UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

Form 10-K/A



Amendment No. 2 
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934




(Mark
One)


|x |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2004OR
|- |  | ---------------------------------------------------------------------------------------------------------------------------------

|o |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the transition period from ____________ to ____________
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



Commission File Number 000-17157


Novellus Systems, Inc.(Exact name of Registrant as specified in its charter)

|California                              | 77-0024666                    
|--------------------------------------- | ------------------------------
|(State
        or other jurisdiction of | (I.R.S.
        Employer      
|incorporation
        of organization)  | 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




NoneSecurities 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 x No o




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




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




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




As of June 25, 2004 the aggregate market value of
voting and non-voting stock held by non-affiliates of the Registrant was $4,313,778,859, based on the average of the high and low price 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 4, 2005 was 140,530,177.




Documents Incorporated by
Reference:Part III of this Annual Report on Form 10-K incorporates information by reference from the Registrants Proxy Statement
for its 2005 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 Annual Report on Form 10-K.







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NOVELLUS
SYSTEMS, INC.2004 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS


|                 |                                                                                                                      |  | Page
|---------------- | -------------------------------------------------------------------------------------------------------------------- |  | ----
|                 | PART I                                                                                                               |  |     
|Item
        1:  | Business                                                                                                             |  | 2   
|Item
        2:  | Properties                                                                                                           |  | 10  
|Item
        3:  | Legal Proceedings                                                                                                    |  | 11  
|Item
        4:  | Submission of Matters to a Vote of Security Holders                                                                  |  | 12  
|                 | PART II                                                                                                              |  |     
|Item
        5:  | Market for Registrants Common Equity, Related Shareholder Matters
        and Issuer Purchases of Equity Securities |  | 13  
|Item
        6:  | Selected Financial Data                                                                                              |  | 14  
|Item
        7:  | Managements Discussion and Analysis of Financial Condition and
        Results of Operations                        |  | 15  
|Item
        7A: | Quantitative and Qualitative Disclosures about Market Risk                                                           |  | 37  
|Item
        8:  | Financial Statements and Supplementary Data                                                                          |  | 40  
|Item
        9:  | Changes in and Disagreements with Accountants on Accounting and Financial
        Disclosure                         |  | 76  
|Item
        9A: | Controls and Procedures                                                                                              |  | 76  
|Item
        9B: | Other Information                                                                                                    |  | 77  
|                 | PART III                                                                                                             |  |     
|Item
        10: | Directors and Executive Officers of the Registrant                                                                   |  | 78  
|Item
        11: | Executive Compensation                                                                                               |  | 78  
|Item
        12: | Security Ownership of Certain Beneficial Owners and Management                                                       |  | 78  
|Item
        13: | Certain Relationships and Related Transactions                                                                       |  | 78  
|Item
        14: | Principal Accounting Fees and Services                                                                               |  | 78  
|                 | PART IV                                                                                                              |  |     
|Item
        15: | Exhibits and Financial Statement Schedules                                                                           |  | 79  
|Signatures       |                                                                                                                      |  | 83  

_________________

EXPLANATORY NOTE

We are filing this Form 10-K/A Amendment No. 2 to our Annual Report
on Form 10-K for the fiscal year ended December 31, 2004 as filed on March 15, 2005 (the Annual Report) and as amended by Amendment No. 1 to the
Annual Report as filed on September 13, 2005, to correct a typographical error in the fiscal year ended date in Exhibits 32.1 and 32.2 to such Annual Report.

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PART I



The following information should be read in
conjunction with the Consolidated Financial Statements and notes thereto included in this Annual Report on Form 10-K.


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

The Company



Novellus Systems, Inc., a California corporation
organized in 1984, develops, manufactures, sells and supports equipment used in the fabrication of integrated circuits, commonly called microchips or
chips. The customers for these products are semiconductor device manufacturers who produce chips for sale or for incorporation in their own products,
or who provide chip manufacturing services to third parties.




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. 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 transistors. Subsequent layers of metal (historically, aluminum) are deposited 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 electrochemical deposition process called ElectrofillTM. 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 aspect
of the semiconductor device 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. Our CVD Tungsten systems are used to deposit tungsten plug films. Our PVD systems use direct-current power to deposit conductive
metal layers by sputtering metallic atoms from the surface of a target source. Our ElectrofillTM (ECD) systems are used for depositing
conductive layers of copper on wafers in a damascene manufacturing process.




Beginning in 2001, Novellus expanded beyond
deposition technologies into the area of wafer surface preparation. That year, we acquired GaSonics International Corporation, a manufacturer of
systems used to clean and prepare a wafer surface. In 2002, we acquired SpeedFam-IPEC, Inc., a manufacturer of chemical mechanical planarization (CMP)
products. In 2004, we further diversified by acquiring Peter Wolters AG, a 200-year-old German company specializing in lapping and polishing equipment
for a number of different industries. With the acquisition of Peter Wolters, Novellus entered into market sectors beyond semiconductor manufacturing
for the first time. In December 2004, the board approved the creation of Novellus Development Company LLC, with funding of up to $10 million, for
investment in private companies at various stages of development.




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.


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Semiconductor 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 is 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 semiconductor device manufacturers to reduce manufacturing costs while 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 the increasing density of the integrated circuit. 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 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, which 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 in comparison to aluminum.




A similar transition is underway from traditional
insulating films made of silicon oxide to insulators with a low dielectric constant, or low-k. Low-k dielectrics reduce the capacitance
between metal lines in a device. This improves the speed and performance of the chip. However, low-k materials are more fragile than silicon oxide, and
this poses a host of new challenges to the semiconductor industry in integrating the new materials into a manufacturing process flow.




Another important trend is the move to larger wafer
sizes. Semiconductor device manufacturers 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 in excess of 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 determined by factoring in the costs for acquisition and installation of a system, operating costs, and net throughput rate. In a fixed period of
time, 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.


Semiconductor Business Strategy



Our business objective is to use our core expertise
to increase our market share in semiconductor manufacturing process equipment, and strengthen our position as a leading supplier to the semiconductor
industry. 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-station sequential deposition, or MSSDTM, system for continuous PECVD processing illustrates our commitment
to productivity. The MSSDTM design enables our PECVD systems to attain very high levels of wafer throughput, uniformity and overall film
quality. The simple architecture of our systems also takes up less space in the fabrication


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facility and requires less downtime than other
system designs. We intend to retain our historical focus on productivity by applying our MSSDTM architecture in product enhancements and new
product offerings.




Be Recognized as the Technology Leader in our
Served Available Markets  In the era of nanoelectronics manufacturing, technology leadership becomes critically important due to the
difficulties in manufacturing chips at challenging design rules. It is our strategy, then, to provide our customers with leading edge technologies in
each of our served available markets.




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 semiconductor device manufacturers 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. We also strive to design our
systems to be extendible over multiple process generations.




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. Our goal is to be the leading industry supplier
of interconnect manufacturing equipment.




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.




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 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.


Semiconductor Manufacturing 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 semiconductor device manufacturers 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.


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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,
and was originally designed to deposit dielectric materials in an aluminum interconnect manufacturing process. However, today, Concept Two SPEED is
primarily used to deposit shallow trend isolation (STI) as part of the transistor formation, as well as deposit pre-metal layer dielectrics (PMD) in
both aluminum or copper based devices.




Concept Three SPEED®  Introduced
in 1997, 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.




SPEED® NExTTM  Introduced in
2004, the SPEED NExT system for 300 mm wafers is designed specifically to address the challenges of dielectric gap fill at 65 nm and beyond. SPEED NExT
builds upon the superior high conductance chamber design of the existing SPEED platform with an innovative source technology that enables repeatable
gap fill across a 300-mm wafer. In addition, the ability to control the wafer position relative to the source allows SPEED NExT to have a wider gap
fill process window.




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 chamber. The ALTUS pulsed
nucleation layer (PNLTM) technology also permits the system to deposit conformal film in device structures with extremely high aspect
ratios, an advantage that has translated into a market leadership position for Novellus in tungsten deposition.




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.




ALTUS DirectFillTM 
Introduced in 2004, the ALTUS DirectFill tungsten nitride/tungsten deposition system is designed for advanced contact and via-fill applications at 65
nm and below. ALTUS DirectFill simplifies the tungsten deposition process by replacing the standard multi-tool Ti/TiN/W approach with a single
three-module system. The advanced plug-fill technology of the ALTUS DirectFill can reduce contact resistance and lower the overall cost of ownership by
50% or more when compared to existing processes.




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 all the dielectric films required for a low-k device at 90
nanometer-and-smaller design rules. Our VECTOR has approximately two-thirds the footprint of the nearest competitor and 33% fewer critical
subsystems.




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


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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
originally developed by the Thin Films Systems division of Varian Associates, acquired by Novellus in 1997. Novellus reintroduced the product in 1998
with the addition of a patented Hollow Cathode Magnetron (HCMTM) ionized PVD source that was designed specifically for the deposition of
copper barrier and seed films. The INOVA continues to gain market acceptance based on its superior barrier seed step coverage in advanced
geometries.




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.




Electrochemical Deposition
Products




Our ElectrofillTM products are used to
build the copper primary conduction layers in advanced integrated circuits. Electrofill uses a copper electrolytic solution to create lines and vias in
a dielectric layer which has been etched with the pattern of the circuitry, in a process called copper damascene. Our highly reliable and
cost-effective ElectrofillTM products employ aqueous chemistries to deposit the copper wiring into the dielectric
structure.




SABRE  The SABRE copper
ElectrofillTM 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 at 65 nanometer and beyond. The SABRE employs a proprietary
electrofill cell that prevents 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 advanced plating chemistries, an integrated anneal module and closed-loop chemical monitoring.




SABRE NExT  Introduced in 2003, the
SABRE NexT, or the Nano Era xT, builds on the SABRE xTs production track record, offering a proprietary 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 its 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. Semiconductor
device manufacturers 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 in 2001, and today we are one of the industrys leading suppliers
of dry-clean surface preparation products.




GAMMATM2100  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
our 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


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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 planar surface before moving on to subsequent manufacturing steps. Since copper films are more difficult to polish than the
tungsten and oxide films used in previous-generation aluminum interconnects and since low-k dielectrics are much more porous than their predecessors,
CMP has been elevated to the forefront of the enabling technologies 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 understand the interactions between 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.




MOMENTUMTM  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 an
orbital polishing motion and features a through-the-pad slurry delivery system that results in more efficient consumption of polishing chemicals,
minimized dishing and reduced erosion.




XCEDATM  Introduced in 2004, the
XCEDA copper CMP system is an advanced 300-mm platform designed to exceed both the technical and economic requirements of CMP at 65 nm and beyond. The
XCEDAs four polishing modules and through-the-pad slurry delivery system can reduce slurry usage by up to 40%, dramatically reducing
cost-of-ownership. The XCEDA system has also demonstrated quality planarization results on porous ultra low-k (ULK) materials with k-values of less
than 2.0.


Marketing, Sales and Service



We rely on a direct sales force to sell our products
in all geographic regions in the world where semiconductors are manufactured, including Europe, the United States, Korea, Japan, China, Taiwan, and
Southeast Asia.




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.


Customers



For the year ended December 31, 2004, Taiwan
Semiconductor Manufacturing Company, Ltd., UMC (United Microelectronics Corporation) and Intel Corporation, each accounted for 10% of our net sales.
For the year ended December 31, 2003, Samsung and Intel Corporation accounted for 27% and 12% of our system sales, respectively. For the year ended
December 31, 2002, Samsung, Intel Corporation, Taiwan Semiconductor Manufacturing Company, Ltd. and IBM Corporation accounted for 17%, 11%, 11% and 10%
of our system sales, respectively. Historically, we have sold a significant proportion of systems in any particular period to a limited number of
customers. System sales to our ten largest customers in 2004, 2003 and 2002 accounted for 69%, 76% and 79% of our system 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 outside of the United States for the
year ended December 31, 2004 were $1.0 billion, or 77% of net sales. For the year ended December 31, 2003, export sales were $603.5 million, or 65% of
net sales, while export sales for the year ended December 31, 2002 were $513.6 million, or 61% of net sales.


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Backlog



As of December 31, 2004, our backlog was $474.7
million, with approximately $3.4 million of cancellations in the period subsequent to December 31, 2004 to the date of this Annual Report on Form 10-K.
As of December 31, 2003, our backlog was $341.0 million, with approximately $8.6 million of cancellations subsequent to December 31, 2003. 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 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, excluding
charges for acquired in-process research and development, during 2004, 2003 and 2002 were $252.1 million, $227.4 million and $222.3 million,
respectively. These expenditures represented approximately 19%, 25% and 26% of our net sales in 2004, 2003 and 2002, 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 and to improve yields for our customers. Following assembly, we package our completed systems in plastic
shrink-wrap to maintain clean-room standards during shipment.


8

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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., a major supplier of systems who has established a substantial base of installed equipment among
todays leading semiconductor manufacturers. In the PECVD market, we also compete against ASM International. 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.


Patents and Proprietary Rights



We intend to continue to pursue patent and trade
secret protection for our technology. We currently hold over 475 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 those 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, 2004, we had 3,505 full-time and
temporary employees. This includes the acquisition of Peter Wolters AG. 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.


9

---



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 purchased all of the outstanding capital stock of
Peter Wolters for an aggregate purchase price, excluding transaction costs, of approximately $149.5 million in cash on June 28, 2004. The Company
funded the purchase price of the acquisition with borrowings under a credit facility with JPMorgan Chase Bank.




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


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



Information regarding our principal properties at
December 31, 2004 is as follows:


|# of Buildings |  |  |  | Location           |  | Operating Segment             |  | Use                                                                                                                                                            |  | Ownership |  | Square Footage   
|-------------- |  |  |  | ------------------ |  | ----------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------- |  | -----------------
|9              |  |  |  | San
Jose, CA       |  | Semiconductor Group           |  | Corporate Headquarters, Manufacturing, Research and Development, Engineering, Applications Demonstration Lab, Customer Support, Administration
and Warehousing |  | Owned     |  | 642,000          
|4              |  |  |  | Tualatin, OR       |  | SemiconductorGroup            |  | Manufacturing, Research and Development, Engineering, Customer Support, Administration and Warehousing                                                         |  | Owned     |  | 442,000          
|1              |  |  |  | Chandler, AZ       |  | Semiconductor Group           |  | Manufacturing, Research and Development, Engineering, Customer Support, Administration and Warehousing                                                         |  | Leased    |  | 108,000          
|1              |  |  |  | Des
Plaines, IL    |  | Industrial Applications Group |  | Manufacturing, Research and Development, Owned Engineering, Customer Support, Administration and Warehousing                                                   |  | Owned     |  | 41,000           
|1              |  |  |  | Plainville, MA     |  | Industrial Applications Group |  | Research and Development, Engineering, Customer Support, and Warehousing                                                                                       |  | Owned     |  | 25,000           
|1              |  |  |  | Leicestershire, UK |  | Industrial Applications Group |  | Manufacturing, Customer Support, Administration and Warehousing                                                                                                |  | Owned     |  | 9,000            
|1              |  |  |  | Rendsburg, Germany |  | Industrial Applications Group |  | Manufacturing, Research and Development, Engineering, Customer Support, Administration and
Warehousing                                                         |  | Owned     |  | 189,000          
|               |  |  |  |                    |  |                               |  | Total                                                                                                                                                          |  | Owned     |  | 1,348,000 Sq. Ft.
|               |  |  |  |                    |  |                               |  |                                                                                                                                                                |  | Leased    |  |                  

10

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In addition to the above properties used by our
Semiconductor Group operating segment, we lease several domestic field offices totaling approximately 59,000 square feet of space. We also lease
several sites outside the United States that we use as sales and customer service centers. These sites total approximately 185,000 square feet of
space. Our facilities in Europe include approximately 48,000 square feet of leased space in various countries including France, Germany, Italy, and
Ireland. Our facilities in Asia include approximately 137,000 square feet of leased space in various countries including China, India, Japan, Korea,
Malaysia, Singapore and Taiwan. We also lease approximately 778,000 square feet of space in and around San Jose, California and Chandler, Arizona, all
of which is occupied by subtenants or available for sublease.




In addition to the above properties used by our
Industrial Applications Group operating segment, we lease three field offices totaling approximately 3,000 square feet in Germany, China and Japan. We
also sublease approximately 65,000 square feet of space in Mettmann, Germany.




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


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

Applied Materials, Inc.



On September 20, 2004, we settled all pending patent
litigation with Applied Materials, Inc., Applied, by entering into a Binding Memorandum of Understanding with Applied. The Memorandum of
Understanding was effective as of September 3, 2004.


Semitool, Inc.



On October 11, 2004, we settled the pending patent
litigation with Semitool, Inc. pursuant to the terms of a settlement agreement effective October 8, 2004.


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 Novellus would prevail in a future lawsuit filed in connection with the alleged indemnification
obligations, if such a lawsuit were brought. 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. However, due to the uncertainty surrounding the litigation
process, we are unable to estimate a range of loss, if any, at this time.


Linear Technology Corporation



In March, 2002, Linear Technology Corporation
(Linear) 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 seeks damages (including punitive damages) and injunctions for causes of actions involving alleged breach of contract, fraud, unfair
competition, breach of warranty and declaratory relief. On September 3, 2004, Novellus filed a demurrer to all causes of action in the complaint, which
the Court granted without leave to amend on October 5, 2004. On January 19, 2005, we received notice that Linear intends to appeal the courts
order granting judgment in favor of Novellus. Although we prevailed on these claims in the Superior Court, it is possible that the Court of Appeals
will reverse the ruling of the Superior Court, in which case Novellus could face potential liability on these claims. We cannot predict how the Court
of Appeals will rule on this issue or, if it does rule against Novellus, estimate a range of potential loss, if any, due to the uncertainty of the
litigation process.


11

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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. However, due to the uncertainty surrounding the litigation process, we are unable to estimate a
range of loss, if any, at this time.


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



Not applicable.


12

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PART II

|Item 5. |  | Market for Registrants Common Equity, Related
Shareholder Matters and Issuer Purchases of Equity Securities
|------- |  | ------------------------------------------------------------------------------------------------------------

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 closing high and low
prices of our common stock as reported by the NASDAQ National Market for the periods indicated:


|               |  |  |  | 2004 |      
|-------------- |  |  |  | ---- | -----
|
|First
Quarter  |  |  |  | $    | 44.44
|Second
Quarter |  |  |  |      | 34.64
|Third
Quarter  |  |  |  |      | 31.44
|Fourth
Quarter |  |  |  |      | 29.55

|               |  |  |  | 2003 |      
|-------------- |  |  |  | ---- | -----
|
|First
Quarter  |  |  |  | $    | 34.74
|Second
Quarter |  |  |  |      | 38.53
|Third
Quarter  |  |  |  |      | 40.85
|Fourth
Quarter |  |  |  |      | 45.03



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 and to repurchase common
shares. As of December 31, 2004, we had approximately $1.1 billion authorized by the Board of Directors for the repurchase of our common stock.
Accordingly, it is anticipated that no cash dividends will be paid to holders of common stock in the foreseeable future. As of March 4, 2005, there
were 1,102 holders of record of our common stock.




Following is a summary of our stock repurchases for
the quarter ended December 31, 2004. (1)


|Period                                 |  |  |  | Total Number of Shares Purchased (2) |         | Average Price Paid per Share |  | Total Number of Shares Purchased as Part of
Publicly Announced Plans or Programs |       | Approximate Dollar Value of Shares that May Yet Be
Purchased Under the Plans or Programs
|-------------------------------------- |  |  |  | ------------------------------------ | ------- | ---------------------------- |  | -------------------------------------------------------------------------------- | ----- | ----------------------------------------------------------------------------------------
|September 26,
2004 to October 30, 2004 |  |  |  |                                      | 360,000 |                              |  | $                                                                                | 23.98 |                                                                                         
|October 31,
2004 to November 27, 2004  |  |  |  |                                      |        |                              |  |                                                                                  |      |                                                                                         
|November 28,
2004 to December 31, 2004 |  |  |  |                                      |        |                              |  |                                                                                  |      |                                                                                         
|Total                                  |  |  |  |                                      | 360,000 |                              |  | $                                                                                | 23.98 |                                                                                         






|(1) |  | On February 24, 2004, we announced that our Board of Directors
had approved a stock repurchase plan that authorized the repurchase of up to $500.0 million of our outstanding common stock through February 13, 2007.
On September 20, 2004 we announced that our Board of Directors had authorized an additional $1.0 billion for repurchase of our outstanding common stock
through September 14, 2009. We may repurchase shares from time to time in the open market, through block trades or otherwise. The repurchases may be
commenced or suspended at any time or from time to time without prior notice depending on prevailing market conditions and other factors.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | All shares were purchased pursuant to the publicly announced
plan.
|--- |  | ------------------------------------------------------------------

13

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|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, 2004 and the Consolidated Balance Sheet data at each year end for the five years ended December 31, 2004
have been derived from our Consolidated Financial Statements, which have been audited. We acquired Peter Wolters, AG, on June 28, 2004, in a
transaction accounted for as a purchase business combination. The Selected Consolidated Financial Data includes the operating results and financial
data of Peter Wolters AG from June 28, 2004. We acquired SpeedFam-IPEC, Inc. on December 6, 2002, in a transaction accounted for as a purchase business
combination. The Selected Consolidated Financial Data includes the operating results and financial data of SpeedFam-IPEC from December 6,
2002.


Selected Consolidated Financial Data

|                                                                                      |  | Years
      Ended December 31,
|------------------------------------------------------------------------------------- |  | ------------------------------
|
|
|Consolidated Statements of Operations Data:                                           |  |                               
|Net
        sales                                                                     |  | $                             
|Gross
        profit                                                                  |  |                               
|Income
        (loss) before cumulative effect of change in accounting principle      |  |                               
|Cumulative
        effect of change in accounting principle                           |  |                               
|Net
        income (loss)                                                             |  | $                             
|Per
        common share:                                                             |  |                               
|Income
        (loss) before cumulative effect of change in accounting principle      |  |                               
|Basic                                                                                 |  | $                             
|Diluted                                                                               |  | $                             
|Cumulative
        effect of change in accounting principle, net of tax
        Basic |  |                               
|Diluted                                                                               |  |                               
|Net
        income (loss)                                                             |  |                               
|Basic                                                                                 |  | $                             
|Diluted                                                                               |  | $                             
|Shares
        used in basic per share calculations                                   |  |                               
|Shares
        used in diluted per share calculations                                 |  |                               
|
|Consolidated Balance Sheet Data:                                                      |  |                               
|Cash,
        cash equivalents and short-term investments                             |  | $                             
|Working
        capital                                                               |  |                               
|Total
        assets                                                                  |  |                               
|Long-term
        debt obligations                                                    |  |                               
|Shareholders equity                                                                  |  |                               






|(1) |  | We recorded a credit to cost of sales of approximately $9.0
million related to the sale of inventories previously written down.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------

|(2) |  | We recorded net restructuring and other charges of $1.5 million,
acquired in-process research and development write-offs of $6.1 million, net recovery from legal settlements of $2.6 million and the reversal of
previously accrued royalty payments of $8.1 million.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

14

---

|(3) |  | 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.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | 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 (included in gross profit), 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | 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.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | 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
International Corporation 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.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) |  | 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. 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
|------- |  | -------------------------------------------------------------------------------------

Cautionary Note Regarding Forward-Looking Statements



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 contained in this Annual Report on Form 10-K, other than statements that are purely historical, are
forward-looking statements and are based upon managements present expectations, objectives, anticipations, plans, hopes, beliefs, intentions or
strategies regarding the future. As such, forward-looking statements are subject to risks and uncertainties that could cause actual results to differ
materially from the results contemplated. We do not undertake, and expressly disclaim, any obligation to update this forward-looking information,
except as required under applicable law.




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 the notes thereto. Forward-looking statements in
this Annual Report on Form 10-K may be identified by words such as anticipates, estimates, expects,
projects, intends, plans, believes or similar expressions, and 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,
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

15

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| |  | 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 
Semiconductor Industry Background regarding our beliefs that (1) unit demand for semiconductor devices will continue to increase; (2) there is a
trend toward increasing density of the integrated circuit; (3) there is a trend toward copper conductive material and away from aluminum wiring; (4)
there is trend toward low-k dielectric insulators and away from traditional silicon oxide insulating films; (5) there is a trend toward larger wafer
sizes; and (6) these trends shape the equipment and process demands of our customers, 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; the inaccuracy of our expectations regarding the future direction of the semiconductor industry; and our inability to develop, improve
and market products that respond to industry trends;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements under the heading Item 1. Business 
Semiconductor 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 goal to be
recognized as the technology leader in each of our served available markets; (4) our focus on reducing customer costs; (5) our service differentiation
philosophy; (6) our intent to broaden our interconnect offerings and become the leading supplier of interconnect manufacturing equipment; (7) our
strategy to expand our market presence in, and our belief in future growth potential of, Asia; and (8) our plan to leverage our low cost manufacturing
structure, which statements are subject to various risks and uncertainties, including, without limitation, difficulties implementing our growth
strategy and leveraging our resources to increase market share; increased competition in our served available markets; shifts in demand from expensive,
high-performance products to lower priced, conventional products, resulting in reduced profit for semiconductor manufacturers; increases in the costs
of material, labor or conducting a global business, or inability to enhance our systems productivity, which may preclude us from containing costs
to customers; the current and other periodic downturns in the semiconductor industry and the global or domestic economy; political or economic
instability in Asia, and fluctuations in interest and foreign currency exchange rates;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements under the heading Item 1. Business 
Semiconductor Manufacturing Products of our beliefs in the performance and effectiveness our products, including (1) that SPEED is one of the top
two product offerings for the HDP CVD marketplace; (2) that Concept Three SPEED offers minimal risk to our customers in making the transition from
200mm to 300mm volume chipmaking; (3) that Concept Two Altuss pulsed nucleation layer technology has led to our market leadership position in
tungsten deposition; (4) that ALTUS DirectFill lowers the overall cost of ownership by 50% or more when compared to existing products; (5) that Concept
Two SEQUEL Express delivers up to 40% higher capital productivity and 40% lower cost of ownership than competing PECVD systems; (6) that VECTOR has
approximately 2/3 of the footprint of the nearest competition and 33% fewer critical subsystems; (7) that the INOVA 200mm system will continue to gain
market acceptance; (8) that SABRE xT is the industrys leading platform for both 200mm and 300mm wafers; (9) the increasing importance of
photoresist strip and clean processes as a result of the industrys migration to copper interconnects; (10) that the GAMMA 2130 system offers a
30% higher throughput rate than the closest competitor; (11) that PEP IRIDIA offers the highest productivity of any 200mm dry-clean system currently on
the market; (12) that we have an important advantage in extending copper/low-k processes to advanced semiconductor devices based on our understanding
of interactions between planarization, deposition and surface preparation, which statements are subject to various risks and uncertainties, including,
among others, the inaccuracy of our assessment of our products capabilities; technical difficulties which preclude our products from performing
as expected; competitors greater financial, marketing, technical, customer service or other resources, broader product lines, and larger and more
established sales organizations and customer bases; future competition from new market entrants; competitors design and performance product
improvements that may offer superior price or performance features over our products; difficulties integrating, developing and commercializing
SpeedFam-IPEC CMP systems; and difficulties in selecting, developing, manufacturing and marketing our new products or enhancing our existing
products;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

16

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| |  | The statements under the heading Item 1. Business 
Marketing, Sales and Service of our beliefs that our strategy of supporting our installed base through customer support and R&D groups has
accelerated penetration of certain key accounts and our marketing efforts are enhanced by the technical expertise of our R&D personnel, 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;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statement under the heading Item 1. Business 
Customers regarding our expectation that sales of our products to relatively few customers will continue to account for a high percentage of our
sales, which statement is subject to various risks and uncertainties, including without limitation, a future decrease in demand from these customers or
the adoption of competing products by these customers;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statement under the heading Item 1. Business 
Research and Development regarding our belief 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; a prolonged inability to obtain certain components
imperative to our operations; our failure to work efficiently with suppliers; 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 ability to compete favorably 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;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements under the heading Item 1. Business 
Patents and Proprietary Rights regarding our 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; and our beliefs (4) that the
outcomes of current litigation will not have a material impact on our business, financial condition or results of operations; 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 future 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 various risks and uncertainties, including, among others, our inability to successfully retain or recruit key personnel and effectively manage
growth;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

17

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| |  | The statement under the heading Item 1. Business 
Environmental Matters that federal, state and local provisions regulating discharge of materials into the environment and remedial agreements or
other environmental actions are not expected to have a material affect on our capital expenditures, financial condition, results of operations or
competitive position, which statement is subject to certain risks and uncertainties, including, among others, that we have inaccurately assessed the
environmental impact of our activities or the compliance requirements of environmental provisions and agreements;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 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, which statement is subject to various
risks and uncertainties, due to, without limitation, growth in our business placing unexpected strains on our resources and properties and
international expansion beyond the capacities of our current properties;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements under the headings Item 3. Legal
Proceedings of our belief that the ultimate disposition of the Plasma Physics Corporation, Solar Physics Corporation, Linear Technology
Corporation and other litigation matters will not have a material adverse effect on the impact on our business, financial condition, or results of
operations, which statements are subject to various risks and uncertainties, including, without limitation, inherent uncertainty surrounding the
litigation process and 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  Results of Operations of our strategies, beliefs, plans,
expectations, anticipations and hopes with respect to Net Sales, Research and Development, Acquired In-Process Research and Development, Legal
Settlement, Restructuring and Other Charges, and Income Taxes including, without limitation, (1) our plan to expand our market presence in Asia; (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 $10.0 million
in 2005 resulting from the previously implemented restructuring plan; (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) managements expectation that our effective tax rate in 2005 will increase as a result of a reduction in our valuation
allowance benefit; (8) managements belief that adequate accruals have been provided for any potential adjustments that may result from
examinations by local and foreign taxing authorities; and (9) managements belief that we will be able to complete our evaluation of the effects
of the repatriation provision within the American Jobs Creation Act of 2004 by the third or fourth quarter of fiscal 2005, which statements are subject
to numerous risks and uncertainties, including, without limitation, 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 in Asia;
our inability to allocate substantial resources to R&D programs; the inaccuracy of our estimates regarding restructuring-related cost savings;
inability to realize or maximize cost savings from our restructuring; the inaccuracy of our beliefs regarding taxes; unanticipated changes in tax
regulations; the impact of certain accounting standards and our synthetic leases; and our inability to accurately evaluate or effectively implement
repatriation provisions;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements under the heading Item 7. Managements
Discussion and Analysis of Financial Condition and Results of Operations  Critical Accounting Policies regarding the calculation of
allowances, reserves, and other estimates that are based on historical experience, 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, and the significant judgments of management that underlie the preparation of our consolidated financial statements
with respect to Revenue Recognition, Inventory Valuation, Goodwill and Other Intangible Assets, Deferred Tax Assets, Warranty Obligations,
Restructuring and Impairment Charges, Foreign Currency Accounting, and Foreign Exchange Contracts including, without limitation, (1) that the majority
of deferred tax assets will be realized due to anticipated future income; (2) that possible revisions to estimated warranty liability could have a
positive or negative impact on gross profit; and (3) that our forward foreign exchange contracts do not subject us to speculative risk, which
statements are subject to certain risks and uncertainties, including, among
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

18

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| |  | others, the inaccuracy of our calculations, estimates,
assumptions and judgments, regarding critical accounting policies; that actual and future product failure rates, material usage, installation costs,
customer reserves or other estimates may differ from our historical experience, requiring revisions to our estimated doubtful account allowances,
additional inventory write-downs, restructuring charges, litigation, warranty, and other reserves; the insufficiency of anticipated future income,
whether due to a downturn in the semiconductor industry or increases in expenses; and the accuracy of our estimates and beliefs regarding warranty
liability and foreign exchange contracts;
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statement in Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations  Liquidity and Capital Resources of our expectation 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 statement is subject to numerous risks and uncertainties, including, without limitation, inability to timely and effectively
develop, manufacture and market our new products, or enhance our existing products, a downturn in our sales or defaults on payments by customers, which
may adversely affect our cash flow;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements in Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations  Off-Balance Sheet Arrangements that we will not be required to pay any amounts
under standby letters of credit arrangements or guarantee arrangements on behalf of our consolidated subsidiaries, which statement is subject to
certain risks and uncertainties, including, without limitation, the inaccuracy of our assessment of our obligations under credit and guarantee
arrangements;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statement in Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations  Purchase Commitments that we made adequate provision for potential exposure
related to inventory on order which may go unused, which statement is subject to certain risks and uncertainties, including, without limitation, an
unanticipated decline in demand that would increase our inventory-related exposure;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements in Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations  Recent Accounting Pronouncements regarding impact upon our results of operation
and financial position as a result of adopting SFAS No. 151, SFAS No. 153 and SFAS No. 123(R), which statements are subject to various risks, due to
the uncertainty of the impact of certain accounting standards and the level of share-based payments granted in the future;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statement 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, which statements are subject to certain risks and uncertainties, including,
without limitation, that we have inaccurately assessed our future borrowing needs;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statement 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, which statements are subject to certain
risks and uncertainties, including, without limitation, unanticipated fluctuations in interest and foreign currency exchange rates;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 2. Significant Accounting Policies  Stock Based
Compensation regarding our belief that the effects of applying SFAS No. 123(R) on pro forma disclosures are not likely to be representative of
the effects on pro forma disclosures of future periods, which statement is subject to certain risks and uncertainties, including, without limitation,
inherent variability underlying the judgments and estimates used to account for share-based compensation;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The statements in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 2. Significant Accounting Policies  Forward Foreign Exchange
Contracts regarding our belief that there is not a significant risk of nonperformance by counterparties on foreign exchange contracts, which
statement is subject to certain risks and uncertainties, including, without limitation, our failure to continuously monitor or accurately evaluate our
positions and the credit ratings of counterparties;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

19

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| |  | Our statement in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 3. Financial Instruments that management intends to liquidate
short-term investment to fund operations within the next twelve months, which statement is subject to certain risks and uncertainties, including,
without limitation, that we have inadequately assessed the liquidity value of our short-term investments and our ability to take advantage of interest
rate re-set periods;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our statement in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 6. Goodwill and Other Intangible Assets of our future estimated
amortization expense for the identifiable intangible assets, which statement is subject to certain risks and uncertainties, including, without
limitation, the accuracy of our accounting judgments and estimates underlying the amortization expense amount;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our statement in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 7. Business Combination that the escrow amount held pursuant to
the acquisition of Peter Wolters AG will be released to its former shareholders, which statement is subject to certain risks and uncertainties,
relating to, without limitation, the possibility of claims for pre-acquisition contingencies made against the escrow and the viability of those
claims;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our statement in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 9. Restructuring and Other Charges that we do not expect to
recover the carrying value of abandoned R&D assets through future cash flows, which statement is subject to certain risks and uncertainties,
including, without limitation, that abandoned technology will have some future economic benefit; and
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our statement in Item 8. Financial Statements and
Supplementary Data  Notes to Consolidated Financial Statements  Note 10. Long-term Debt that as of December 31, 2004 we have an
aggregate amount of $10.7 million available for future borrowing, which statement is subject to certain risks and uncertainties, including, without
limitation, an inaccurate assessment of available borrowed funds or future needs for funds, and the continued viability of our long-term borrowing
arrangements.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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. Our MD&A
addresses the following topics:


| |  | 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.
|- |  | -------------

Overview of Our Business and Industry



Novellus Systems, Inc., a California corporation
organized in 1984, develops, manufactures, sells and supports equipment used in the fabrication of integrated circuits, commonly called microchips. The
customers for these products are semiconductor manufacturers who produce chips for sale or for incorporation in their own products, or who provide chip
manufacturing services to third parties.


20

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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. In 2002, we acquired SpeedFam-IPEC, Inc., a manufacturer of chemical
mechanical planarization (CMP) products. In 2004, we further diversified by acquiring Peter Wolters AG, a 200-year-old German company specializing in
lapping and polishing equipment for a number of different industries. With the acquisition of Peter Wolters, Novellus entered into market sectors
beyond semiconductor manufacturing for the first time. In December 2004, the Company approved the creation of Novellus Development Company LLC, with
funding of up to $10 million, for investment in private companies at various stages of development.




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. We continue 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 future growth.




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,
although we also use certain non-GAAP measures such as net orders to assess business trends and performance. Net orders are also used to forecast and
plan future operations. Net orders consist of current period orders less current period cancellations. The following table sets forth certain quarterly
and annual financial information for the periods indicated:







|                                    |  |  |  | Quarterly Financial Data |        
|----------------------------------- |  |  |  | ------------------------ | -------
|
|2004:                               |  |  |  |                          |        
|Net
sales                           |  |  |  | $                        | 262,862
|Gross
profit                        |  |  |  | $                        | 124,605
|Net
income                          |  |  |  | $                        | 16,681 
|Diluted net
income per share        |  |  |  | $                        | 0.11   
|Net
orders                          |  |  |  | $                        | 346,793
|2003:                               |  |  |  |                          |        
|Net
sales                           |  |  |  | $                        | 238,410
|Gross
profit                        |  |  |  | $                        | 109,814
|Net income
(loss)                   |  |  |  | $                        | 11,872 
|Diluted net
income (loss) per share |  |  |  | $                        | 0.08   
|Net
orders                          |  |  |  | $                        | 241,825
|2002:                               |  |  |  |                          |        
|Net
sales                           |  |  |  | $                        | 169,679
|Gross
profit                        |  |  |  | $                        | 71,530 
|Net
income                          |  |  |  | $                        | 3,836  
|Diluted net
income per share        |  |  |  | $                        | 0.03   
|Net
orders                          |  |  |  | $                        | 170,304



The semiconductor equipment industry is subject to
cyclical conditions which play a major role in demand, as defined by net orders. These fluctuations, in turn, affected our net sales over the past
three years. In 2004, we experienced a significant increase in demand for our products. Net orders increased by $561.9 million or 60% from 2003 to
2004. The increase in demand began in the fourth quarter of 2003, when net orders increased 25% sequentially, and continued into 2004. In the first
three quarters of 2004, we experienced sequential increases in


21

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net orders of
26%, 15%, and 6%, respectively. The net order  growth in 2004 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. In the fourth quarter of 2004, demand began to slow and we experienced a 22%
decrease in net orders.



In 2003, we experienced a modest increase in net
orders from 2002. 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. Demand
increased in the fourth quarter of 2003.




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 to six months of receiving the related order and if applicable, customer acceptance is typically received one to six months
after shipment. These time lines are general estimates and actual times may vary depending on specific customer circumstances. We do not report orders
for systems with delivery dates greater than twelve months after receipt of the order.




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 2004, 2003 and 2002 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, |          
|--------- |  |  |  | ------------------------ | ---------
|
|Net
Sales |  |  |  | $                        | 1,357,288



The increase in net sales of
$432.2 million, or 47%, from 2003 to 2004 was primarily due to improved market conditions during 2004, driven mainly by increased volume. The increase
in volume was a result of increased capital spending by our customers as demand for semiconductor devices increased. 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 a moderate increase in capital spending by our customers as demand for semiconductor devices
increased.




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, |   
|------------- |  |  |  | ------------------------ | --
|
|North
America |  |  |  |                          | 23
|Europe        |  |  |  |                          | 9 
|Asia          |  |  |  |                          | 68



The increase in international net
sales (sales outside North America) as a percentage of net sales for the current year over the prior year is due to an increase in net sales in the
Asia region. We consider the Asia region to consist of Korea, Japan, Singapore, China and Taiwan. A significant portion of our net sales is generated
in Asia, primarily because 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.


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The increase in
net sales in Europe and Asia as a  percentage of total net sales during 2003 was
attributable to higher demand.



Gross Profit


|               |  |  |  | Years Ended December 31, |        
|-------------- |  |  |  | ------------------------ | -------
|
|Gross
profit   |  |  |  | $                        | 665,130
|% of net
sales |  |  |  |                          | 49     



The increase in gross profit as a percentage of net
sales in 2004 compared to 2003 is due primarily to a $44.0 million write-down of inventory in 2003, a favorable product mix and increased absorption of
our fixed overhead costs from higher shipment levels. Sales of inventory previously written down resulted in a credit to cost of sales of approximately
$9.0 million for the year ended December 31, 2004. In the comparable prior-year periods, sales of previously reserved inventory did not have a material
effect on the margin in absolute dollars or as a percentage of net sales.




The decline in gross profit as a percentage of net
sales in 2003 compared to 2002 was due primarily to a $44.0 million write-down of inventory in 2003. In the third quarter of 2003, we experienced a
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 weakness in demand for semiconductor capital
equipment negatively affected our gross margin as we experienced low absorption of our fixed overhead costs.




Our gross profit from period to period is affected
by the treatment of certain product sales in accordance with Securities and Exchange Commission 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, |        
|-------------- |  |  |  | ------------------------ | -------
|
|SG&A           |  |  |  | $                        | 194,652
|% of net
sales |  |  |  |                          | 14     



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




The increase in SG&A expense in 2004, in
absolute dollars, is primarily due to costs in the operations of Peter Wolters AG, which we acquired on June 28, 2004, as well as higher selling costs,
profit sharing and employee-related expenses. The increase in selling costs, profit sharing and employee-related expenses is due to an increase in
business volume. This increase was partially offset by a credit to SG&A of $8.1 million for the reversal of previously accrued royalty payments in
connection with our legal settlement with Applied Materials, Inc. The decrease in SG&A expense as a percentage of net sales is due to an increase
in net sales.




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


23

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Research and Development
(R&D)


|                         |  |  |  | Years Ended December 31, |        
|------------------------ |  |  |  | ------------------------ | -------
|
|Research and
development |  |  |  | $                        | 252,083
|% of net
sales           |  |  |  |                          | 19     



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 and depreciation. 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. 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.




The increase in R&D expense in absolute dollars
in 2004 from the prior-year period is a result of the acquisition of Peter Wolters AG, increased usage of project materials and increased profit
sharing expense due to improved operating performance. R&D expense as a percentage of net sales decreased compared to the respective prior-year
periods primarily due to an increase in net sales.




The increase in absolute dollars in 2003 was
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. As a percentage of net sales, R&D expense in 2003 remained
relatively flat compared to 2002.




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


|               |  |  |  | Years Ended December 31, |            
|-------------- |  |  |  | ------------------------ | -----------
|
|IPR&D          |  |  |  | $                        | 6,124      
|% of net
sales |  |  |  |                          | less than 1



During 2004, we incurred a charge totaling $6.1
million for acquired in-process research and development in connection with the acquisition of Angstron Systems, Inc. We incurred no such charges
during 2003. 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 relevant market sizes and growth factors, expected trends in
technology and the nature and expected timing of new product introductions.




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 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, discount rates of 25% and 33% were deemed appropriate for valuing the
IPR&D for SpeedFam-IPEC and Angstron Systems, Inc., respectively. 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.


24

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Legal
Settlement







|                 |  |  |  | Years Ended December 31, |            
|---------------- |  |  |  | ------------------------ | -----------
|
|Legal
settlement |  |  |  | $                        | 5,400      
|% of net
sales   |  |  |  |                          | less than 1



During 2004, we incurred a charge of $2.9 million
related to the Semitool litigation and a charge of $2.5 million related to the settlement of a class action lawsuit by field service engineers relating
to overtime compensation. In 2003, we incurred a legal settlement charge of $2.7 million to settle certain indemnification claims. No such legal
charges were incurred during the year ended December 31, 2002.




Restructuring and Other
Charges


|                                |  |  |  | Years Ended December 31, |            
|------------------------------- |  |  |  | ------------------------ | -----------
|
|Restructuring
and other charges |  |  |  | $                        | 1,484      
|% of net
sales                  |  |  |  |                          | less than 1



During 2004, we incurred a severance charge of $1.2
million and asset impairments of $1.2 million. These charges were offset by the reversal of a previously recorded restructuring accrual of $0.9 million
due to a change in future estimated sublease income related to vacated facilities.




During 2003, we incurred $15.8 million of
restructuring and other charges consisting of $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 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.




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, 2004, except for future rent obligations of $41.7 million,
which are to be paid in cash through year 2017. For further discussion, see Note 9 to the Consolidated Financial Statements.




The restructuring plans are estimated to have
reduced our expenses by approximately $9.6 million in 2004, of which $7.9 million relates to savings from vacated facilities and $1.7 million relates
to savings from workforce reductions. We estimate cost savings related to facilities of approximately $10.0 million in 2005 resulting from the
implemented restructuring plans. Actual savings may differ from our estimated savings.




Bad Debt
Recovery


|                  |  |  |  | Years Ended December 31, |  
|----------------- |  |  |  | ------------------------ | -
|
|Bad debt
recovery |  |  |  | $                        | 
|% of net
sales    |  |  |  |                          | 



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.


25

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Other Income, net


|                  |  |  |  | Years Ended December 31, |       
|----------------- |  |  |  | ------------------------ | ------
|
|Other income,
net |  |  |  | $                        | 17,804
|% of net
sales    |  |  |  |                          | 1     



Other income, net, includes interest income,
interest expense and other non-operating items. The increase in interest and other income, net, in absolute dollars for 2004 compared to 2003 is
primarily due to the cash receipt of $8.0 million in connection with the settlement of the Applied Materials, Inc. litigation. This was partially
offset by an increase in interest expense on long term debt of $1.8 million from the Euro based loan used to acquire Peter Wolters AG and a decrease in
interest income due to lower balances of interest-bearing cash and short-term investments and lower interest rates during 2004. Lower cash and
investment balances resulted mainly from repurchases of our common stock during the year ended December 31, 2004. The exercise of our purchase options
on properties previously leased under synthetic leases during the year ended December 31, 2003 reduced our interest income by $6.0 million for the year
ended December 31, 2004 as compared to the prior-year period.




The decrease in interest and 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 also resulted from a reduction in interest income due to a 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.




Income Taxes




Our effective tax provision (benefit) rates were 30%
in 2004, (67%) in 2003 and zero percent in 2002. Our effective tax rate in 2004 differs from 2003 as a result of increased profitability. The effective
tax rate in 2004 reflects the benefits of R&D tax credits and foreign tax credits, partially offset by the impact of an in-process R&D charge
taken in the second quarter. The in-process R&D charge is not deductible for income tax purposes.




Our effective tax benefit rate in 2003 was higher
than in 2002 as a result of the combined benefit of the net operating loss and tax credit carryforwards. 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.




We expect our effective tax rate in 2005 to increase
as a result of a reduction in our valuation allowance benefit.




We received a notification from the Internal Revenue
Service that a settlement agreement with respect to tax years through 2002 has been proposed and is pending with the Congressional Joint Committee on
Taxation. In addition, certain of our foreign subsidiaries are subject to examination by the foreign taxing authorities. The timing of the settlement
of these examinations is uncertain. We believe that adequate accruals have been provided for any potential adjustments that may result from these
examinations.




On October 22, 2004, the American Jobs Creation Act
of 2004 was enacted into law. The Act provided for a special one-time 85% dividends received deduction on certain foreign earnings repatriated, as
defined in the Act. The deduction could result in an approximate 5.25% federal tax rate on repatriated foreign earnings, if we elect to apply this
provision to qualifying earnings repatriation. We are in the process of evaluating the effects of utilization of the repatriation provisions pending
issuance of further regulatory guidance regarding certain provisions of the Act. We believe that we will be able to complete our evaluation of the
effects of the repatriation provision by the third or fourth quarter of fiscal 2005. We have previously been subject to US tax at a 35% tax rate on
approximately $44 million of foreign earnings. While we would benefit from the reduced 5.25% tax rate if we repatriate some or all of these earnings
under the Act, we would also lose the ability to benefit from foreign


26

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tax credits otherwise available with respect to
such earnings. Accordingly, we are unable to estimate the net impact of the Act currently, although it is unlikely to be significant.


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.




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 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 equipment 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. Our equipment sales
generally have two elements: 1) delivery of the equipment and 2) installation of the equipment and customer acceptance. If we have met defined customer
acceptance experience levels with both the customer and the specific type of equipment, we recognize revenue for the equipment element upon shipment
and transfer of title, with the installation and acceptance element recognized at customer acceptance. All other equipment sales are recognized upon
customer acceptance.




Installation services are not essential to the
functionality of the delivered equipment. As provided for in EITF 00-21, Revenue Arrangements with Multiple Deliverables, 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
billable until customer acceptance, we defer revenue for the final payment until 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.


27

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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. In accordance with our policy, we completed the goodwill impairment test in the fourth quarter of 2004. 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, 2004, we had approximately $126.3 million of deferred
tax assets, net of a valuation allowance of $80.3 million principally related to acquired net operating loss carryforwards and foreign tax credits that
are not realizable until 2007 and beyond. The valuation allowance includes $44.0 million related to acquired deferred tax assets of SpeedFam-IPEC which
will be credited to goodwill when realized and $32.9 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 will 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).


28

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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 2004 and 2003, these hedging contracts
were denominated primarily in the Japanese Yen, Singapore Dollar and Taiwanese Dollar. 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 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, 2004 consisted of approximately $587.8 million of cash, cash equivalents and short-term investments. This amount represents a decrease of $418.3
million from the December 31, 2003 balance of $1,006.0 million. The decrease was due primarily to the repurchase of common stock for $410.2 million and
an increase in restricted cash of $173.8 million, offset by cash generated from operations.




Net cash provided by operating activities for the
year ended December 31, 2004 was $179.2 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 increases in accounts receivable of
$146.1 million, inventories of $46.1 million, and prepaid and other current assets of $5.7 million, offset by increases in accounts payable, accrued
payroll and related expenses, accrued warranty, other accrued liabilities, income tax payable, and deferred profit of $88.3
million.




Net cash used in investing activities in the year
ended December 31, 2004 was $333.1 million, which consisted primarily of cash paid for the acquisition of Peter Wolters AG of $142.9 million, an
increase in restricted cash and cash equivalents of $173.8 million and capital expenditures of $31.7 million, offset by net sales and maturities of
short-term investments of $26.6 million. As of December 31, 2004, we did not have any significant commitments to purchase property and
equipment.




Net cash used in financing activities for the year
ended December 31, 2004 was $238.8 million, primarily for the repurchase of common stock for $410.2 million, partially offset by proceeds from employee
stock compensation plans of $38.7 million and net borrowings of $132.7 million.




Effective June 25, 2004, two of our European
subsidiaries entered into a credit arrangement denominated in Euros that allowed for borrowing up to $153.1 million. On June 28, 2004, we borrowed the
entire amount available to fund the acquisition of Peter Wolters AG and for general corporate purposes. Borrowings are secured by cash or marketable
securities on deposit and included within restricted cash on the consolidated balance sheet. All borrowings under the credit arrangement are due and
payable on or before June 25, 2009.




On February 23, 2004, our Board of Directors renewed
a stock repurchase program originally approved in September 2001. Under the repurchase program, we may repurchase up to $500.0 million of our
outstanding common stock through February 13, 2007. On September 20, 2004 we announced that our Board of Directors had authorized an additional $1.0
billion for repurchase of our outstanding common stock through September 14, 2009.




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


29

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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. We 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 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 2002 levels. 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 initiate during the ordinary course of business. As of December 31, 2004, the maximum potential amount
of future payments that we could be required to make under these letters of credit was approximately $4.4 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
short-term credit facilities with various financial institutions total $57.8 million, of which $54.7 million was unutilized as of December 31, 2004.
These credit facilities bear interest at various rates, expire on various dates through December 2005 and are used for general corporate purposes. As
of December 31, 2004, our subsidiaries had $3.1 million outstanding under the short-term lines of credit at a weighted-average interest rate of
5.0%.




We also have available long-term credit facilities
with various institutions that total $171.8 million, of which $10.7 million was unutilized as of December 31, 2004. The long-term credit facilities are
used to fund the acquisition of Peter Wolters AG and for general corporate purposes. These credit facilities bear interest at various rates and expire
in June 2009. As of December 31, 2004, we had $161.1 million in long-term outstanding debt.




In the event of default of the guaranteed facilities
by our subsidiaries, we would be required to pay a maximum of $48.8 million as of December 31, 2004.




In addition, we guarantee the lease arrangements of
certain subsidiaries. These subsidiary leases will expire between 2005 and 2010. In the event that our subsidiaries do not make the required payments,
we could be required to make payments on 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, 2004, 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 believe it is probable that any amounts will be
required to be paid under these guarantee arrangements.


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Contractual Obligations



We have non-cancelable operating leases for various
facilities. Rent expense was approximately $11.0 million, $13.1 million and $10.4 million for the years ended December 31, 2004, 2003 and 2002,
respectively, net of sublease income of $3.7 million, $7.9 million and $7.4 million, respectively. Certain of the operating leases contain provisions
which permit us to renew the leases at the end of their respective 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, 2004.


|                                |  |  |  | Years Ending December 31, |       
|------------------------------- |  |  |  | ------------------------- | ------
|
|
|Non-cancelable operating leases |  |  |  | $                         | 12,626



The following is a table
summarizing our contractual obligations under long-term borrowing arrangements. This table excludes amounts recorded on our balance sheet as current
liabilities at December 31, 2004.


|                           |  |  |  | Years Ending December 31, |  
|-------------------------- |  |  |  | ------------------------- | -
|
|
|Long-term
debt obligations |  |  |  | $                         | 

Purchase Commitments



We have firm purchase commitments with various
suppliers to ensure the availability of components. Our minimum obligation at December 31, 2004 under these arrangements was $45.9 million. All amounts
under these arrangements are due in 2005. Actual expenditures will vary based upon the volume of the transactions and length of contractual service
provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or cancelled. Certain
agreements provide for potential cancellation penalties. 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.


Recent Accounting Pronouncements



In March 2004, the Emerging Issues Task Force (EITF)
issued EITF No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments or EITF No. 03-1. EITF No.
03-1 includes guidance for determining and recording impairment for both debt and equity securities. EITF No. 03-1 also requires additional disclosure
for investments that are deemed to be temporarily impaired under the standard. In September 2004, the FASB Staff issued FASB Staff Position (FSP) EITF
03-1-1, or FSP EITF 03-1-1. Effective upon issuance, FSP EITF 03-1-1 delayed, indefinitely, certain measurement and recognition guidance contained in
EITF No. 03-1. Disclosures required under EITF No. 03-1 are included within Note 2 and Note 3 of the Notes to our Consolidated Financial
Statements.




In November 2004, the Financial Accounting Standards
Board (FASB) issued SFAS No. 151, Inventory Costs  An Amendment of ARB No. 43, Chapter 4, which clarifies the accounting for abnormal amounts of
idle facility expense, freight, handling costs and wasted material (spoilage). The Company is required to adopt SFAS No. 151 on January 1, 2006 and its
adoption is not expected to have a significant impact on the Companys results of operations or financial position.




In December 2004, the FASB issued SFAS No. 153,
Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and
redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for the Company
for nonmonetary asset exchanges beginning in the third quarter of 2005. The adoption of SFAS No. 153 is not expected to have a material effect on the
Companys consolidated financial position or results of operations.


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On December 16, 2004, the FASB issued FASB Statement
No. 123 (revised 2004), Share-Based Payment, or Statement 123(R), which is a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. or Opinion 25, and amends
FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in the
unrevised Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be
recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no
later than the beginning of our fiscal third quarter, with early adoption permitted. We expect to adopt Statement 123(R) on July 3,
2005.




As permitted by the unrevised Statement 123, we
currently account for share-based payments to employees using Opinion 25s intrinsic value method, under which we generally do not record
compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)s fair value method will have a significant impact on
our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be
predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in
prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income
and earnings per share in Note 2 to our Consolidated Financial Statements. Statement 123(R) also requires the benefits of tax deductions in excess of
recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This
requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the company cannot estimate
what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating
cash flows recognized in prior periods for such excess tax deductions were zero in 2004 and 2003, and $19.4 million in 2002.


Risk Factors



Set forth below and elsewhere in this Annual Report
on Form 10-K 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 on Form 10-K.




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. The rate of changes in demand is
accelerating, rendering the global semiconductor industry increasingly volatile. 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 been higher than optimal, 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. Our
business may be adversely affected if we fail to respond to rapidly changing industry cycles in a timely and effective manner. After experiencing a
significant increase in demand throughout the first, second and third quarters of 2004, we experienced a downturn in demand in the fourth quarter of
2004. 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.


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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. Our success will depend on our ability to accurately predict evolving industry standards, to develop innovative solutions and
improve existing technologies, to win market acceptance of our new and advanced technologies and to manufacture our products in a timely and
cost-effective manner and in a manner that addresses changing customer needs. If we do not continue to gain market acceptance for our new technologies
and products, or develop and introduce improvements in a timely manner in response to changing market conditions or customer requirements, our business
could be seriously harmed.




As is typical in the semiconductor capital equipment
market, technological innovations have long development cycles and 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. The increased costs and reduced
efficiencies that may be associated with the development, manufacture, sale and support of future products or product enhancements relative to our
existing products, may adversely affect our operating results.




Our success in developing, introducing and selling
new and enhanced systems depends upon a variety of factors, including product selection, hiring and provide competitive incentives for highly qualified
design and engineering personnel, 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 and marketing new products, or in enhancing our existing products. There can be no assurance that revenue from future
products or product enhancements will be sufficient to recover our investments in research and development. To ensure the functionality and reliability
of our future product introductions or product improvements, we incur substantial research and development costs early in development cycles, before we
can confirm the technical feasibility or commercial viability of a product or product improvement. 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.


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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 and
providing prompt and effective field support to our customers outside of the United States;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 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;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Inadequate protection or enforcement of our intellectual
property and other legal rights in foreign jurisdictions;
|- |  | ------------------------------------------------------------------------------------------------------------------

| |  | 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 or geopolitical instability 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. Our strategy to expand our market presence in Asia will render us
increasingly vulnerable to these risks.




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;
|- |  | ------------------------------------------------------------------------------------------------------------------

| |  | Competitive pricing pressures;
|- |  | ------------------------------

| |  | 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.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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:


34

---

| |  | 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.




Diversification
Strategy




Our core business and expertise has historically
been in the development, manufacture, sale and support of deposition technologies, and more recently, wafer surface preparation technologies. Our
acquisition of Peter Wolters and subsequent entry into the market for high-precision machine manufacturing equipment represents the first expansion of
our business beyond the semiconductor equipment industry. We lack experience in the high-precision machine manufacturing equipment market, relative to
our knowledge of the semiconductor equipment industry, and cannot give any assurance that we can maintain or improve the quality of products, level of
sales, or relations with customers or suppliers, that are necessary to compete in or lead the market for high-precision machine manufacturing tools.
The success of the Peter Wolters business depends in part on our ability to utilize and build upon the expertise of key employees. Our efforts to
integrate and develop the Peter Wolters business may divert capital, management attention, research and development and other critical resources away
from, and adversely affect, our core business.




Concentration of Net
Sales




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. 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. Seeking patent protection is a lengthy and costly process, and 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, given the speed with which technology becomes obsolete
in the semiconductor industry. Our competitors may also develop and obtain patents to technologies that are similar or superior to our technologies. In
addition, the laws of foreign jurisdictions in which we develop, manufacture or sell our products may not protect our intellectual property rights to
the same extent as do the laws of the United States.




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


35

---



to significant liabilities to third parties,
require us to seek licenses from third parties, or prevent us from manufacturing or selling our products. Regardless of the merit of these legal
disputes, we incur substantial costs to prosecute or defend our intellectual property rights. In addition, if the terms of settlements entered into
with certain of our competitors is not observed or enforced, we may suffer further costs. Any of these circumstances could have a material adverse
effect on our business, financial condition or results of operations.




Our ability to develop intellectual property depends
on hiring, retaining and motivating highly qualified design and engineering staff with the knowledge and technical competence to advance our technology
and productivity goals. To protect our trade secrets and proprietary information generally, we have entered into confidentiality or invention
assignment agreements with our employees, as well as consultants and other parties. If these agreements are breached, our remedies may not be
sufficient to cover our losses.




Supply Shortages and Outsourcing
Activities




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. We also outsource the manufacture of major subassemblies, which enables us to focus on performing system design, assembly and testing in-house,
thereby minimizing our fixed costs and capital expenditures. Although we make reasonable efforts to ensure that third party providers will perform to
our standards, we cannot give any assurance that they will do so. Manufacturing disruption beyond our control may also impair our ability to manage
inventory and cause delays in shipments, cancellation of orders or loss of business.




Outside Audit Firm
Independence




Our independent registered public accounting firm
communicates with us at least annually regarding any relationships between the firm and Novellus that, in the firms professional judgment, might
have a bearing on the firms independence with respect to Novellus. If our independent registered public accounting firm finds that it cannot
confirm that it is independent of Novellus based on existing securities laws and registered public accounting firm independence standards, we could
experience delays or otherwise fail to meet our regulatory reporting obligations.




In this regard, our independent registered public
accounting firm has advised us that its affiliate offices in Japan, China and Taiwan had previously performed certain services for Novellus
subsidiaries. The fees associated with these services were not substantial, although the services themselves might be characterized as prohibited
non-audit services under existing securities laws. We, together with the Audit Committee of our Board of Directors and our independent registered
public accounting firm have concluded that the performance of these services did not impair our accounting firms independence with respect to
Novellus.




Costs of Corporate Governance and Financial
Reporting Compliance




To comply with the requirements of the
Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and adopted by Nasdaq in response to Sarbanes-Oxley, we have made
changes to our financial reporting, securities disclosure and corporate governance practices. We may incur increased legal and financial compliance
costs due to these new or revised rules, regulations, and listing requirements and management time and resources may be re-directed to implement our
compliance initiatives. These rules may make it more difficult for us to attract and retain qualified executive officers and members of our board of
directors, particularly to serve on our audit committee, as well as make it more costly to obtain liability coverage for our officers and
directors.


36

---



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.




Changes in Accounting Standards For Stock
Option Plans




Pursuant to SFAS 123(R), we will be required to
recognize, beginning in our third fiscal quarter of 2005 compensation expense in our statement of operations for the fair value of unvested employee
stock options at the date of adoption, and new stock options granted to our employees after the adoption date over the related vesting periods of the
stock options. The requirement to expense stock options granted to employees reduces the attractiveness of granting stock options because the expense
associated with these grants may adversely affect our profitability. However, stock options remain an important employee recruitment and retention
tool, and we may not be able to attract and retain key personnel if we reduce the scope of our employee stock option program following the adoption of
FAS 123R. We may decide to replace our stock option programs with other compensation arrangements, but those are likely to negatively impact
profitability. Our employees are critical to our ability to develop and design systems that advance our productivity and technology goals, increase our
sales goals and provide support to customers. Accordingly, as a result of the requirement under SFAS 123(R) to recognize the fair value of stock
options as compensation expense, beginning in the third quarter of 2005, our future profitability may be reduced.




Investment Activities




Our ability to compete in the semiconductor
manufacturing industry depends on our success in developing new and enhanced technologies and integrating such technologies into our systems at
competitive prices on a timely basis. To further these goals, we have formed the Novellus Development Company, a venture fund that will enable us to
invest in emerging technologies and strengthen our technology portfolio for both existing and potentially new market opportunities. Although the fund
intends to make enquiries reasonably necessary to make an informed decision as to the companies and technologies in which it will invest, we cannot
provide any assurance as to any future return on investment. There are risks inherent in investing in start-up companies which may lack a stable
management team, operating history or adequate cash flow. Also, the securities in which the fund may invest may not be registered under the Securities
Act or any applicable state securities laws, and may be subject to restrictions on marketability or transferability. Given the nature of the
investments that may be contemplated by the fund, there is a significant risk that it will be unable to realize its investment objectives by sale or
other disposition at attractive prices within any given period of time or will otherwise be unable to complete a particular exit strategy. In
particular, these risks could arise from changes in the financial condition or prospects of the properties in which investment are made, changes in
national or local economic conditions, and changes in laws, regulations or fiscal policies of jurisdictions in which investments are made. Investments
that may be contemplated by the fund may divert management time and attention, as well as capital, away from our core operating business. Any future
losses on investments attributable to the fund may adversely impact our business, financial condition and operating results.


|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, short-term and long-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.


37

---



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 interest rate of the majority of our short-term
and long-term obligations is floating. 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.




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, 2004 and 2003.


|                            |  |  |  | Periods of Maturity |        
|--------------------------- |  |  |  | ------------------- | -------
|
|
|Assets:                     |  |  |  |                     |        
|Cash
equivalents            |  |  |  | $                   | 106,117
|Average
interest rate       |  |  |  |                     | 2.12   
|Short-term
investments      |  |  |  | $                   | 151,279
|Average
interest rate       |  |  |  |                     | 1.99   
|Restricted
investments      |  |  |  | $                   | 176,708
|Average
interest rate       |  |  |  |                     | 2.18   
|Total
investment securities |  |  |  | $                   | 434,104
|Average
interest rate       |  |  |  |                     | 2.12   
|Liabilities:                |  |  |  |                     |        
|Short-term
borrowings       |  |  |  | $                   | 3,103  
|Average
interest rate       |  |  |  |                     | 5.05   
|Long-term
borrowings        |  |  |  | $                   |       
|Average
interest rate       |  |  |  |                     |       

|                            |  |  |  | Periods of Maturity |        
|--------------------------- |  |  |  | ------------------- | -------
|
|
|Assets:                     |  |  |  |                     |        
|Cash
equivalents            |  |  |  | $                   | 497,178
|Average
interest rate       |  |  |  |                     | 1.10   
|Short-term
investments      |  |  |  | $                   | 290,082
|Average
interest rate       |  |  |  |                     | 1.19   
|Restricted
investments      |  |  |  | $                   | 2,861  
|Average
interest rate       |  |  |  |                     | 1.03   
|Total
investment securities |  |  |  | $                   | 790,121
|Average
interest rate       |  |  |  |                     | 1.13   
|Liabilities:                |  |  |  |                     |        
|Short-term
borrowings       |  |  |  | $                   | 13,023 
|Average
interest rate       |  |  |  |                     | 1.20   



The less than 1 year
category contains $4.7 million and $6.7 million in mutual funds that do not have contractual maturities at December 31, 2004 and 2003,
respectively.


Foreign Currency Risk



We transact business in various foreign countries.
Our primary foreign currency cash flows are in Asia and Europe. During 2004 and 2003, 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


38

---



hedging instruments. 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.




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, 2004 and 2003 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, 2004
|---------------------------------------------------- |  | -----------------------
|
|
|Foreign
        currency forward exchange contracts: |  |                        
|Japanese
        yen                                 |  |                        
|British
        pound                                |  |                        
|Euro                                                 |  |                        
|Singapore
        dollar                             |  |                        
|Taiwanese
        dollar                             |  |                        
|Korean
        won                                   |  |                        
|Indian
        Rupee                                 |  |                        
|                                                     |  |                        

|                                                     |  | December
      31, 2003
|---------------------------------------------------- |  | -----------------------
|
|
|Foreign
        currency forward exchange contracts: |  |                        
|Japanese
        yen                                 |  |                        
|British
        pound                                |  |                        
|Euro                                                 |  |                        
|Singapore
        dollar                             |  |                        
|Taiwanese
        dollar                             |  |                        
|Korean
        won                                   |  |                        
|                                                     |  |                        

39

---



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

NOVELLUS SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In
thousands, except per share data)

|                                                                                                                                    |  | Years
      Ended December 31,
|----------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------
|
|Net
        sales                                                                                                                   |  | $                             
|Cost
        of sales                                                                                                               |  |                               
|Gross
        profit                                                                                                                |  |                               
|Operating
        expenses:                                                                                                         |  |                               
|Selling,
        general and administrative                                                                                         |  |                               
|Research
        and development                                                                                                    |  |                               
|Acquired
        in-process research and development                                                                                |  |                               
|Legal
        settlements                                                                                                           |  |                               
|Restructuring
        and other charges                                                                                             |  |                               
|Bad
        debt recovery                                                                                                           |  |                               
|Total
        operating expenses                                                                                                    |  |                               
|Operating
        income (loss), net                                                                                                |  |                               
|Other
        income (expense):                                                                                                     |  |                               
|Interest
        income                                                                                                             |  |                               
|Interest
        expense                                                                                                            |  |                               
|Other,
        net                                                                                                                  |  |                               
|Other
        income, net                                                                                                           |  |                               
|Income
        (loss) before provision (benefit) for income taxes and cumulative effect
        of a change in accounting principle |  |                               
|Provision
        (benefit) for income taxes                                                                                        |  |                               
|Income
        (loss) before cumulative effect of a change in accounting principle                                                  |  |                               
|Cumulative
        effect of a change in accounting principle, net of tax of $33,067
        for 2003                               |  |                               
|Net
        income (loss)                                                                                                           |  | $                             
|Net
        income (loss) per share:                                                                                                |  |                               
|Basic                                                                                                                               |  |                               
|Income
        (loss) before cumulative effect of a change in accounting principle                                                  |  | $                             
|Cumulative
        effect of a change in accounting principle                                                                       |  |                               
|Basic
        net income (loss) per share                                                                                           |  | $                             
|Diluted                                                                                                                             |  |                               
|Income
        (loss) before cumulative effect of a change in accounting principle                                                  |  | $                             
|Cumulative
        effect of a change in accounting principle                                                                       |  |                               
|Diluted
        net income (loss) per share                                                                                         |  | $                             
|Shares
        used in basic per share calculations                                                                                 |  |                               
|Shares
        used in diluted per share calculations                                                                               |  |                               

See accompanying Notes to the Consolidated Financial Statements.

40

---

NOVELLUS SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (In
thousands)

|                                                                                                                                             |  | December
      31,
|-------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------
|
|ASSETS                                                                                                                                       |  |                   
|Current
        assets:                                                                                                                      |  |                   
|Cash
        and cash equivalents                                                                                                            |  | $                 
|Short-term
        investments                                                                                                               |  |                   
|Accounts
        receivable, net of allowance for doubtful accounts of $8,247 in
        2004 and $7,655 in 2003                             |  |                   
|Inventories                                                                                                                                  |  |                   
|Deferred
        tax assets, net                                                                                                             |  |                   
|Prepaid
        and other current assets                                                                                                     |  |                   
|Total
        current assets                                                                                                                 |  |                   
|Property
        and equipment, net                                                                                                          |  |                   
|Restricted
        cash and cash equivalents                                                                                                 |  |                   
|Goodwill                                                                                                                                     |  |                   
|Intangible
        and other assets                                                                                                          |  |                   
|Total
        assets                                                                                                                         |  | $                 
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                         |  |                   
|Current
        liabilities:                                                                                                                 |  |                   
|Accounts
        payable                                                                                                                     |  | $                 
|Accrued
        payroll and related expenses                                                                                                 |  |                   
|Accrued
        warranty                                                                                                                     |  |                   
|Other
        accrued liabilities                                                                                                            |  |                   
|Income
        taxes payable                                                                                                                 |  |                   
|Deferred
        profit                                                                                                                      |  |                   
|Current
        obligations under lines of credit                                                                                            |  |                   
|Total
        current liabilities                                                                                                            |  |                   
|Long-term
        debt                                                                                                                       |  |                   
|Other
        non-current liabilities                                                                                                        |  |                   
|Total
        liabilities                                                                                                                    |  |                   
|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  140,306 in 2004 and 152,899 in 2003 |  |                   
|Deferred
        stock compensation                                                                                                          |  |                   
|Retained
        earnings                                                                                                                    |  |                   
|Accumulated
        other comprehensive income                                                                                               |  |                   
|Total
        shareholders equity                                                                                                           |  |                   
|Total
        liabilities and shareholders equity                                                                                           |  | $                 

See accompanying Notes to the Consolidated Financial Statements.

41

---

NOVELLUS SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In
thousands)

|                                                                                                |  | Years
      Ended December 31,
|----------------------------------------------------------------------------------------------- |  | ------------------------------
|
|Cash
        flows from operating activities:                                                   |  |                               
|Net
        income (loss)                                                                       |  | $                             
|Adjustment
        to reconcile net income (loss) to net cash provided by operating activities: |  |                               
|Write-off
        of debt issuance costs                                                        |  |                               
|Gain
        on sale of equity investments                                                      |  |                               
|Cumulative
        effect of a change in accounting principle                                   |  |                               
|Non-cash
        portion of restructuring and legal settlement                                  |  |                               
|Loss
        on disposal of fixed assets                                                        |  |                               
|Bad
        debt recovery                                                                       |  |                               
|Depreciation
        and amortization                                                           |  |                               
|Amortization
        of deferred compensation                                                   |  |                               
|Acquired
        in-process research and development                                            |  |                               
|Income
        tax benefits from employee stock plans                                           |  |                               
|Changes
        in operating assets and liabilities:                                            |  |                               
|Accounts
        receivable                                                                     |  |                               
|Inventories                                                                                     |  |                               
|Deferred
        income taxes                                                                   |  |                               
|Prepaid
        and other current assets                                                        |  |                               
|Accounts
        payable                                                                        |  |                               
|Accrued
        payroll and related expenses                                                    |  |                               
|Accrued
        warranty                                                                        |  |                               
|Other
        accrued liabilities                                                               |  |                               
|Income
        taxes payable                                                                    |  |                               
|Deferred
        profit                                                                         |  |                               
|Net
        cash provided by operating activities                                               |  |                               
|Cash
        flows from investing activities:                                                   |  |                               
|Purchases
        of short-term investments                                                     |  |                               
|Proceeds
        from sales of short-term investments                                           |  |                               
|Proceeds
        from maturities of short-term investments                                      |  |                               
|Capital
        expenditures                                                                    |  |                               
|Decrease
        (increase) in restricted cash and cash equivalents                             |  |                               
|Decrease
        (increase) in intangible and other assets                                      |  |                               
|Increase
        in synthetic lease collateral                                                  |  |                               
|Cash
        acquired from SpeedFam-IPEC acquisition, net                                       |  |                               
|Purchase
        of Peter Wolters AG, net of cash acquired                                      |  |                               
|Net
        cash provided by (used in) investing activities                                     |  |                               

See accompanying Notes to the Consolidated Financial Statements.

42

---

NOVELLUS SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS 
(Continued) (In thousands)

|                                                                                                                                         |  | Years
      Ended December 31,
|---------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------
|
|Cash
        flows from financing activities:                                                                                            |  |                               
|Repayments
        of convertible subordinated debentures                                                                                |  |                               
|Proceeds
        from employee stock compensation plans                                                                                  |  |                               
|Proceeds
        (repayments) from lines of credit, net                                                                                  |  |                               
|Proceeds
        from long-term debt                                                                                                     |  |                               
|Payment
        on long-term debt                                                                                                        |  |                               
|Repurchases
        of common stock                                                                                                      |  |                               
|Net
        cash used in financing activities                                                                                            |  |                               
|Effects
        of exchange rate changes on cash and cash equivalents                                                                    |  |                               
|Net
        increase (decrease) in cash and cash equivalents                                                                             |  |                               
|Cash
        and cash equivalents at the beginning of the year                                                                           |  |                               
|Cash
        and cash equivalents at the end of the year                                                                                 |  | $                             
|Supplemental
        disclosures:                                                                                                        |  |                               
|Cash
        paid (received) during the year for:                                                                                        |  |                               
|Interest                                                                                                                                 |  | $                             
|Income
        taxes, net                                                                                                                |  | $                             
|Non-cash
        financing activities:                                                                                                   |  |                               
|Issuance
        of common stock and stock options related to SpeedFam-IPEC acquisition,
        net of deferred compensation of $ 3,104 |  | $                             
|Subordinated
        debt assumed from SpeedFam-IPEC acquisition                                                                         |  | $                             

See accompanying Notes to the Consolidated Financial Statements.

43

---

NOVELLUS SYSTEMS, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY (In thousands)

|                                                                                                                             |  |         |   | Deferred
      Compensation |   | Retained
      Earnings |   | Accumulated
      Other
      Comprehensive
      Income
      (Loss) |  | Total
      Shareholders
      Equity
|---------------------------------------------------------------------------------------------------------------------------- |  | ------- | - | --------------------------- | - | ----------------------- | - | --------------------------------------------------------------------- |  | --------------------------------------
|
|
|Balance
        at December 31, 2001                                                                                         |  | 143,606 |   |                             | $ | 1,275,591               |   |                                                                       |  | $                                     
|Components
        of comprehensive income:                                                                                  |  |         |   |                             |   |                         |   |                                                                       |  |                                       
|Net
        income                                                                                                           |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Net
        change in unrealized losses on available-for-sale securities                                                     |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Less:
        reclassification adjustment for gain on sale of an equity investment,
        net of tax of $ 966              |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Foreign
        currency translation adjustments                                                                             |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Comprehensive
        income                                                                                                 |  |         |   |                             |   |                         |   |                                                                       |  |                                       
|Issuance
        of common stock under employee compensation plans                                                           |  | 2,870   |   |                             |   | 54,434                  |   |                                                                       |  |                                       
|Issuance
        of common stock and assumption of stock options in connection with the
        acquisition of SpeedFam-IPEC |  | 5,733   |   |                             |   | 169,840                 |   |                                                                       |  |                                       
|Issuance
        of restricted common stock                                                                                  |  | 100     |   |                             |   | 3,811                   |   |                                                                       |  |                                       
|Amortization
        of deferred compensation                                                                                |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Income
        tax benefits realized from activity in employee stock plans                                                   |  |        |   |                             |   | 19,427                  |   |                                                                       |  |                                       
|Repurchases
        of common stock                                                                                          |  | (3,190  | ) |                             |   | (28,143                 | ) |                                                                       |  |                                       
|Balance
        at December 31, 2002                                                                                         |  | 149,119 |   |                             |   | 1,494,960               |   |                                                                       |  |                                       
|Components
        of comprehensive loss:                                                                                    |  |         |   |                             |   |                         |   |                                                                       |  |                                       
|Net
        loss                                                                                                             |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Net
        change in unrealized loss on available-for-sale securities                                                       |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Foreign
        currency translation adjustments                                                                             |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Comprehensive
        loss                                                                                                   |  |         |   |                             |   |                         |   |                                                                       |  |                                       
|Issuance
        of common stock under employee compensation plans                                                           |  | 3,696   |   |                             |   | 75,651                  |   |                                                                       |  |                                       
|Issuance
        of restricted common stock, net                                                                             |  | 116     |   |                             |   | 3,963                   |   |                                                                       |  |                                       
|Amortization
        of deferred compensation                                                                                |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Repurchases
        of common stock                                                                                          |  | (32     | ) |                             |   | (335                    | ) |                                                                       |  |                                       
|Balance
        at December 31, 2003                                                                                         |  | 152,899 |   |                             |   | 1,574,239               |   |                                                                       |  |                                       
|Components
        of comprehensive income:                                                                                  |  |         |   |                             |   |                         |   |                                                                       |  |                                       
|Net
        income                                                                                                           |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Net
        change in unrealized loss on available-for-sale securities                                                       |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Less:
        reclassification adjustment for gain on sale of available-for-sale securities                                  |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Foreign
        currency translation adjustments, net of tax of $ 4,194                                                      |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Comprehensive
        income                                                                                                 |  |         |   |                             |   |                         |   |                                                                       |  |                                       
|Issuance
        of common stock under employee compensation plans, net                                                      |  | 1,731   |   |                             |   | 38,847                  |   |                                                                       |  |                                       
|Issuance
        of restricted common stock, net                                                                             |  | 450     |   |                             |   | 12,939                  |   |                                                                       |  |                                       
|Amortization
        of deferred compensation                                                                                |  |        |   |                             |   |                        |   |                                                                       |  |                                       
|Repurchases
        of common stock                                                                                          |  | (14,774 | ) |                             |   | (152,196                | ) |                                                                       |  |                                       
|Balance
        at December 31, 2004                                                                                         |  | 140,306 |   |                             | $ | 1,473,829               |   |                                                                       |  | $                                     

See accompanying Notes to the Consolidated Financial Statements.

44

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



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



Novellus Systems, Inc. is primarily 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 semiconductor device manufacturers with high productivity and low cost
of ownership.




As part of our growth strategy, from time to time we
make acquisitions. On June 28, 2004, we acquired Peter Wolters AG, a manufacturer of high-precision machine manufacturing tools. The acquisition was
accounted for as a purchase business combination. Our consolidated financial statements for 2004 include the financial position, results of operations
and cash flows of Peter Wolters from the date of acquisition. With the acquisition of Peter Wolters AG, Novellus entered into the Industrial
Applications market segment for the first time.




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 2004, 2003 and 2002 include the financial position, results of operations and cash flows of SpeedFam-IPEC from date of
acquisition.


Note 2.    Significant Accounting Policies



Principles of Consolidation and 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 2004 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.




In our consolidated statements of operations we
recognize stock-based compensation, measured at the intrinsic value, on the graded vesting method over the vesting periods for restricted stock awards
and stock options, which is 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.




In the disclosure presented below we recognize
stock-based compensation, measured at the fair value, on the graded vesting method over the vesting periods for restricted stock awards and stock
options, which is generally four years, and for employee purchases of common stock under our employee stock purchase plan, which is generally six
months. 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.


45

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 2.    Significant Accounting Policies
(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, |        
|--------------------------------------------------------------------------------- |  |  |  | ------------------------ | -------
|
|Net income
(loss) as reported                                                     |  |  |  | $                        | 156,690
|Add
back:                                                                         |  |  |  |                          |        
|Intrinsic
value method expense included in reported net income (loss), net of tax |  |  |  |                          | 2,906  
|Less:                                                                             |  |  |  |                          |        
|Fair value
method expense, net of tax                                             |  |  |  |                          | (49,086
|Pro-forma net
income (loss)                                                       |  |  |  | $                        | 110,510
|Pro-forma
basic net income (loss) per share                                       |  |  |  | $                        | 0.76   
|Pro-forma
diluted net income (loss) per share                                     |  |  |  | $                        | 0.75   



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 2004, 2003 and
2002:


|                        |  |  |  | 2004 |      | 2003  |  | 2002
|----------------------- |  |  |  | ---- | ---- | ----- |  | ----
|Dividend
yield          |  |  |  |      | None |       |  |     
|Expected
volatility     |  |  |  |      | 74   | %     |  |     
|Risk free
interest rate |  |  |  |      | 2.7  | %     |  |     
|Expected
lives          |  |  |  |      | 3.6  | years |  |     



The weighted-average fair value of options granted
during the year was $ 15.45, $ 21.56 and $ 17.67 for 2004, 2003 and 2002, respectively. 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 periods.




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 2004, 2003 and 2002:


|                        |  |  |  | 2004 |      | 2003 |  | 2002
|----------------------- |  |  |  | ---- | ---- | ---- |  | ----
|Dividend
yield          |  |  |  |      | None |      |  |     
|Expected
volatility     |  |  |  |      | 43   | %    |  |     
|Risk free
interest rate |  |  |  |      | 1.6  | %    |  |     
|Expected
lives          |  |  |  |      | 1/2  | year |  |     



The weighted average fair value of purchase rights
granted during the year was $8.04, $9.52 and $12.88 for 2004, 2003 and 2002, 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 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


46

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 2.    Significant Accounting Policies
(Continued)



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 101. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, our
price is fixed or determinable, and collectibility is reasonably assured.




Certain of our equipment 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. Our equipment sales
generally have two elements: 1) delivery of the equipment and 2) installation of the equipment and customer acceptance. If we have met defined customer
acceptance experience levels with both the customer and the specific type of equipment, we recognize revenue for the equipment element upon shipment
and transfer of title, with the installation and acceptance element recognized at customer acceptance. All other equipment sales are recognized upon
customer acceptance.




Installation services are not essential to the
functionality of the delivered equipment. As provided for in Emerging Issues Task Force (EITF) No. 00-21, Revenue Arrangements with
Multiple Deliverables, 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 billable until customer acceptance, we defer revenue for the final payment until 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 which are available for use in current operations 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. 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.




Restricted Cash and Cash Equivalents 
We maintain certain amounts of cash and cash equivalents on deposit which are restricted from general use. These amounts are used primarily to secure
our Euro Loan (see Note 10).




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. We charge accounts receivable balances against our allowance for doubtful accounts
once we have concluded our collection efforts. Accounts receivable is considered past due in accordance with the contractual terms of the
arrangement.




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.




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, 2004 relates primarily to acquired


47

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 2.    Significant Accounting Policies
(Continued)



net operating loss carryforwards and foreign tax
credits that are not realizable until 2007 and beyond. The valuation allowance includes $44.0 million related to acquired deferred tax assets of
SpeedFam-IPEC which will be credited to goodwill when realized, and $32.9 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.




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 |  | 310 years                                    
|------------------------------- |  | ----------------------------------------------
|Furniture
        and fixtures  |  | 510 years                                    
|Buildings                       |  | 3040 years                                   
|Building
        improvements   |  | Shorter of useful life or remaining lease term



Goodwill and Other Intangible 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. In accordance with our policy, we completed the goodwill
impairment test in the fourth quarter of 2004. The first step of the test identifies if potential impairment may have occurred, while the second step
of the test measures the amount of the impairment, if any. Impairment is recognized when the carrying amount of the asset exceeds the fair value. The
results of our impairment tests did not indicate impairment.




Investments in non-marketable equity
securities  We record investments in non-marketable equity securities at historical cost or, if we have significant influence over the
investee, using the equity method of accounting. At December 31, 2004 and December 31, 2003, we did not have any equity securities that required the
equity method of accounting. Non-marketable equity securities are included in other assets. The carrying value of non-marketable equity securities as
of December 31, 2004 was $2.5 million. At December 31, 2003, we did not have any investments in non-marketable equity securities. Non-marketable
securities are periodically reviewed for impairment, which is based on an analysis of factors that may have adverse affects on the fair value of the
investment. No impairment existed at December 31, 2004.




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. 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.




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 will adjust the accruals
accordingly.


48

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 2.    Significant Accounting Policies
(Continued)



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,
2004.




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 2004 and 2003, these hedging
contracts were denominated primarily in the Japanese Yen, Singapore Dollar and the Taiwanese Dollar. 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 are recorded in our results of
operations.




Shipping and Handling Costs  Shipping
and handling costs are included as a component of cost of sales.




Advertising Expenses  We expense
advertising costs as incurred. Advertising expenses for 2004, 2003 and 2002 were $2.9 million, $1.9 million and $2.7 million,
respectively.




Concentrations 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 2004, 2003 and 2002 accounted for 69%, 76% and 79% of our total system sales,
respectively. One customer accounted for 11% of receivables at December 31, 2004. No customer accounted for more than 10% of our accounts receivable as
of December 31, 2003. We expect sales of our products to relatively few customers will continue to account for a high percentage of our total system
sales in the foreseeable future. None of our customers have entered into a long-term purchase agreements that would require them to purchase our
products.




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.




Certain of the raw materials used by the Company in
the manufacture of its products are available from a limited number of suppliers. Shortages could occur in these essential materials due to an
interruption of supply or increased demand in the industry.




Recent Accounting Pronouncements  In
March 2004, the Emerging Issues Task Force (EITF) issued EITF No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments or EITF No. 03-1. EITF No. 03-1 includes guidance for determining and recording impairment for both debt and equity
securities. EITF No. 03-1 also requires additional disclosure for investments that are deemed to be temporarily


49

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 2.    Significant Accounting Policies
(Continued)



impaired under the standard. In September 2004,
the FASB Staff issued FASB Staff Position (FSP) EITF 03-1-1, or FSP EITF 03-1-1. Effective upon issuance, FSP EITF 03-1-1 delayed, indefinitely,
certain measurement and recognition guidance contained in EITF No. 03-1. Disclosures required under EITF No. 03-1 are included within Note 2 and Note 3
of the Notes to our Consolidated Financial Statements.




In November 2004, the Financial Accounting Standards
Board (FASB) issued SFAS No. 151, Inventory Costs  An Amendment of ARB No. 43, Chapter 4, which clarifies the accounting for abnormal amounts of
idle facility expense, freight, handling costs and wasted material (spoilage). We are required to adopt SFAS No. 151 on January 1, 2006 and its
adoption is not expected to have a significant impact on our results of operations or financial position.




In December 2004, the FASB issued SFAS No. 153,
Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and
redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for us for
nonmonetary asset exchanges beginning in the third quarter of 2005. The adoption of SFAS No. 153 is not expected to have a material effect on our
consolidated financial position or results of operations.




On December 16, 2004, the FASB issued FASB Statement
No. 123 (revised 2004), Share-Based Payment, or Statement 123(R), which is a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. or Opinion 25, and amends
FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in the
unrevised Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be
recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no
later than the beginning of our fiscal third quarter, with early adoption permitted. We expect to adopt Statement 123(R) on July 3,
2005.




As permitted by the unrevised Statement 123, we
currently account for share-based payments to employees using Opinion 25s intrinsic value method, under which we generally do not record
compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)s fair value method will have a significant impact on
our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be
predicted at this time because it will depend, in part, on levels of share-based payments granted in the future. However, had we adopted Statement
123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma
net income and earnings per share in Note 2 to our Consolidated Financial Statements. Statement 123(R) also requires the benefits of tax deductions in
excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current
literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot
estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of
operating cash flows recognized in prior periods for such excess tax deductions were zero in 2004 and 2003, and $19.4 million in 2002.


50

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

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



Short-term
Investments




The cost and estimated fair value of our short-term
investments are as follows (in thousands):


|                                      |  | December
      31, 2004
|------------------------------------- |  | -----------------------
|
|U.S.
        Government agencies      |  | $                      
|Municipal
        securities          |  |                        
|Corporate
        securities          |  |                        
|Tax-exempt
        auction rate notes |  |                        
|Mutual
        funds                  |  |                        
|Total                                 |  | $                      

|                                      |  | December
      31, 2003
|------------------------------------- |  | -----------------------
|
|U.S.
        Government agencies      |  | $                      
|Municipal
        securities          |  |                        
|Commercial
        paper              |  |                        
|Corporate
        securities          |  |                        
|Tax-exempt
        auction rate notes |  |                        
|Mutual
        funds                  |  |                        
|Total                                 |  | $                      



For the year ended December 31, 2004, gross realized
gains and losses on short-term investments were $0.4 million and $0.1 million, respectively. For the year ended December 31, 2003, gross realized gains
or losses on short-term investments were not significant. The maturities of our restricted cash and cash equivalents and our short-term investments as
of December 31, 2004 are as follows (in thousands):


|December
      31, 2004              |   | Amount 
|------------------------------------ | - | -------
|Due
        in less than one year    | $ | 327,987
|Due
        in 1 to 3 years          |   | 157,505
|Due
        in 3 to 5 years          |   | 5,000  
|Due
        in 5 to 10 years         |   | 6,715  
|Due
        in greater than 10 years |   | 161,146
|Total                                | $ | 658,353



Securities with contractual maturities of over three
years are either auction rate securities or variable rate demand notes. While the contractual maturities are long-term, we believe the securities are
highly liquid and that the Company can take advantage of interest rate re-set periods of between one and thirty-five days to liquidate the securities.
Management has the ability and intent, if necessary, to liquidate these investments to fund operations within the next twelve months and accordingly
has classified all non-restricted investments as short-term investments in the Consolidated Balance Sheets. The due in less than one year
category contains $4.7 million in mutual funds that do not have contractual maturities.


51

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 3.    Financial Instruments
(Continued)



The breakdown of the short-term investments with
unrealized losses at December 31, 2004 is as follows (in thousands):


|                                 |  | In
      Loss Position for Less
      Than 12 Months |         | In
      Loss Position for
      12 Months or Greater |  | Total |      |  
|-------------------------------- |  | ---------------------------------------------------- | ------- | ----------------------------------------------------- |  | ----- | ---- | -
|
|U.S.
        Government agencies |  | $                                                    | 25,455  |                                                       |  | $     | (155 | )
|Municipal
        securities     |  |                                                      | 168,688 |                                                       |  |       | (617 | )
|Corporate
        securities     |  |                                                      | 26,572  |                                                       |  |       | (107 | )
|Mutual
        funds             |  |                                                      |        |                                                       |  |       |     |  
|Total                            |  | $                                                    | 220,715 |                                                       |  | $     | (879 | )



The gross unrealized losses related to investments
are primarily due to changes in interest rates. We view these unrealized losses as temporary in nature. We review our investment portfolio for possible
impairment. Impairment is based on an analysis of factors that may have adverse affects on the fair value of the investment. Factors considered in
determining whether a loss is temporary include the stability of the credit quality, the structure of the security and the ability to hold the
investment to maturity.




Fair Value of Other Financial
Instruments




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


|                                                         |  | December
      31,
|-------------------------------------------------------- |  | ------------------
|
|
|Restricted
        cash & cash equivalents  non-current |  | $                 
|Current
        obligations under lines of credit        |  |                   
|Long-term
        debt                                   |  |                   



For certain of our financial instruments, including
restricted investments and current obligations under our lines of credit, the carrying amounts approximate fair value due to their short maturities.
The investments included in non-current restricted investments are all cash and cash equivalents. The estimated fair values of our restricted
investments in 2004 and 2003 are based on quoted prices as of December 31, 2004 and December 31, 2003, respectively. Our long-term debt is not publicly
traded and is denominated in Euros. Judgment is required to estimate the fair value, using available market information and appropriate valuation
methods. The estimated fair value of the long-term debt is based primarily on borrowing rates currently available to the company for bank loans with
similar terms and 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,
|------------------------------------- |  | ------------------
|
|
|Sell
        (buy) foreign currencies |  | $47,997           



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, 2004 and 2003,
respectively.


52

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 3.    Financial Instruments
(Continued)



Interest Rate Swap




In our acquisition of Peters Wolters AG, we acquired
an interest rate and currency swap, which is marked to market at the end of each reporting period. The swap has a notional amount of $1.4 million and
expires in September 2006. The fair market value adjustment as of December 31, 2004 was not significant.


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



Inventories


|                                  |  | December
      31,
|--------------------------------- |  | ------------------
|
|
|Purchased
        and spare parts |  | $                 
|Work-in-process                   |  |                   
|Finished
        goods            |  |                   
|Total
        inventories         |  | $                 



Property and equipment,
net


|                                      |  | December
      31,
|------------------------------------- |  | ------------------
|
|
|Property
        and equipment:       |  |                   
|Machinery
        and equipment       |  | $                 
|Buildings
        and land            |  |                   
|Building
        improvements         |  |                   
|Furniture
        and fixtures        |  |                   
|                                      |  |                   
|Less
        accumulated depreciation |  |                   
|Total
        property and equipment  |  | $                 



Depreciation expense for the years ended December
31, 2004, 2003 and 2002 was $80.2 million, $58.7 million and $44.7 million, respectively.




Accrued warranty




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


|                                                                                |  | Years
      Ended
      December 31,
|------------------------------------------------------------------------------- |  | ------------------------------------
|
|Balance,
        beginning of period                                            |  | $                                   
|Warranties
        issued                                                       |  |                                     
|Settlements                                                                     |  |                                     
|Peter
        Wolters AG balance at acquisition                                 |  |                                     
|Changes
        in liability for pre-existing warranties, including expirations |  |                                     
|Balance,
        end of period                                                  |  | $                                   

53

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

|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 basic 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 (loss) 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.




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,
|--------------------------------------------------- |  | ------------------------------
|
|Numerator:                                          |  |                               
|Net
        income (loss)                           |  | $                             
|Denominator:                                        |  |                               
|Basic
        weighted-average shares outstanding   |  |                               
|Employee
        stock options and restricted stock |  |                               
|Diluted
        weighted-average shares outstanding |  |                               
|Basic
        net income (loss) per share           |  | $                             
|Diluted
        net income (loss) per share         |  | $                             



Options to purchase 15.2 million, 8.8 million and
8.7 million shares of common stock at weighted-average prices of $38.85, $43.13 and $42.60 per share were outstanding during 2004, 2003 and 2002,
respectively, but were not included in the computation of diluted net income per common share because the effect would be
anti-dilutive.


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



Goodwill




Changes in goodwill are as follows (in
thousands):


|                                     |  | Years
      ended
|------------------------------------ |  | -----------------
|
|Balance,
        beginning of period |  | $                
|SpeedFam-IPEC
        adjustment     |  |                  
|Peter
        Wolters AG acquisition |  |                  
|Peter
        Wolters AG adjustment  |  |                  
|Foreign
        currency translation |  |                  
|Balance,
        end of period       |  | $                



We completed the annual goodwill impairment test in
the fourth quarters of 2004 and 2003 in accordance with our policy. We also completed a goodwill impairment test in the third quarter of 2003 in
conjunction with our restructuring activities. The first step of the test identifies if potential 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.




During 2004, we determined that certain tax accruals
recorded during the acquisition of SpeedFam-IPEC in 2002 were no longer required, and we accordingly reversed $11.0 million against goodwill. As a
result of our acquisition of Peter Wolters AG on June 28, 2004, we recorded goodwill in the amount of $104.2 million, which is subject to foreign
currency translation effects. The related foreign currency translation effects for the year ended


54

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 6.    Goodwill and Other Intangible Assets
(Continued)

December 31,
2004 resulted in an increase to goodwill of $12.1 million. Additionally, we recorded an
increase to goodwill of $0.4 million related to a  property tax accrual associated with
the acquisition of Peter Wolters AG.



In 2003, we recorded a net increase to goodwill of
approximately $10.1 million. The adjustment to goodwill is a result of additional purchase price costs and the reallocation of the initial estimated
purchase price allocation for the acquisition of SpeedFam-IPEC.




The goodwill associated with the Peter Wolters
acquisition is attributable to the Industrial Applications Group operating segment, as are the translation-related changes to goodwill and the
adjustment of $0.4 million related to a property tax accrual. All other goodwill, including any adjustments made to goodwill during 2004 is
attributable to the Semiconductor Group operating segment.




Intangible Assets




Our acquired intangible assets (in
thousands):


|December
      31, 2004         |   | Gross  |  | Accumulated
      Amortization |   | Net   
|------------------------------- | - | ------ |  | ------------------------------ | - | ------
|Patents                         | $ | 4,197  |  |                                | $ | (525  
|Developed
        technology    |   | 28,095 |  |                                |   | (6,928
|Trademark                       |   | 6,809  |  |                                |   | (340  
|Other
        intangible assets |   | 138    |  |                                |   | (81   
|Total                           | $ | 39,239 |  |                                | $ | (7,874

|December
      31, 2003         |   | Gross  |  | Accumulated
      Amortization |         | Net
|------------------------------- | - | ------ |  | ------------------------------ | ------- | ---
|Patents                         | $ | 11,680 |  | $                              | (10,912 | )  
|Developed
        technology    |   | 17,380 |  |                                | (3,138  | )  
|Other
        intangible assets |   | 1,160  |  |                                | (1,093  | )  
|Total                           | $ | 30,220 |  | $                              | (15,143 | )  



The amortization expense for the identifiable
intangible assets was approximately $7.9 million, $3.6 million and $1.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. Our
estimated amortization expense for the identifiable intangible assets for each of the next five fiscal years will be approximately $6.1 million for
2005 through 2007, $5.8 million for 2008 and $3.2 million for 2009. As of December 31, 2004, we have no identifiable intangible assets with indefinite
lives. During 2003, we wrote off $5.5 million of purchased technology. For further discussion of this write-off, see Note 9.


|Note 7. |  | Business Combination
|------- |  | --------------------



On June 28, 2004, we acquired all of the outstanding
stock of Peter Wolters AG, a privately-held manufacturer of high-precision machine manufacturing tools based in Rendsburg, Germany. The acquisition of
Peter Wolters enables us to diversify our product offerings. We funded the purchase price of the acquisition, excluding transaction costs, with
approximately $149.5 million of borrowings under a credit facility. For further discussion regarding the credit facility, see Note 10. Under the terms
of the purchase agreement, we deposited ten percent of the purchase price into escrow. The escrow amount will be released to the former shareholders of
Peter Wolters on June 25, 2005, to the extent we have not made claims against the escrow for pre-acquisition contingencies.




The acquisition of Peter Wolters was accounted for
as a business combination in accordance with SFAS No. 141, Business Combinations. Tangible and intangible assets and liabilities were
recorded at their estimated fair value.


55

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 7.    Business Combination
(Continued)



The preliminary purchase price was allocated to the
fair value of assets acquired and liabilities assumed as follows (in thousands):


|Cash
        consideration                        |  | $ | 149,512 |  
|------------------------------------------------- |  | - | ------- | -
|Estimated
        transaction costs               |  |   | 2,100   |  
|Total
        purchase price                      |  | $ | 151,612 |  
|Cash
        and cash equivalents                 |  | $ | 8,696   |  
|Accounts
        receivable                       |  |   | 10,560  |  
|Inventory                                         |  |   | 25,216  |  
|Deferred
        tax asset                        |  |   | 1,454   |  
|Prepaid
        expenses and other current assets |  |   | 147     |  
|Property,
        plant and equipment             |  |   | 19,492  |  
|Goodwill                                          |  |   | 104,221 |  
|Developed
        technology                      |  |   | 9,600   |  
|Customer
        backlog                          |  |   | 2,400   |  
|Trademark/Tradename                               |  |   | 6,100   |  
|Other
        assets                              |  |   | 23      |  
|Accounts
        payable                          |  |   | (4,726  | )
|Accrued
        payroll and related expenses      |  |   | (7,399  | )
|Accrued
        warranty                          |  |   | (1,761  | )
|Other
        current liabilities                 |  |   | (6,634  | )
|Deferred
        tax liability                    |  |   | (8,306  | )
|Income
        tax payable                        |  |   | (102    | )
|Long-term
        debt                            |  |   | (967    | )
|Other
        long-term liabilities               |  |   | (6,402  | )
|Total
        net assets acquired                 |  | $ | 151,612 |  



Intangible Assets  As of the closing
of our acquisition of Peter Wolters on June 28, 2004, $18.1 million of the total purchase price was allocated to intangible assets subject to
amortization. Included in these intangible assets are developed and core technologies, customer backlog and trademark/trade name rights with weighted
average lives of 6.0, 0.5, and 10.0 years, respectively. The weighted average life for all intangibles acquired in the acquisition was 6.6
years.




Goodwill The potential value of the
combined companies products and technologies contributed to a purchase price that resulted in goodwill. Goodwill represents the excess of the
purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. Goodwill is not deductible for tax
purposes and is not subject to amortization, however, it is to be tested for impairment at least annually in accordance with SFAS No. 142.
Approximately $104.2 million of the total purchase price was allocated to goodwill upon the closing of our acquisition of Peter Wolters on June 28,
2004. Subsequent to the acquisition date, we recorded an additional liability related to a property tax accrual of $0.4 million with a corresponding
increase to goodwill.


56

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 7.    Business Combination
(Continued)








Unaudited Pro Forma Results  The
following table represents the unaudited pro forma consolidated results of operations, assuming the acquisition of Peter Wolters was consummated as of
the beginning of the periods presented. The unaudited pro forma information has been prepared for comparative purposes only and may not be indicative
of what operating results would have been if the acquisition had taken place at the beginning of the periods presented. In addition, the unaudited pro
forma information may not be indicative of future operating periods. The combined operating results below consist of historical results of Novellus and
Peter Wolters for the years ended December 31, 2004 and 2003.


|                                                                                   |  | December
      31,
|---------------------------------------------------------------------------------- |  | ------------------
|
|Net
        sales                                                                  |  | $                 
|Income
        (loss) before cumulative effect of a change in accounting principle |  | $                 
|Cumulative
        effect of change in accounting principle, net of tax            |  | $                 
|Net
        income (loss)                                                          |  | $                 
|Diluted
        net income (loss) per share                                        |  | $                 

|Note 8. |  | Asset Purchase Transaction
|------- |  | --------------------------



In April 2004, we acquired Angstron Systems, Inc., a
developer of atomic layer deposition technology for advanced semiconductor manufacturing for total consideration of approximately $9.8 million,
including transaction costs of approximately $0.3 million. We evaluated the business combination criteria within SFAS No. 141, and, after consideration
of these criteria and the criteria included within EITF No. 98-3 Determining Whether a Nonmonetary Transaction Involves Receipt of Productive
Assets or of a Business, determined that the purchase of Angstron represented a purchase of assets rather than a business combination, and
accordingly, the tangible assets acquired and liabilities assumed were recorded at their estimated fair values at the date of acquisition. The
intangible assets acquired were valued under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. A portion of the
purchase price was allocated to existing technology and acquired in-process research and development (IPR&D). The assets were
identified and valued through analysis of data concerning developmental products, their stage of development, the time and resources needed to complete
them, their expected income generating ability, target markets and associated risks.




Those developmental projects that had not reached
technological feasibility and had no alternative future use were classified as IPR&D and expensed in the second quarter of 2004. The nature of the
efforts required to develop the IPR&D into commercially viable products principally relates to the completion of all planning, designing,
prototyping, verification and testing activities that are necessary to establish that the products can be produced to meet their design specifications,
including functions, features and technical performance requirements.




The purchase price was allocated to the fair value
of assets acquired and liabilities assumed as follows (in thousands):


|Cash
        consideration                           |  | $ | 9,500 |  
|---------------------------------------------------- |  | - | ----- | -
|Estimated
        transaction costs                  |  |   | 320   |  
|Total
        purchase price                         |  | $ | 9,820 |  
|Patents                                              |  | $ | 4,197 |  
|Acquired
        in-process research and development |  |   | 6,124 |  
|Tangible
        assets acquired                     |  |   | 265   |  
|Deferred
        tax liability, net                  |  |   | (267  | )
|Liabilities
        assumed                          |  |   | (499  | )
|Total
        net assets acquired                    |  | $ | 9,820 |  



The estimated useful life for all patents acquired
in the acquisition was 6.0 years.


57

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

|Note 9. |  | Restructuring and Other Charges
|------- |  | -------------------------------



As of December 31, 2004, substantially all actions
under the 2004, 2003, 2002 and 2001 restructuring plans had been completed, except for payments of future rent obligations of $41.7 million, which are
to be paid in cash through year 2017. All restructuring and other charges are related to the semiconductor segment.




The following table summarizes activity related to
restructuring charges that we recorded in the three years ended December 31, 2004 (in thousands):


|                                                  |  | Facilities |        | Asset
      Impairment |  | Severance |   | Acquisition
      Expense |   | Total |   | Inventory
      Write-
      down
|------------------------------------------------- |  | ---------- | ------ | ---------------------- |  | --------- | - | ------------------------- | - | ----- | - | ---------------------------------
|Balance
        at December 31, 2001              |  | $          | 26,849 |                        |  |           | $ |                          |   |       | $ |                                 
|Restructuring
        charges for 2002            |  |            | 1,478  |                        |  |           |   |                          |   |       |   | 4,989                            
|SpeedFam-IPEC
        restructuring charges       |  |            | 27,024 |                        |  |           |   |                          |   |       |   | 251                              
|Cash
        payments                             |  |            | (9,783 | )                      |  |           |   |                          |   |       |   | (4,989                           
|Balance
        at December 31, 2002              |  |            | 45,568 |                        |  |           |   |                          |   |       |   | 251                              
|Restructuring
        charges for 2003            |  |            | 4,088  |                        |  |           |   | 7,943                     |   |       |   | 3,807                            
|SpeedFam-IPEC
        acquisition adjustment      |  |            | 11,032 |                        |  |           |   |                          |   |       |   |                                 
|Cash
        payments                             |  |            | (9,828 | )                      |  |           |   |                          |   |       |   | (3,466                           
|Non-cash
        adjustment                       |  |            | (347   | )                      |  |           |   | (7,943                    | ) |       |   |                                 
|Balance
        at December 31, 2003              |  |            | 50,513 |                        |  |           |   |                          |   |       |   | 592                              
|Restructuring
        charges (benefits) for 2004 |  |            | (923   | )                      |  |           |   | 1,220                     |   |       |   | 1,187                            
|SpeedFam-IPEC
        acquisition adjustment      |  |            |       |                        |  |           |   |                          |   |       |   |                                 
|Non-cash
        adjustment                       |  |            |       |                        |  |           |   | (1,057                    | ) |       |   |                                 
|Cash
        payments                             |  |            | (7,909 | )                      |  |           |   |                          |   |       |   | (1,619                           
|Balance
        at December 31, 2004              |  | $          | 41,681 |                        |  |           | $ | 163                       |   |       | $ | 160                              



In 2004, we incurred a net restructuring charge of
$1.5 million to align our research and development and manufacturing operations with current business conditions. The restructuring charge is comprised
of $1.2 million for asset write-offs, $1.2 million for severance and a reversal of $0.9 million for facilities. These charges are included in
restructuring and other charges in the consolidated statement of operations.




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 a pre-tax charge 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 is included in cost of sales and
the other charges are included in restructuring and other charges in the consolidated statement of operations.




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 facilities-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.




Facilities




During the third quarter 2004, we entered into a
sublease for a building in the U.S. that was previously included in our estimate of future costs to be incurred under the 2001 restructuring plan. We
have revised our estimate of future facilities-related expenses based primarily on this sublease and recorded a reduction of $0.9 million in the
accrual.




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.


58

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 9.    Restructuring and Other Charges
(Continued)



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. In the third quarter of 2003, we
lowered the estimated sublease income related to the SpeedFam-IPEC facilities by $11.0
million, as  discussed above. During 2002 an additional charge of $1.5 million was
recorded due to a decrease in our future sublease income estimate.



Asset Impairment




In the fourth quarter of 2004, we abandoned R&D
assets in the U.S. and recorded a charge of $1.2 million. We do not expect to recover the carrying value of these assets through future cash
flows.




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 related to previous generation lab
equipment. These assets were abandoned as we did 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 was written off as these research and development projects were cancelled and there was no estimated future economic benefit
for the purchased technology.




Severance




In the fourth quarter of 2004, we reduced our
workforce by approximately 3% in response to market conditions and recorded charges of $1.2 million, primarily for the cost of severance compensation.
This workforce reduction affected approximately 80 people primarily within our manufacturing and research and development functions in the US.
Substantially all of these severance-related charges had been paid as of December 31, 2004.




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.




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.




Acquisition Costs




In the third quarter of 2004, we determined that a
tax accrual recorded during the acquisition of SpeedFam-IPEC in 2002 was no longer required and reversed $0.8 million of the accrual recorded in the
original purchase price allocation against goodwill.




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 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.


59

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 9.    Restructuring and Other Charges
(Continued)



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.


|Note 10. |  | Long-term Debt
|-------- |  | --------------



On June 28, 2004, we borrowed $153.1 million to fund
the acquisition of Peter Wolters AG and for general corporate purposes. The credit arrangement allows for periodic borrowings in Euros, with an
interest rate equal to the Eurocurrency Rate plus 0.2% (2.35% at December 31, 2004) and requires us to maintain certain financial covenants. We were in
compliance with our debt covenants as of December 31, 2004. The outstanding balance of $160.2 million is recorded as long-term debt at December 31,
2004. This credit facility is required to be secured by cash or marketable securities on deposit and is due and payable on or before June 25, 2009.
Amounts to secure this borrowing are included within restricted cash and cash equivalents on the consolidated balance sheets at December 31,
2004.




One of our subsidiaries also maintains a borrowing
of $0.9 million at December 31, 2004. This facility is for general corporate purposes and bears interest of 4.82% at December 31, 2004. Amounts under
this credit arrangement are due and payable in installments through June 30, 2009.




At December 31, 2004, we have an aggregate amount of
$10.7 million available for future borrowing under our long-term borrowing arrangements.


|Note 11. |  | Other, net
|-------- |  | ----------



The components of other, net within the consolidated
statements of operations are as follows (in thousands):


|                                          |  | Years
      Ended December 31,
|----------------------------------------- |  | ------------------------------
|
|Litigation
        proceeds               |  | $                             
|Gain
        on sale of equity security   |  |                               
|Write-off
        of debt issuance costs  |  |                               
|Other
        income                      |  |                               
|Other
        expense                     |  |                               
|Foreign
        currency gain (loss), net |  |                               
|Total
        other, net                  |  | $                             

|Note 12. |  | 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. We 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,


60

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 12.    Commitments and Guarantees
(Continued)



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 represented 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 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 2002 levels. 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 initiate during the ordinary course of business. As of December 31, 2004, the maximum potential amount
of future payments that we could be required to make under these letters of credit was approximately $4.4 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
short-term credit facilities with various financial institutions total $57.8 million, of which $54.7 million was unutilized as of December 31, 2004.
These credit facilities bear interest at various rates, expire on various dates through December 2005 and are used for general corporate purposes. As
of December 31, 2004, our subsidiaries had $3.1 million outstanding under the short-term lines of credit at a weighted-average interest rate of
5.0%.




We also have available long-term credit facilities
with various institutions that total $171.8 million, of which $10.7 million was unutilized as of December 31, 2004. The long-term credit facilities are
used to fund the acquisition of Peter Wolters AG and for general corporate purposes. These credit facilities bear interest at various rates and expire
in June 2009. As of December 31, 2004, we had $161.1 million in long-term outstanding debt.




In the event of default of these facilities by our
subsidiaries, we would guarantee up to a maximum exposure of $48.8 million as of December 31, 2004.




In addition, we guarantee the lease arrangements of
certain subsidiaries. These subsidiary leases will expire between 2005 and 2010. In the event that our subsidiaries do not make the required payments,
we could be required to make payments on 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, 2004, 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 believe it is probable that 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 $11.0 million, $13.1 million and $10.4 million for the years ended December 31, 2004, 2003 and 2002,
respectively, net of sublease income of $3.7 million, $7.9 million and $7.4 million, respectively. Certain of the operating leases contain provisions
which permit us to renew the leases at the end of their respective lease terms.


61

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 12.    Commitments and Guarantees
(Continued)



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 (in thousands).


|                                |  |  |  | Years Ending December 31, |       
|------------------------------- |  |  |  | ------------------------- | ------
|
|Non-cancelable
operating leases |  |  |  | $                         | 12,626



Purchase Commitments




We have firm purchase commitments with various
suppliers to ensure the availability of components. Our minimum obligation at December 31, 2004 under these arrangements was $45.9 million. All amounts
under these arrangements are due in 2005. Actual expenditures will vary based upon the volume of the transactions and length of contractual service
provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or cancelled. Certain
agreements provide for potential cancellation penalties.


|Note 13. |  | Litigation
|-------- |  | ----------



Applied Materials,
Inc.




On September 20, 2004, we settled all pending patent
litigation with Applied Materials, Inc. by entering into a Binding Memorandum of Understanding, referred to herein as an MOU, with Applied. The MOU was
effective as of September 3, 2004.


Background of the Litigation



On June 13, 1997, we acquired the Thin Film Systems
(TFS) business of Varian Associates, Inc. On the same day, Applied 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 business acquisition. On July 7, 1997, Applied amended its complaint in its suit against Varian to add
Novellus as a defendant. We requested that the Court dismiss us as a defendant in this suit.




The relief requested by Applied in both suits
included a permanent injunction against future infringement, damages for alleged past infringement and treble damages for alleged willful infringement.
Trial had been set to commence on September 20, 2004.


Settlement



Under the terms of the MOU, all then pending patent
litigation between us and Applied was dismissed with prejudice. As part of the settlement, Applied agreed to pay us $8.0 million and released us from
all amounts owed or claimed to be owed as of September 3, 2004 under a previous Settlement Agreement between us dated May 4, 1997 (TEOS Agreement),
including Applieds claim that $3.5 million was owed by us. In addition, the MOU effected a change in the terms of settlement under the TEOS
Agreement to cause the license by Applied of U.S. Patent No. 5,362,526 to us, and the cross-license of our CVD Patents and the Applied CVD Patents
(each as defined in the TEOS Agreement), in each case to be fully-paid and royalty-free, except in limited circumstances. The MOU also effected a
change in the terms of settlement under the TEOS Agreement to eliminate all rights of Applied to terminate the license based upon Novellus merger
or acquisition of or by other entities.




Under the MOU, the parties also agreed to covenants
not to sue each other for specified periods, as well as notice and cure periods, each of which limits the ability of the parties to bring patent
infringement claims against the other and the others customers, suppliers and distributors, regarding products existing at September 3, 2004 and
new products, subject to certain exceptions in specified product areas and for certain suppliers to the parties. The MOU also provides a general
release of the patent claims covered by the MOU for periods prior to September 3, 2004. Neither party admitted any liability in connection with the
settlement.


62

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 13.    Litigation (Continued)



The current year results include the cash receipt of
$8.0 million and the reversal of $8.1 million previously accrued as a result of the settlement of litigation with Applied Materials,
Inc.




Semitool, Inc.




On October 11, 2004, we settled the pending patent
litigation with Semitool, Inc. pursuant to the terms of a settlement agreement effective October 8, 2004.


Background of the Litigation



On June 11, 2001, Semitool sued us for patent
infringement in the United States District Court for the District of Oregon. Semitool alleged that we infringed one of Semitools patents related
to copper electroplating. Semitool sought an injunction against future infringement, 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 alleged that Semitool infringed certain of our patents related to copper electroplating. We sought an injunction against Semitool, damages
for past infringement, and treble damages for willful infringement by Semitool.


Settlement



On October 11, 2004, we entered into a settlement
agreement with Semitool that resolves all patent infringement claims at issue between us and Semitool. We made a $2.9 million settlement payment to
Semitool in accordance with the terms of the settlement agreement. In addition, we agreed to covenants not to sue Semitool for infringement of the four
counterclaim patents we asserted in the litigation based on acts prior to or after October 8, 2004 and Semitool agreed to a covenant not to sue us for
infringement of the patent Semitool asserted in the litigation. This covenant not to sue is limited to the activities where Semitool accused us of
infringement prior to October 8, 2004. The settlement agreement does not include any license of either partys patents. Neither party admitted any
liability in connection with the settlement.




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 Novellus would prevail in a future lawsuit filed in connection with the alleged indemnification
obligations, if such a lawsuit were brought. 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. However, due to the uncertainty surrounding the litigation
process, we are unable to estimate a range of loss, if any, at this time.




Linear Technology
Corporation




In March, 2002, Linear Technology Corporation
(Linear) 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 seeks damages (including punitive damages) and injunctions for causes of actions involving alleged breach of contract, fraud, unfair
competition, breach of warranty and declaratory relief. On September 3, 2004, Novellus filed a demurrer to all causes of action in the complaint, which
the Court granted without leave to amend on October 5, 2004. On January 19, 2005, we received notice that Linear intends to appeal the courts
order granting judgment in favor of Novellus. Although we prevailed


63

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 13.    Litigation (Continued)



on these claims in the Superior Court, it is
possible that the Court of Appeals will reverse the ruling of the Superior Court, in which case Novellus could face potential liability on these
claims. We cannot predict how the Court of Appeals will rule on this issue or, if it does rule against Novellus, estimate a range of potential loss, if
any, due to the uncertainty of the litigation process.




Employment
Litigation




On April 4, 2003, Thomas Graziani and others filed a
class action lawsuit against Novellus in the United States District Court for the District of Oregon. On August 1, 2003, David Robinson and others
filed a class action lawsuit against Novellus in the United States District Court for the Northern District of California, San Jose Division. Both
lawsuits sought 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. 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. Subsequently, the
parties have agreed to the material terms of a settlement, including a cap on exposure to Novellus of $2.5 million. On May 3, 2004, a fully executed
agreement resolving these matters was filed with the United States District Court for the Northern District of California. The court approved the
settlement on June 7, 2004. Novellus recorded a charge of $2.5 million during 2004 related to the settlement.




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. However, due to the uncertainty surrounding the litigation process, we are unable to estimate a
range of loss, if any, at this time.


|Note 14. |  | 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,
|------------------------------------------------------------------------------------------------------------------ |  | ------------------------------
|
|Federal                                                                                                            |  |                               
|Current                                                                                                            |  | $                             
|Deferred                                                                                                           |  |                               
|                                                                                                                   |  |                               
|State                                                                                                              |  |                               
|Current                                                                                                            |  |                               
|Deferred                                                                                                           |  |                               
|                                                                                                                   |  |                               
|Foreign                                                                                                            |  |                               
|Current                                                                                                            |  |                               
|Income
        tax benefits attributable to employee stock plan activity allocated to
        shareholders equity |  |                               
|Total
        provision (benefit) for income taxes                                                                 |  | $                             

64

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 14.    Income Taxes (Continued)



Income (loss) before income taxes and cumulative
effect of a change in accounting principle consisted of the following (in thousands):


|         |  | Years
      Ended December 31,
|-------- |  | ------------------------------
|
|Domestic |  | $                             
|Foreign  |  |                               
|Total    |  | $                             



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,
|------------------------------------------------------- |  | ------------------
|
|Deferred
        tax assets:                            |  |                   
|Reserves
        and accruals                           |  | $                 
|Expenses
        not currently deductible               |  |                   
|Capitalized
        in-process research and development |  |                   
|Deferred
        profit                                 |  |                   
|Net
        operating loss carryforwards                |  |                   
|Credits                                                 |  |                   
|Other                                                   |  |                   
|Total
        deferred tax assets                       |  |                   
|Valuation
        allowance                             |  |                   
|Deferred
        tax assets, net of valuation allowance |  |                   
|Deferred
        tax liabilities:                       |  |                   
|Depreciation                                            |  |                   
|Acquisition
        related items                       |  |                   
|Total
        net deferred tax assets                   |  | $                 



The net increase in the valuation allowance was $3.8
million, $19.5 million and $49.4 million during the years ended December 31, 2004, 2003 and 2002, respectively. The valuation allowance balance at
December 31, 2004 includes $44.0 million related to the acquired deferred tax assets of SpeedFam-IPEC which will be credited to goodwill when realized
and $32.9 million related to stock option benefits that will be credited to equity when and if realized.




As of December 31, 2004, we had federal and state
tax credit carryforwards of approximately $38.8 million and $18.7 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 at various dates
beginning in 2012 through 2024, if not utilized. The state tax credit carries forward indefinitely.




As of December 31, 2004, our federal net operating
losses for tax return purposes were $126.6 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
2017.




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, |       
|------------------------- |  |  |  | ------------------------ | ------
|
|Expected
provision at 35% |  |  |  | $                        | 78,117

65

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 14.    Income Taxes (Continued)

|                                                   |  | Years
      Ended December 31,
|-------------------------------------------------- |  | ------------------------------
|
|State
        tax, net of federal benefit          |  |                               
|Research
        and development credits           |  |                               
|Export
        sales incentive                     |  |                               
|Valuation
        allowance increase (decrease)    |  |                               
|Write-off
        of acquired IPR&D                |  |                               
|Other                                              |  |                               
|Total
        provision (benefit) for income taxes |  | $                             



We received a notification from the Internal Revenue
Service that a settlement agreement with respect to tax years through 2002 has been proposed and is pending with the Congressional Joint Committee on
Taxation. In addition, certain of our foreign subsidiaries are subject to examination by the foreign taxing authorities. The timing of the settlement
of these examinations is uncertain. We believe that adequate accruals have been provided for any potential adjustments that may result from these
examinations.




On October 22, 2004, the American Jobs Creation Act
of 2004 was enacted into law. The Act provided for a special one-time 85% dividends received deduction on certain foreign earnings repatriated, as
defined in the Act. The deduction could result in an approximate 5.25% federal tax rate on repatriated foreign earnings, if we elect to apply this
provision to qualifying earnings repatriation.




We are in the process of evaluating the effects of
utilization of the repatriation provisions pending issuance of further regulatory guidance regarding certain provisions of the Act. We believe that we
will be able to complete our evaluation of the effects of the repatriation provision by the third or fourth quarter of fiscal 2005. We have previously
been subject to US tax at a 35% tax rate on approximately $44.0 million of foreign earnings. While we would benefit from the reduced 5.25% tax rate if
we repatriate some or all of these earnings under the Act, we would also lose the ability to benefit from foreign tax credits otherwise available with
respect to such earnings. Accordingly, we are unable to estimate the net impact of the Act now, although it is unlikely to be
significant.


|Note 15. |  | Shareholders Equity
|-------- |  | --------------------



Other Comprehensive
Income




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


|                                                                      |  |  |  | December 31, |      
|--------------------------------------------------------------------- |  |  |  | ------------ | -----
|
|Foreign
currency translation adjustments, net of tax of $4,194 and $0 |  |  |  | $            | 6,232
|Unrealized
loss on available-for-sale securities                      |  |  |  |              | (987 
|Accumulated
other comprehensive income                                |  |  |  | $            | 5,245



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.




On February 24, 2004, we announced that our Board of
Directors had approved a stock repurchase plan that authorized the repurchase of up to $500.0 million of our outstanding common stock through February
13, 2007. On September 20, 2004 we announced that our Board of Directors had authorized an additional $1.0 billion for


66

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 15.    Shareholders Equity
(Continued)



repurchase of our outstanding common stock
through September 14, 2009. As of December 31, 2004, 14.8 million shares had been repurchased under this plan at a weighted average purchase price of
$27.76.


|Note 16. |  | Employee Benefit Plans
|-------- |  | ----------------------



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




During 2004, the Company granted 250,000 stock
options and 50,000 shares of restricted stock under an inducement grant. The shares subject to the stock option grant vest over a four-year period. The
restricted stock vests over a five-year period. New employee inducement grants represent incremental amounts available for grant and are not subject to
shareholder approval. These shares have been included in the stock option and restricted stock activity table presented below.




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


|                                                    |  |  |        | Options
      Outstanding |  | Restricted
      Stock
|--------------------------------------------------- |  |  | ------ | ------------------------- |  | ----------------------
|
|Balances
        at December 31, 2001               |  |  | 9,174  |                           |  |                       
|Additional
        authorization                    |  |  | 4,500  |                           |  |                       
|Assumption
        of
        SpeedFam-IPEC options |  |  | 530    |                           |  |                       
|Granted                                             |  |  | (6,292 | )                         |  |                       
|Exercised                                           |  |  |       |                           |  |                       
|Canceled                                            |  |  | 942    |                           |  |                       
|Vested
        restricted stock                     |  |  |       |                           |  |                       
|Balances
        at December 31, 2002               |  |  | 8,854  |                           |  |                       
|Granted                                             |  |  | (3,966 | )                         |  |                       
|Exercised                                           |  |  |       |                           |  |                       
|Canceled                                            |  |  | 1,148  |                           |  |                       
|Vested
        restricted stock                     |  |  |       |                           |  |                       
|Balances
        at December 31, 2003               |  |  | 6,036  |                           |  |                       
|New
        plan                                    |  |  | 300    |                           |  |                       
|Granted                                             |  |  | (5,850 | )                         |  |                       
|Exercised                                           |  |  |       |                           |  |                       
|Canceled                                            |  |  | 1,726  |                           |  |                       
|Vested
        restricted stock                     |  |  |       |                           |  |                       
|Balances
        at December 31, 2004               |  |  | 2,212  |                           |  |                       

67

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 16.    Employee Benefit Plans
(Continued)



There were approximately 976,000 shares, 440,000
shares and 529,000 shares cancelled due to employee terminations that were restricted from being returned to the plan for future issuance during the
years ended December 31, 2004, 2003 and 2002, respectively.




Stock options outstanding as of December 31, 2004
are summarized below (share data in thousands):


|Options
      Outstanding    |  | Options
      Exercisable
|---------------------------- |  | -------------------------
|
|$   5.89 to $   25.56        |  |                          
|$ 25.56
        to $   28.46 |  |                          
|$ 28.76
        to $   30.25 |  |                          
|$ 30.77
        to $   40.43 |  |                          
|$ 40.69
        to $ 253.71  |  |                          
|$   5.89 to $ 253.71         |  |                          



The range of option exercise prices for options
outstanding at December 31, 2004 is wide, primarily due to the impact of assumed options of acquired companies that had experienced significant price
fluctuations.




Restricted Stock and Deferred
Compensation




We award restricted stock to our employees from our
1992 Stock Option Plan and our 2001 Stock Incentive Plan, collectively referred to as the Plans. We awarded a total of approximately 511,000 shares of
common stock under the Plans during the year ended December 31, 2004. 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. Approximately 688,000 shares of restricted common stock remain subject to
vesting requirements as of December 31, 2004. 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. Approximately $3.9 million, $1.9 million, and $1.7 million was recorded as amortization
expense related to restricted stock issuances for the years ended December 31, 2004, 2003 and 2002, respectively.




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, 2004 and 2003, approximately $0.2 million and $1.4 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. Under the Purchase
Plans, qualified employees are entitled to purchase shares at 85% of the fair market value on specified dates. There were approximately 364,000,
557,000 and 366,000 shares issued under the Purchase Plans in 2004, 2003 and 2002, respectively. As of December 31, 2004, approximately 341,000 shares
were reserved for future issuance under the Purchase Plans.


68

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 16.    Employee Benefit Plans
(Continued)



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 100% of their eligible pre-tax compensation, limited by the maximum dollar
amount allowed by the Internal Revenue Code. We contribute a percentage of each participating employees salary deferral contributions up to a
maximum of $2,000, or 3% of an employees annual compensation, whichever is greater. Our matching contributions are invested in Novellus common
stock and become fully vested at the end of the employees third year of service. We recorded $4.0 million, $3.5 million and $3.6 million of
expense in connection with matching contributions under the 401(k) plan for the years ended December 31, 2004, 2003 and 2002,
respectively.




Deferred Compensation
Plan




Under the Deferred Compensation Plan, certain
employees may elect to defer a portion of their earnings. Amounts payable under the Deferred Compensation Plan totaled $6.0 million and $4.7 million at
December 31, 2004 and 2003, respectively.




Profit Sharing




Profit sharing is awarded to employees based upon
the Companys performance against certain financial and operating goals. Distributions to employees are made annually based upon a percentage of
base salary, provided that a threshold level of financial and performance goals are met. Charges to expense under the profit sharing plans were $33.5
million, $1.9 million and $9.3 million for the years ended December 31, 2004, 2003 and 2002, respectively.




Defined Benefit Pension
Plan




In connection with our acquisition of Peter Wolters
AG on June 28, 2004, we assumed the obligation of its defined benefit pension plan covering substantially all eligible Peter Wolters employees.
Benefits under the plan are based on years of service and compensation levels. The terms of the plan and local statutory requirements do not require
the plan to be funded. The projected benefit obligation at the acquisition date was $6.4 million. The accumulated benefit obligation is approximately
equal to the projected benefit obligation at December 31, 2004. We maintain a liability for the unfunded obligation under the pension plan. The changes
in the obligation consisted of interest cost, service cost, benefit payments and currency translation adjustments, which were not significant. At
December 31, 2004, the projected benefit obligation was $7.0 million. Our estimated benefit payments for each of the next ten fiscal years will be
approximately $0.5 million per year in 2005 through 2009, and an aggregate of $2.6 million for years 2010 through 2014.




At December 31, 2004, the weighted-average actuarial
assumptions used to determine the projected benefit obligation, the accumulated benefit obligation and net period benefit costs, as applicable, are as
follows:


|Discount
        rate        |  | 5.30%
|---------------------------- |  | -----
|Salary
        increase rate |  | 2.00%

|Note 17. |  | Operating Segments
|-------- |  | ------------------



We operate primarily in one segment, the
manufacturing, marketing and servicing of semiconductor equipment for thin film deposition, surface preparation and chemical mechanical planarization.
This operating segment is referred to as the Semiconductor Group. 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. All semiconductor-related operating
units qualify for aggregation under SFAS No. 131, due to their customer base and similarities in economic characteristics, nature of products and
services, and process for procurement, manufacturing and distribution processes. In the third quarter of 2004, we acquired Peter Wolters AG. Due to the
diversity of Peter Wolters existing product lines and customer base from the Semiconductor Group, we have determined that the qualitative
thresholds required for aggregation under SFAS No. 131 have not been


69

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 17.    Operating Segments
(Continued)



met. As a result, we have included a new segment
in our disclosures for the year ended December 31, 2004. This segment is referred to as the Industrial Applications Group. This segment had no
reportable activity prior to the acquisition of Peter Wolters. Since we primarily operated in one segment, with one group of similar products and
services prior to 2004, all financial segment and product line information required by SFAS No. 131 prior to 2004 can be found in the Consolidated
Financial Statements.




Our Semiconductor Group develops, manufactures,
sells and supports equipment used in the fabrication of integrated circuits, commonly called microchips, or chips. Our Industrial Applications Group is
a supplier of lapping, grinding, polishing and deburring products for fine-surface optimization.


|                                                    |  | Semiconductor
      Group |           | Industrial
      Applications
      Group |   | Consolidated
|--------------------------------------------------- |  | ------------------------- | --------- | ----------------------------------------- | - | ------------
|2004                                                |  |                           |           |                                           |   |             
|Sales
        to unaffiliated customers             |  | $                         | 1,299,918 |                                           | $ | 57,370      
|Sales
        between reportable operating segments |  |                           |          |                                           |   |            
|Total
        net sales                             |  | $                         | 1,299,918 |                                           | $ | 57,370      
|Operating
        income                            |  | $                         | 204,569   |                                           | $ | 818         
|Long-lived
        assets                           |  | $                         | 456,023   |                                           | $ | 20,469      
|All
        other identifiable assets               |  |                           | 1,721,646 |                                           |   | 203,694     
|Total
        assets                                |  | $                         | 2,177,669 |                                           | $ | 224,163     



For the year ended December 31, 2004, three
customers each accounted for 10% of our net sales. For the year ended December 31, 2003, two customers accounted for 27% and 12% of our system sales,
respectively. For the year ended December 31, 2002, four customers accounted for 17%, 11%, 11% and 10% of our system sales, respectively. All such
customer concentration is contained exclusively within the Semiconductor Group.




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
|---------------------------------------------- |  | ------------------- | --------- | ------ | - | ------- |  | ----------- | ------- | ------------
|2004                                           |  |                     |           |        |   |         |  |             |         |             
|Sales
        to unaffiliated customers        |  | $                   | 1,051,553 |        | $ | 47,661  |  | $           | 258,074 |             
|Transfers
        between geographic locations |  |                     | 134,013   |        |   | 24,369  |  |             | 36,966  |             
|Total
        net sales                        |  | $                   | 1,185,566 |        | $ | 72,030  |  | $           | 295,040 |             
|Operating
        income                       |  | $                   | 164,106   |        | $ | 4,060   |  | $           | 37,221  |             
|Long-lived
        assets                      |  | $                   | 455,218   |        | $ | 18,794  |  | $           | 2,480   |             
|All
        other identifiable assets          |  |                     | 1,561,672 |        |   | 195,957 |  |             | 167,711 |             
|Total
        assets                           |  | $                   | 2,016,890 |        | $ | 214,751 |  | $           | 170,191 |             

70

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 17.    Operating Segments
(Continued)

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

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



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 18. |  | Bad Debt 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 19. |  | 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 $0.9 million, $0.8 million and $0.2 million for the years ended December 31, 2004, 2003 and 2002,
respectively.




Mr. Hill is a member of the Board of Directors of
the University of Illinois Foundation. Novellus regularly provides research funding to certain groups, including the University of Illinois. Novellus
provided research grants to the University of Illinois and certain of its professors in the amount of $0.1 million in each of the years ended December
31, 2004, 2003 and 2002. Mr. Hill is also a member of the Board of Directors of LTX Corporation. We recorded sublease income from LTX Corporation of
approximately $1.4 million, $1.4 million and $1.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.




D. James Guzy, a member of our Board of Directors
until April 16, 2004, was also a member of the Board of Directors of Intel Corporation, which is one of our significant customers. Intel Corporation
represented approximately 10%, 12% and 11% of net sales for the years ended December 31, 2004, 2003 and 2002, respectively. Intel Corporation also
accounted for 8% and 6% of our accounts receivable as of December 31, 2004 and 2003, respectively.


71

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 19.    Related Party Transactions
(Continued)



During each of the years ended December 31, 2004,
2003 and 2002, Novellus employed, in non-executive positions, three immediate family members of our executive officers. The aggregate compensation
amounts recognized for these immediate family members during the years ended December 31, 2004, 2003 and 2002 were $0.5 million, $0.5 million and $0.4
million, respectively.




From time to time we have made secured and unsecured
relocation loans to our executive officers, vice presidents and other key personnel. As of December 31, 2004, 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 other key personnel. As of December 31, 2004 and 2003, the total outstanding balance of loans to non-executive vice
presidents and other key personnel was approximately $5.0 million and $5.7 million, respectively. Of the amount outstanding at December 31, 2004, $3.8
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.


|Note 20. |  | Quarterly Financial Data (Unaudited)
|-------- |  | ------------------------------------

|                                                      |  | Quarter
      Ended
|----------------------------------------------------- |  | -------------------
|
|
|Net
        sales                                     |  | $                  
|Gross
        profit                                  |  | $                  
|Net
        income                                    |  | $                  
|Basic
        and diluted net income per share        |  | $                  
|Shares
        used in basic per share calculations   |  |                    
|Shares
        used in diluted per share calculations |  |                    

|                                                                                                                           |  | Quarter
      Ended
|-------------------------------------------------------------------------------------------------------------------------- |  | -------------------
|
|
|Net
        sales                                                                                                          |  | $                  
|Gross
        profit                                                                                                       |  | $                  
|Net
        income (loss) before cumulative effect of a change in accounting principle                                     |  | $                  
|Cumulative
        effect of change in accounting principle                                                                |  |                    
|Net
        income (loss)                                                                                                  |  | $                  
|Basic
        and diluted net income (loss) per share
        before cumulative effect of a change in accounting principle |  | $                  
|Cumulative
        effect of change in accounting principle                                                                |  |                    
|Basic
        and diluted net income (loss) per share                                                                      |  | $                  
|Shares
        used in basic per share calculations                                                                        |  |                    
|Shares
        used in diluted per share calculations                                                                      |  |                    






|(1) |  | The first quarter 2004 results include a charge of $2.5 million
related to the settlement of an overtime class action lawsuit by field service engineers and a pre-tax benefit to cost of sales of approximately $0.9
million for the sale of inventory previously reserved.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | The second quarter 2004 results include a charge totaling $6.1
million for acquired in-process research and development in connection with the acquisition of Angstron Systems, Inc. and a pre-tax benefit to cost of
sales of approximately $3.6 million for the sale of inventory previously reserved.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

72

---

NOVELLUS SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)

Note 20.    Quarterly Financial Data (Unaudited)
(Continued)

|(3) |  | The third quarter 2004 results included a cash receipt of $8.0
million, and the reversal of $8.1 million in previously accrued royalty payments, as a result of the settlement of litigation with Applied Materials,
Inc. The third quarter 2004 results also included a pre-tax charge of $2.9 million related to the settlement of litigation with Semitool, Inc., the
reversal of a previously recorded restructuring accrual of $0.9 million and a pre-tax benefit to cost of sales of approximately $2.8 million for the
sale of inventory previously reserved.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | The fourth quarter results include restructuring and other
charges of $2.4 million and the pre-tax benefit to cost of sales of approximately $1.7 million for the sale of inventory previously
reserved.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | 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.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

73

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON CONSOLIDATED FINANCIAL STATEMENTS



The Board of
Directors and Shareholders of Novellus
Systems, Inc.


We have audited the accompanying consolidated balance sheets of Novellus Systems,
Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders equity, and cash flows for each of the
three years in the period ended December 31, 2004. 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 the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit 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. at December 31, 2004 and 2003 and the consolidated results of its
operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting
principles. 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 12 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.

We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Novellus Systems, Inc.s internal control over financial reporting as of December
31, 2004, based on criteria established in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission and our report dated March 11, 2005 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

San Jose, California March 11, 2005

74

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Report of Independent Registered Public Accounting Firm on Internal Control over
Financial Reporting

The Board of Directors and Shareholders of Novellus Systems, Inc.



We have audited
managements assessment, included in the accompanying Management Report on Internal Control over Financial Reporting, that Novellus Systems, Inc.
(the Company) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The
Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion
on the effectiveness of the companys internal control over financial reporting based on our audit.


We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion.

A companys internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions
of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial
statements.

Because of its inherent limitations, internal control over financial reporting may
not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As indicated in the accompanying Management Report on Internal Control over
Financial Reporting, managements assessment of and conclusion on the effectiveness of internal control over financial reporting did not include
the internal controls of Peter Wolters AG, which is included in the 2004 consolidated financial statements of the Company and constituted 8.8% of total
assets as of December 31, 2004 and 3.0% of net sales for the year then ended. Our audit of internal control over financial reporting of the Company
also did not include an evaluation of the internal control over financial reporting of Peter Wolters AG.

In our opinion, managements assessment that Novellus Systems, Inc. maintained
effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria.
Also, in our opinion, Novellus Systems, Inc. maintained, in all material respects, effective internal control over financial reporting as of December
31, 2004, based on the COSO criteria.

We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of Novellus Systems, Inc. as of December 31, 2004 and 2003, and the related
consolidated statements of operations, shareholders equity, and cash flows for each of the three years in the period ended December 31, 2004 of
Novellus Systems, Inc. and our report dated March 11, 2005 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

San Jose, California March 11, 2005

75

---

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



Not applicable.


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



Attached as exhibits to this Annual Report on Form
10-K are certifications of our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), which are required pursuant to Rule 13a-14 of the
Securities Exchange Act of 1934, as amended (the Exchange Act). This Controls and Procedures section of this Annual Report on
Form 10-K includes information concerning the controls and controls evaluation referenced in the certifications. The report of Ernst & Young LLP,
our independent registered public accounting firm, is set forth at the end of Part II, Item 8 of this Annual Report on Form 10-K. This report addresses
Ernst & Young LLPs audit of our internal control over financial reporting and of managements assessment of internal control over
financial reporting set forth below. This section of the Annual Report on Form 10-K should be read in conjunction with the certifications and the
report of Ernst & Young LLP for a more complete understanding of the matters presented.


Evaluation of Disclosure Controls



We evaluated the effectiveness of the design and
operation of our disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. This controls evaluation
was performed under the supervision and with the participation of management, including our CEO and CFO. Disclosure controls are procedures that are
designed to ensure 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 by the Securities and Exchange
Commission, or the SEC. Disclosure controls are also designed to ensure that such information is accumulated and communicated to our management,
including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our quarterly evaluation of disclosure controls
includes an evaluation of some components of our internal control over financial reporting. We also perform a separate annual evaluation of internal
control over financial reporting for the purpose of providing the management report below.




The evaluation of our disclosure controls included a
review of their objectives and design, the Companys implementation of the controls 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 reviewed identified data errors or control problems and sought
to confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a
quarterly basis so that the conclusions of management, including the CEO and CFO, concerning the effectiveness of the disclosure controls can be
reported in our periodic reports on Form 10-Q and Form 10-K. Many of the components of our disclosure controls are also evaluated on an ongoing basis
by both our internal audit and finance organizations. The overall goals of these various evaluation activities are to monitor our disclosure controls
and to modify them as necessary. We intend to maintain the disclosure controls as dynamic systems that we adjust as circumstances
merit.




Based on the controls evaluation, our CEO and CFO
have concluded that, subject to the limitations noted in this Part II, Item 9A, as of the end of the period covered by this Form 10-K, our disclosure
controls were effective to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed,
summarized and reported within the time periods specified by the SEC, and that material information relating to the Company is made known to
management, including the CEO and the CFO, particularly during the time when our periodic reports are being prepared.


Management Report on Internal Control over Financial Reporting



Our management is responsible for establishing and
maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the
supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal
control over financial reporting as of December 31, 2004 based on the guidelines established in Internal Control  Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have excluded from our evaluation the internal control over
financial reporting of Peter


76

---

| |  | Wolters AG, which we acquired on June 28, 2004. As of and for
the year ended December 31, 2004, total assets and net sales of Peter Wolters AG represented 8.8% and 3.0% of consolidated net sales and total assets,
respectively. Based on the results of our evaluation, our management concluded that our internal control over financial reporting was effective as of
December 31, 2004 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for
external reporting purposes in accordance with generally accepted accounting principles.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Managements assessment of the effectiveness of
our internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public
accounting firm, as stated in their report which is included at the end of Part II, Item 8 of this Annual Report on Form 10-K.


Limitations on 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.


|Item 9B. |  | Other Information
|-------- |  | -----------------



On March 11, 2005, Novellus Systems, Inc. (the
Company) entered into an Amended and Restated Employment Agreement (the Agreement) with Richard S. Hill, who is currently
serving as the Companys Chairman and Chief Executive Officer. The Agreement amends and restates in its entirety Mr. Hills prior Employment
Agreement dated as of October 1, 1998, as amended December 17, 1999 and January 14, 2004.




The Agreement provides for an initial employment
term through December 31, 2006, with automatic renewals for successive two year periods if Mr. Hill continues to serve on the last day of each term.
The Agreement further provides that Mr. Hill will receive a base salary of $840,000 per annum and will be eligible to participate in the Companys
existing executive bonus plan. In addition, Mr. Hill is entitled to receive certain benefits and/or payments in connection with the termination of the
Agreement. These benefits and/or payments will vary depending upon whether termination of the Agreement occurs as a result of Mr. Hills death,
disability, resignation for Good Reason, or termination Not for Cause or the Companys termination Not for
Cause (all as defined in the Agreement). If the Company terminates the Agreement for Cause (as defined in the Agreement), Mr. Hill
will have no further rights to compensation or benefits.




The foregoing description does not purport to be
complete and is qualified by reference to the full text of the Agreement. A copy of the Agreement is included as Exhibit 10.30 to this Annual Report on
Form 10-K.


77

---

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, filed in connection with our 2005 Annual Meeting of Shareholders, and is incorporated
herein by reference.


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



The information required by this item is included
under Other Information  Executive Compensation in our Proxy Statement, filed in connection with our 2005 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, filed in
connection with our 2005 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, filed in connection with our 2005 Annual Meeting of
Shareholders, and is incorporated herein by reference.


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



The information required by this item is included
under Audit and Non-Audit Fees in our Proxy Statement, filed in connection with our 2005 Annual Meeting of Shareholders, and is
incorporated herein by reference.


78

---

PART IV

|Item 15. |  | Exhibits and Financial Statement
Schedules
|-------- |  | ------------------------------------------

|(a) |  | The following documents were filed as part of the
report on Form 10-K on March 15, 2005:
|--- |  | ----------------------------------------------------------------------------------------

|(1) |  | Financial Statements and Reports of Independent Registered
Public Accounting Firm
|--- |  | ---------------------------------------------------------------------------------



Consolidated Statements of Operations  Years
Ended December 31, 2004, 2003, and 2002. Consolidated Balance Sheets at December 31, 2004 and 2003. Consolidated Statements of Cash Flows  Years
Ended December 31, 2004, 2003, and 2002. Consolidated Statement of Shareholders Equity  Years Ended December 31, 2004, 2003 and 2002. Notes
to Consolidated Financial Statements. Reports of Independent Registered Public Accounting Firm.


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

The following financial statement schedule was filed as part of the Report on Form
10-K on March 15, 2005 and should be read in conjunction with the financial statements:



Schedule II  Valuation and Qualifying
Accounts.


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

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

Except as indicated, the following exhibits were filed as part of the Report on Form 10-K on March 15, 2005:

|3.1(1)     |  |  |  | Amended and Restated Articles of Incorporation of Novellus.                                                                                                                                                                                        
|---------- |  |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.2        |  |  |  | Amended and Restated Bylaws of Novellus.                                                                                                                                                                                                           
|10.1(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.
|10.2(3)    |  |  |  | Environmental Agreement by and between Varian Associates, Inc. and Novellus dated May 7, 1997.                                                                                                                                                     
|*10.3(4)   |  |  |  | Novellus 1992 Stock Option Plan, together with forms of agreements thereunder.                                                                                                                                                                    
|*10.4(5)   |  |  |  | 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.                                                                                 
|*10.5(6)   |  |  |  | Novellus 1992 Employee Stock Purchase Plan.                                                                                                                                                                                                       
|*10.6(7)   |  |  |  | Form
of Directors and Officers Indemnification Agreement.                                                                                                                                                                                          
|*10.7(8)   |  |  |  | GaSonics International Corporation Amended and Restated 1994 Stock Option/Stock Issuance Plan, together with forms of agreements thereunder,
as assumed by Novellus.                                                                               
|*10.8(9)   |  |  |  | Gamma Precision Technology, Inc. 1998 Stock Option Plan, together with forms of agreements thereunder, as assumed by
Novellus.                                                                                                                     
|*10.9(10)  |  |  |  | GaSonics International Corporation Supplemental Stock Option Plan, as assumed by Novellus.                                                                                                                                                         
|10.10(11)  |  |  |  | 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.                                                                    
|*10.11(12) |  |  |  | Novellus Systems, Inc. 2001 Stock Incentive Plan dated May 11, 2001, together with forms of agreement thereunder.                                                                                                                                  
|*10.12(13) |  |  |  | SpeedFam-IPEC, Inc. Amended and Restated 1995 Stock Plan, as assumed by Novellus.                                                                                                                                                                  

79

---

|*10.13(14) |  |  |  | SpeedFam-IPEC, Inc. 2001 Nonstatutory Stock Option Plan, together with forms of agreements thereunder, as assumed by
Novellus.                                                                                                                              
|---------- |  |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*10.14(15) |  |  |  | Integrated Process Equipment Corporation 1992 Stock Option Plan, as assumed by Novellus.                                                                                                                                                                    
|*10.15(16) |  |  |  | SpeedFam International, Inc. Amended and Restated 1991 Employee Incentive Stock Option Plan, as assumed by Novellus.                                                                                                                                        
|*10.16(17) |  |  |  | SpeedFam-IPEC, Inc. Stand-Alone Stock Option Agreement dated June 14, 2001 between SpeedFam-IPEC, Inc. and Peter Simone, as assumed by
Novellus.                                                                                                            
|10.17(18)  |  |  |  | Lease Agreement between Seldin Properties and Integrated Process Equipment Corp. dated December 26, 1996.                                                                                                                                                   
|10.18(19)  |  |  |  | Purchase and Sale Agreement between Glen Una Management Company, Inc. and SpeedFam-IPEC, Inc. dated May 31, 2002.                                                                                                                                           
|10.19(20)  |  |  |  | Lease Agreement between Phoenix Industrial Investment Partners, L.P. and SpeedFam-IPEC, Inc. dated June 21, 2002.                                                                                                                                           
|10.20(21)  |  |  |  | First Amendment to Lease Agreement between Phoenix Industrial Investment Partners, L.P. and SpeedFam-IPEC, Inc. dated January 21,
2003.                                                                                                                     
|10.21(22)  |  |  |  | Lease Guaranty between Novellus and Phoenix Industrial Investment Partners, L.P. dated January 21, 2002.                                                                                                                                                    
|*10.22(23) |  |  |  | Letter Agreement between Novellus and Sasson Somekh dated January 23, 2004.                                                                                                                                                                                 
|*10.23(24) |  |  |  | Letter Agreement between Novellus and Thomas St. Dennis dated June 27, 2003.                                                                                                                                                                                
|*10.24(25) |  |  |  | Restricted Stock Purchase Agreement between Novellus and Richard S. Hill dated December 13, 2002.                                                                                                                                                           
|*10.25(26) |  |  |  | Stand-Alone Stock Option Agreement dated January 23, 2004, between Novellus and Sasson Somekh.                                                                                                                                                              
|*10.26(27) |  |  |  | Stand-Alone Restricted Stock Award dated January 23, 2004, between Novellus and Sasson Somekh.                                                                                                                                                              
|10.27(28)  |  |  |  | Credit Agreement, dated June 25, 2004, between Johanna 34 Vermogensverwaltungs GmbH, Novellus Systems BV, Novellus Systems, Inc. and JPMorgan
Chase Bank, as Administrative Agent                                                                           
|10.28(29)  |  |  |  | Guarantee and Collateral Agreement, dated June 25, 2004, made by Novellus Systems, Inc. in favor of JPMorgan Chase Bank, as Administrative
Agent                                                                                                            
|10.29(30)  |  |  |  | Binding Memorandum of Understanding between Novellus Systems, Inc., and Applied Materials, Inc., effective as of September 3, 2004. Portions
of this exhibit have been omitted pursuant to a request for confidential treatment.                            
|*10.30     |  |  |  | Amended and Restated Employment Agreement effective as of March 11, 2005 between Novellus Systems, Inc. and Richard S. Hill.                                                                                                                                
|21.1       |  |  |  | Subsidiaries of Novellus.                                                                                                                                                                                                                                   
|23.1       |  |  |  | Consent of Independent Registered Public Accounting Firm.                                                                                                                                                                                                   
|24.1       |  |  |  | Power of Attorney (see page 83).                                                                                                                                                                                                                            
|31.1.1     |  |  |  | Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc. dated October 14,
2005 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
|31.2.1     |  |  |  | Certification of William H. Kurtz, Executive Vice President and Chief Financial Officer of Novellus Systems, Inc. dated October 14, 2005 in accordance with
18 U.S.C. 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**         

80

---

|32.1.1 |  |  |  | Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc. dated October 14,
2005 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
|------ |  |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|32.2.1 |  |  |  | Certification of William H. Kurtz, Executive Vice President and Chief Financial Officer of Novellus Systems, Inc. dated October 14, 2005 in accordance with
18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**         

*Compensatory plan

**Filed herewith






|(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 10.30 filed with
Novellus Report on Form 10-K filed with the Securities and Exchange Commission on February 26, 1993.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | 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.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | 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.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) |  | 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(9) |  | 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(10) |  | 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.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(11) |  | 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.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(12) |  | 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.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------

|(13) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(14) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(15) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(16) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(17) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(18) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(19) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(20) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(21) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

81

---

|(22) |  | 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.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|(23) |  | Incorporated by reference to Exhibit 10.39 to Novellus
Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(24) |  | Incorporated by reference to Exhibit 10.40 to Novellus
Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(25) |  | Incorporated by reference to Exhibit 10.41 to Novellus
Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(26) |  | Incorporated by reference to Exhibit 10.42 to Novellus
Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(27) |  | Incorporated by reference to Exhibit 10.43 to Novellus
Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(28) |  | Incorporated by reference to Exhibit 10.1 to Novellus
Report on Form 8-K filed with the Securities and Exchange Commission on July 12, 2004.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------

|(29) |  | Incorporated by reference to Exhibit 10.2 to Novellus
Report on Form 8-K filed with the Securities and Exchange Commission on July 12, 2004.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------

|(30) |  | Incorporated by reference to Exhibit 99.1 to Novellus
Report on Form 8-K filed with the Securities and Exchange Commission on September 24, 2004.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------






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

82

---

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 Form 10-K/A Amendment No. 2 to our Annual 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 14th day of October, 2005.


| | NOVELLUS
      SYSTEMS, INC.
| | ----------------------------
| |                             
| | By:                         



Pursuant to the requirements of the Securities
Exchange Act of 1934, this Form 10-K/A Amendment No. 2 to our 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. Hill       |  | Chairman of the Board of Directors and
        Chief Executive Officer
        (Principal Executive Officer)                        |  | October 14, 2005
|Richard S. Hill           |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|/s/ William H. Kurtz      |  | Executive Vice President and Chief Financial Officer
        (Principal Financial Officer and
        Principal Accounting Officer) |  | October 14, 2005
|William H. Kurtz          |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|Neil R. Bonke             |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|Youssef A. El-Mansy       |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|J. David Litster          |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|Yoshio
        Nishi      |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|Glen G. Possley           |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|Ann D. Rhoads             |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|William
        R. Spivey |  |                                                                                                                                    
|                          |  |                                                                                                                                     |  |                 
|*                         |  | Director                                                                                                                            |  | October 14, 2005
|Delbert Whitaker          |  |                                                                                                                                    

|     |                                        | 
|---- | -------------------------------------- | 
|*By: | /s/ Richard S. Hill                    | 
|     | Richard S. Hill
      Attorney-in-Fact | 

83

---

EXHIBIT INDEX

3.1(1)
    
    
    Amended and Restated Articles of Incorporation of Novellus.3.2
    
    
    Amended and Restated Bylaws of Novellus.10.1(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, 1997.10.2(3)
    
    
    Environmental Agreement by and between Varian Associates,    Inc. and Novellus dated May 7, 1997.*10.3(4)
    
    
    Novellus 1992 Stock Option Plan, together with forms of     agreements thereunder.*10.4(5)
    
    
    Form of Restated Stock Purchase Agreement between            Novellus and Jeff Benzing, Wilbert van den Hoek and          certain other employees dated December 16,1999.*10.5(6)
    
    
    Novellus 1992 Employee Stock Purchase Plan.*10.6(7)
    
    
    Form of Directors and Officers Indemnification Agreement.*10.7(8)
    
    
    GaSonics International Corporation Amended and Restated      1994 Stock Option/Stock Issuance Plan, together with         forms of agreements thereunder, as assumed by Novellus.*10.8(9)
    
    
    Gamma Precision Technology, Inc. 1998 Stock Option Plan,     together with forms of agreements thereunder, as assumed     by Novellus.*10.9(10)
    
    
    GaSonics International Corporation Supplemental Stock        Option Plan, as assumed by Novellus.10.10(11)
    
    
    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.*10.11(12)
    
    
    Novellus Systems, Inc. 2001 Stock Incentive Plan dated       May 11, 2001, together with forms of agreement thereunder.*10.12(13)
    
    
    SpeedFam-IPEC, Inc. Amended and Restated 1995 Stock Plan,    as assumed by Novellus.*10.13(14)
    
    
    SpeedFam-IPEC, Inc. 2001 Nonstatutory Stock Option Plan,     together with forms of agreements thereunder, as assumed     by Novellus.*10.14(15)
    
    
    Integrated Process Equipment Corporation 1992 Stock          Option Plan, as assumed by Novellus.*10.15(16)
    
    
    SpeedFam International, Inc. Amended and Restated 1991       Employee Incentive Stock Option Plan, as assumed by Novellus.*10.16(17)
    
    
    SpeedFam-IPEC, Inc. Stand-Alone Stock Option Agreement       dated June 14, 2001 between SpeedFam-IPEC, Inc. and Peter    Simone, as assumed by Novellus.10.17(18)
    
    
    Lease Agreement between Seldin Properties and Integrated     Process Equipment Corp. dated December 26, 1996.10.18(19)
    
    
    Purchase and Sale Agreement between Glen Una Management      Company, Inc. and SpeedFam-IPEC, Inc. dated May 31, 2002.10.19(20)
    
    
    Lease Agreement between Phoenix Industrial Investment        Partners, L.P. and SpeedFam-IPEC, Inc. dated June 21, 2002.10.20(21)
    
    
    First Amendment to Lease Agreement between Phoenix           Industrial Investment Partners, L.P. and SpeedFam-IPEC,      Inc. dated January 21, 2003.10.21(22)
    
    
    Lease Guaranty between Novellus and Phoenix Industrial       Investment Partners, L.P. dated January 21, 2002.*10.22(23)
    
    
    Letter Agreement between Novellus and Sasson Somekh dated    January 23, 2004.*10.23(24)
    
    
    Letter Agreement between Novellus and Thomas St. Dennis      dated June 27, 2003.




---

---

*10.24(25)
    
    
    Restricted Stock Purchase Agreement between Novellus and     Richard S. Hill dated December 13, 2002.*10.25(26)
    
    
    Stand-Alone Stock Option Agreement dated January 23,         2004, between Novellus and Sasson Somekh.*10.26(27)
    
    
    Stand-Alone Restricted Stock Award dated January 23,         2004, between Novellus and Sasson Somekh.10.27(28)
    
    
    Credit Agreement, dated June 25, 2004, between Johanna 34 Vermogensverwaltungs GmbH, Novellus Systems BV, Novellus Systems, Inc. and JPMorgan Chase Bank, as Administrative Agent10.28(29)
    
    
    Guarantee and Collateral Agreement, dated June 25, 2004, made by Novellus Systems, Inc. in favor of JPMorgan Chase Bank, as Administrative Agent10.29(30)
    
    
    Binding Memorandum of Understanding between Novellus Systems, Inc., and Applied Materials, Inc., effective as of September 3, 2004. Portions of this exhibit have been omitted pursuant to a request for confidential treatment.*10.30
    
    
    Amended and Restated Employment Agreement effective as of March 11, 2005 between Novellus Systems, Inc. and Richard S. Hill.21.1
    
    
    Subsidiaries of Novellus.23.1
    
    
    Consent of Independent Registered Public Accounting Firm.24.1
    
    
    Power of Attorney (see page 75).31.1.1
    
    
    Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc.
dated October 14, 2005 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2.1
    
    
    Certification of William H. Kurtz, Executive Vice President and Chief Financial Officer of Novellus Systems, Inc. dated
October 14, 2005 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1.1
    
    
    Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus
Systems, Inc. dated October 14, 2005 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2.1
    
    
    Certification of William H. Kurtz, Executive Vice President and Chief Financial Officer of Novellus Systems, Inc.
dated October 14, 2005 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 10.30 filed with Novellus Report on Form 10-K filed with the Securities and Exchange Commission on February 26, 1993.


(5)

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.




---

---

(6)

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.


(7)

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.


(8)

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.


(9)

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.


(10)

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.


(11)

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.


(12)

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.


(13)

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.


(14)

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.


(15)

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.


(16)

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.


(17)

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.


(18)

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.


(19)

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.


(20)

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.


(21)

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.


(22)

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.


(23)

Incorporated by reference to Exhibit 10.39 to Novellus Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.


(24)

Incorporated by reference to Exhibit 10.40 to Novellus Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.




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(25)

Incorporated by reference to Exhibit 10.41 to Novellus Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.


(26)

Incorporated by reference to Exhibit 10.42 to Novellus Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.


(27)

Incorporated by reference to Exhibit 10.43 to Novellus Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004.


(28)

Incorporated by reference to Exhibit 10.1 to Novellus Report on Form 8-K filed with the Securities and Exchange  Commission on July 12, 2004.


(29)

Incorporated by reference to Exhibit 10.2 to Novellus Report on Form 8-K filed with the Securities and Exchange  Commission on July 12, 2004.


(30)

Incorporated by reference to Exhibit 99.1 to Novellus Report on Form 8-K filed with the Securities and Exchange  Commission on September 24, 2004.




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*     Management contracts or compensatory plans or arrangements.



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