J. DAVID LITSTER J.J. David Litster J. |  | Director                                                                                                         |  | March 12, 2004
|                                          
|/s/ YOSHIO NISHIYoshio Nishi               |  | Director                                                                                                         |  | March 12, 2004
|                                          
|/s/ GLEN POSSLEYGlen Possley               |  | Director                                                                                                         |  | March 12, 2004
|                                          
|/s/ WILLIAM R. SPIVEYWilliam R. Spivey     |  | Director                                                                                                         |  | March 12, 2004

75



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##### Table of Contents



|                                     |  |          |  |                |  | 
|------------------------------------ |  | -------- |  | -------------- |  | 
|                                     |  |          |  |               
|Signature                            |  | Title    |  | Date          
|                                     |  |          |  |               
|                                    
|/s/ ANN D. RHOADSAnn D. Rhoads       |  | Director |  | March 12, 2004
|                                    
|/s/ DELBERT WHITAKERDelbert Whitaker |  | Director |  | March 12, 2004

76



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##### Table of Contents



SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

|                                |  |                |        |            |  |            |       |            |  |            |      |   |  |   |        |   |  |   |        | 
|------------------------------- |  | -------------- | ------ | ---------- |  | ---------- | ----- | ---------- |  | ---------- | ---- | - |  | - | ------ | - |  | - | ------ | 
|                                |  | Balance at     |        |            |  |            |       |            |  | Balance at
|                                |  | Beginning      |        | Charged to |  |            |       |            |  | End       
|Description                     |  | of Period      |        | Expense    |  | Write-offs |       | Recoveries |  | of Period 
|                                |  |                |        |            |  |            |       |            |  |           
|                                |  |               
|                                |  | (In thousands)
|Year Ended December 31, 2001    |  |                |        |            |  |            |       |            |  |            |      |   |  |   |        |   |  |   |        | 
|Allowance for Doubtful Accounts |  | $              | 5,392  |            |  | $          | 9,209 |            |  | $          | (211 | ) |  | $ |       |   |  | $ | 14,390 | 
|Year Ended December 31, 2002    |  |                |        |            |  |            |       |            |  |            |      |   |  |   |        |   |  |   |        | 
|Allowance for Doubtful Accounts |  |                | 14,390 |            |  |            | 1,042 |            |  |            | (431 | ) |  |   | (7,662 | ) |  |   | 7,339  | 
|Year Ended December 31, 2003    |  |                |        |            |  |            |       |            |  |            |      |   |  |   |        |   |  |   |        | 
|Allowance for Doubtful Accounts |  |                | 7,339  |            |  |            |      |            |  |            | (67  | ) |  |   | 383    |   |  |   | 7,655  | 

77



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##### Table of Contents



EXHIBIT INDEX

| |     |         |  |                                                                                                                                                                                                                                                                    
| | --- | ------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3   | .1(1)   |  | Amended and Restated Articles of Incorporation of
    Novellus.                                                                                                                                                                                                    
| | 3   | .2      |  | Amended and Restated Bylaws of Novellus.                                                                                                                                                                                                                           
| | 10  | .3(2)   |  | Assignment and Assumption of Lessees
    Interest in Lease (Units 8 and 9, Palo Alto) and Covenants,
    Conditions and Restrictions on Leasehold Interests (Units 1-12,
    Palo Alto) by and between Varian Associates, Inc. and
    Novellus dated May 7, 1997.
| | 10  | .5(3)   |  | Environmental Agreement by and between Varian
    Associates, Inc. and Novellus dated May 7, 1997.                                                                                                                                                                 
| | 10  | .8(4)   |  | Settlement Agreement by and between Applied
    Materials, Inc. and Novellus dated May 4, 1997.
    Confidential treatment has been granted with respect to portions
    of this Exhibit.                                                                          
| | *10 | .9(5)   |  | Novellus 1992 Stock Option Plan, together
    with forms of agreements thereunder.                                                                                                                                                                                
| | *10 | .10(6)  |  | Form of Restated Stock Purchase Agreement between
    Novellus and Jeff Benzing, Wilbert van den Hoek and certain
    other employees of Novellus dated December 16, 1999.                                                                                         
| | *10 | .11(7)  |  | Novellus 1992 Employee Stock Purchase Plan.                                                                                                                                                                                                                       
| | *10 | .12(8)  |  | Form of Directors and Officers Indemnification
    Agreement.                                                                                                                                                                                                      
| | *10 | .13(9)  |  | Employment Agreement between Novellus and Peter
    Hanley dated June 15, 1992.                                                                                                                                                                                    
| | *10 | .14(10) |  | Offer Letter Agreement between Novellus and
    Richard S. Hill dated November 1, 1993.                                                                                                                                                                            
| | *10 | .15(11) |  | Employment Agreement between Novellus and Richard
    S. Hill dated October 1, 1998.                                                                                                                                                                               
| | *10 | .16(12) |  | Amendment to Employment Agreement between
    Novellus and Richard S. Hill dated December 16, 1999.                                                                                                                                                                
| | *10 | .18(13) |  | GaSonics International Corporation Amended and
    Restated 1994 Stock Option/Stock Issuance Plan, together with
    forms of agreements thereunder, as assumed by Novellus.                                                                                       
| | *10 | .19(14) |  | Gamma Precision Technology, Inc. 1998 Stock
    Option Plan, together with forms of agreements thereunder, as
    assumed by Novellus.                                                                                                                             
| | *10 | .20(15) |  | GaSonics International Corporation Supplemental
    Stock Option Plan, as assumed by Novellus.                                                                                                                                                                     
| | 10  | .21(16) |  | Form of Light Industrial Lease between Teachers
    Insurance and Annuity Association of America and
    GaSonics, Inc. for office space at 2730 Junction Avenue,
    San Jose, California.                                                                        
| | 10  | .22(17) |  | Participation Agreement among Novellus
    Systems, Inc., ABN AMRO Leasing, Inc., the
    participants named therein and ABN AMRO Bank N.V. dated
    April 18, 2001.                                                                                              
| | *10 | .23(18) |  | Novellus Systems, Inc. 2001 Stock Incentive
    Plan dated May 11, 2001, together with forms of agreement
    thereunder.                                                                                                                                          
| | 10  | .24(19) |  | Participation Agreement among Novellus
    Systems, Inc., ABN AMRO Leasing, Inc., Novellus
    Investment I, LLC and ABN AMRO Bank N.V. dated
    September 21, 2001.                                                                                              
| | 10  | .25(20) |  | Amended and Restated Ground Lease Agreement
    between Novellus Systems, Inc. and ABN AMRO
    Leasing, Inc. dated September 21, 2001.                                                                                                                            
| | *10 | .26(21) |  | SpeedFam-IPEC, Inc. Amended and Restated
    1995 Stock Plan, as assumed by Novellus.                                                                                                                                                                              
| | *10 | .27(22) |  | SpeedFam-IPEC, Inc. 2001 Nonstatutory Stock
    Option Plan, together with forms of agreements thereunder, as
    assumed by Novellus.                                                                                                                             
| | *10 | .28(23) |  | Integrated Process Equipment Corporation 1992
    Stock Option Plan, as assumed by Novellus.                                                                                                                                                                       
| | *10 | .29(24) |  | SpeedFam International, Inc. Amended and
    Restated 1991 Employee Incentive Stock Option Plan, as assumed
    by Novellus.                                                                                                                                       
| | *10 | .30(25) |  | SpeedFam-IPEC, Inc. Stand-Alone Stock Option
    Agreement dated June 14, 2001 between
    SpeedFam-IPEC, Inc. and Peter Simone, as assumed by
    Novellus.                                                                                                       
| | 10  | .31(26) |  | Lease Agreement between Seldin Properties and
    Integrated Process Equipment Corp. dated December 26, 1996.                                                                                                                                                      
| | 10  | .32(27) |  | Purchase and Sale Agreement between Glen Una
    Management Company, Inc. and SpeedFam-IPEC, Inc. dated
    May 31, 2002.                                                                                                                                          
| | 10  | .33(28) |  | Lease Agreement between Phoenix Industrial
    Investment Partners, L.P. and SpeedFam-IPEC, Inc. dated
    June 21, 2002.                                                                                                                                          



---



##### Table of Contents



| |     |         |  |                                                                                                                                                                                                                                                                        
| | --- | ------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10  | .34(29) |  | First Amendment to Lease Agreement between
    Phoenix Industrial Investment Partners, L.P. and
    SpeedFam-IPEC, Inc. dated January 21, 2003.                                                                                                                        
| | 10  | .35(30) |  | Lease Guaranty between Novellus and Phoenix
    Industrial Investment Partners, L.P. dated January 21, 2002.                                                                                                                                                           
| | 10  | .36(31) |  | Separation Agreement between Novellus and Asuri
    Raghavan dated February 5, 2003.                                                                                                                                                                                   
| | *10 | .37     |  | Amendment to Employment Agreement between
    Novellus and Richard S. Hill dated January 14, 2004.                                                                                                                                                                     
| | *10 | .38     |  | Letter Agreement between Novellus and Peter
    Hanley dated December 11, 2003.                                                                                                                                                                                        
| | *10 | .39     |  | Letter Agreement between Novellus and Sasson
    Somekh dated January 23, 2004.                                                                                                                                                                                        
| | *10 | .40     |  | Letter Agreement between Novellus and Thomas St.
    Dennis dated June 27, 2003.                                                                                                                                                                                       
| | *10 | .41     |  | Restricted Stock Purchase Agreement between
    Novellus and Richard S. Hill dated December 13, 2002.                                                                                                                                                                  
| | *10 | .42     |  | Stand-Alone Stock Option Agreement dated
    January 23, 2004, between Novellus and Sasson Somekh.                                                                                                                                                                     
| | *10 | .43     |  | Stand-Alone Restricted Stock Award dated
    January 23, 2004, between Novellus and Sasson Somekh.                                                                                                                                                                     
| | 21  | .1      |  | Subsidiaries of Novellus.                                                                                                                                                                                                                                              
| | 23  | .1      |  | Consent of Ernst & Young
    LLP, Independent Auditors.                                                                                                                                                                                                                
| | 24  | .1      |  | Power of Attorney (see page 75).                                                                                                                                                                                                                                       
| | 31  | .1      |  | Certification of Richard S. Hill, Chairman of the
    Board of Directors and Chief Executive Officer of Novellus
    Systems, Inc. dated March 5, 2004 in accordance with
    18 U.S.C. 1350, as adopted pursuant to Section 302 of
    the Sarbanes-Oxley Act of 2002.
| | 31  | .2      |  | Certification of Kevin S. Royal, Vice President
    and Chief Financial Officer of Novellus Systems, Inc. dated
    March 5, 2004 in accordance with 18 U.S.C. 1350, as
    adopted pursuant to Section 302 of the Sarbanes-Oxley Act
    of 2002.                     
| | 32  | .1      |  | Certification of Richard S. Hill, Chairman of the
    Board of Directors and Chief Executive Officer of Novellus
    Systems, Inc. dated March 5, 2004 in accordance with
    18 U.S.C. 1350, as adopted pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.
| | 32  | .2      |  | Certification of Kevin S. Royal, Vice President
    and Chief Financial Officer of Novellus Systems, Inc. dated
    March 5, 2004 in accordance with 18 U.S.C. 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002.                     



---



| |     |                                                                                                                                                                                                 
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the exhibit with the
    corresponding exhibit number in Novellus Report on
    Form 10-K filed with the Securities and Exchange Commission
    on March 30, 2000.
|
| | (2) | Incorporated by reference to Exhibit 2.3 to
    Novellus Report on Form 8-K filed with the Securities
    and Exchange Commission on July 7, 1997.                                             
|
| | (3) | Incorporated by reference to Exhibit 2.6 to
    Novellus Report on Form 8-K filed with the Securities
    and Exchange Commission on July 7, 1997.                                             
|
| | (4) | Incorporated by reference to Exhibit 10.1 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on August 11, 1997.                                        
|
| | (5) | Incorporated by reference to Exhibit 10.30
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 26, 1993.                             
|
| | (6) | Incorporated by reference to Exhibit 10.21
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 30, 2000.                                        
|
| | (7) | Incorporated by reference to Exhibit 10.31
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 26, 1993.                             
|
| | (8) | Incorporated by reference to Exhibit 10.1
    filed with Novellus Report on Form 10-Q filed with
    the Securities and Exchange Commission on August 13, 2002.                                
|
| | (9) | Incorporated by reference to Exhibit 10.34
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 26, 1993.                             



---



##### Table of Contents





|     |                                                                                                                                                                    
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to Exhibit 10.41
    filed with Novellus Report on Form 10-K filed with
    the Securities and Exchange Commission on February 18, 1994.
|    
|(11) | Incorporated by reference to Exhibit 10.27
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 10, 1999.           
|    
|(12) | Incorporated by reference to Exhibit 10.27
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 30, 2000.           
|    
|(13) | Incorporated by reference to Exhibit 10.31
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(14) | Incorporated by reference to Exhibit 10.32
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(15) | Incorporated by reference to Exhibit 10.33
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(16) | Incorporated by reference to Exhibit 10.34
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 23, 2001.           
|    
|(17) | Incorporated by reference to Exhibit 10.6 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on May 15, 2001.              
|    
|(18) | Incorporated by reference to Exhibit 10.7 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on May 15, 2001.              
|    
|(19) | Incorporated by reference to Exhibit 10.1 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on November 13, 2001.         
|    
|(20) | Incorporated by reference to Exhibit 10.2 to
    Novellus Report on Form 10-Q filed with the
    Securities and Exchange Commission on November 13, 2001.         
|    
|(21) | Incorporated by reference to Exhibit 10.30
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(22) | Incorporated by reference to Exhibit 10.31
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(23) | Incorporated by reference to Exhibit 10.32
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(24) | Incorporated by reference to Exhibit 10.33
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(25) | Incorporated by reference to Exhibit 10.34
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(26) | Incorporated by reference to Exhibit 10.35
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(27) | Incorporated by reference to Exhibit 10.36
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(28) | Incorporated by reference to Exhibit 10.37
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(29) | Incorporated by reference to Exhibit 10.38
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(30) | Incorporated by reference to Exhibit 10.39
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 5, 2003.            
|    
|(31) | Incorporated by reference to Exhibit 10.29
    to Novellus Report on Form 10-K filed with the
    Securities and Exchange Commission on March 21, 2002.           



---



|  |  |                                                                
|- |  | ---------------------------------------------------------------
|* |  | Management contracts or compensatory plans or
    arrangements.