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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended April 2, 2005 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from                               to Commission File Number 000-17157 NOVELLUS SYSTEMS, INC. (Exact name of Registrant as specified in its charter)
 California
    
    77-0024666(State or other jurisdiction of
    
    (I.R.S. Employer Identificationincorporation of organization)
    
    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) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES þ NO o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). YES þ NO o As of April 29, 2005, 138,109,942 shares of the Registrants common stock, no par value, were
issued and outstanding.




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NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED APRIL 2, 2005 TABLE OF CONTENTS PagePart I: Financial Information
    
    3Item 1: Condensed Consolidated Financial Statements
    
    3Condensed Consolidated Statements of Operations for the quarters ended April 2, 2005 and March 27, 2004
    
    3Condensed Consolidated Balance Sheets as of April 2, 2005 and December 31, 2004
    
    4Condensed Consolidated Statements of Cash Flows for the quarters ended April 2, 2005 and March 27, 2004
    
    5Notes to Condensed Consolidated Financial Statements
    
    6Item 2: Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    13Item 3: Quantitative and Qualitative Disclosures About Market Risk
    
    26Item 4: Controls and Procedures
    
    26Part II: Other Information
    
    27Item 1: Legal Proceedings
    
    27Item 5: Other Information
    
    28Item 6: Exhibits
    
    28Signatures
    
    29EXHIBIT 10.31EXHIBIT 10.32EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I: FINANCIAL INFORMATION 
 ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited) Quarters EndedApril 2, 2005
    
    
    March 27, 2004Net sales
    
    $
    339,740
    
    
    $
    262,862Cost of sales
    
    
    185,871
    
    
    
    138,257Gross profit
    
    
    153,869
    
    
    
    124,605Operating expenses:Selling, general and administrative
    
    
    51,760
    
    
    
    42,403Research and development
    
    
    62,048
    
    
    
    58,957Legal settlement
    
    
    
    
    
    
    2,500Total operating expenses
    
    
    113,808
    
    
    
    103,860Operating income
    
    
    40,061
    
    
    
    20,745Interest income, net
    
    
    3,060
    
    
    
    2,455Other income, net
    
    
    409
    
    
    
    294Interest and other, net
    
    
    3,469
    
    
    
    2,749Income before income taxes
    
    
    43,530
    
    
    
    23,494Provision for income taxes
    
    
    13,059
    
    
    
    6,813Net income
    
    $
    30,471
    
    
    $
    16,681Net income per share:Basic net income per share
    
    $
    0.22
    
    
    $
    0.11Diluted net income per share
    
    $
    0.22
    
    
    $
    0.11Shares used in basic per share calculation
    
    
    139,890
    
    
    
    152,911Shares used in diluted per share calculation
    
    
    141,099
    
    
    
    156,100
 See accompanying notes to condensed consolidated financial statements. 3




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CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands) April 2,
    
    
    December 31,2005
    
    
    2004 *(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    124,363
    
    
    $
    106,117Short-term investments
    
    
    548,150
    
    
    
    481,645Accounts receivable, net
    
    
    347,295
    
    
    
    395,522Inventories
    
    
    246,856
    
    
    
    261,046Deferred tax assets, net
    
    
    113,422
    
    
    
    110,644Prepaid and other current assets
    
    
    21,132
    
    
    
    14,350Total current assets
    
    
    1,401,218
    
    
    
    1,369,324Property and equipment, net
    
    
    467,391
    
    
    
    476,492Restricted cash and cash equivalents
    
    
    171,406
    
    
    
    176,708Goodwill
    
    
    273,709
    
    
    
    278,972Intangible and other assets
    
    
    98,548
    
    
    
    100,336Total assets
    
    $
    2,412,272
    
    
    $
    2,401,832LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    66,709
    
    
    $
    70,446Accrued payroll and related expenses
    
    
    42,421
    
    
    
    64,531Accrued warranty
    
    
    47,979
    
    
    
    45,526Other accrued liabilities
    
    
    55,595
    
    
    
    54,517Income taxes payable
    
    
    25,646
    
    
    
    14,691Deferred profit
    
    
    72,148
    
    
    
    71,216Current obligations under lines of credit
    
    
    1,574
    
    
    
    3,103Total current liabilities
    
    
    312,072
    
    
    
    324,030Long term debt
    
    
    150,280
    
    
    
    161,103Other liabilities
    
    
    52,124
    
    
    
    54,865Total liabilities
    
    
    514,476
    
    
    
    539,998Shareholders equity:Common stock
    
    
    1,481,951
    
    
    
    1,473,829Deferred stock compensation
    
    
    (15,591
    )
    
    
    (17,159
    )Retained earnings
    
    
    430,223
    
    
    
    399,919Accumulated other comprehensive income
    
    
    1,213
    
    
    
    5,245Total shareholders equity
    
    
    1,897,796
    
    
    
    1,861,834Total liabilities and shareholders equity
    
    $
    2,412,272
    
    
    $
    2,401,832
   *
    
    Amounts as of December 31, 2004 are derived from the December 31, 2004 audited financial
statements. See accompanying notes to condensed consolidated financial statements. 4




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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Quarters EndedApril 2,
    
    
    March 27,2005
    
    
    2004Cash flows from operating activities:Net income
    
    $
    30,471
    
    
    $
    16,681Adjustments to reconcile net income to net cash provided by operating activities:Gain on sale of an investment
    
    
    
    
    
    
    (348
    )Loss on sale of fixed assets
    
    
    287
    
    
    
    Depreciation and amortization
    
    
    21,275
    
    
    
    20,547Deferred income taxes
    
    
    (1,158
    )
    
    
    (10,081
    )Stock-based compensation
    
    
    1,213
    
    
    
    979Changes in operating assets and liabilities:Accounts receivable
    
    
    43,526
    
    
    
    (53,338
    )Inventories
    
    
    9,300
    
    
    
    (18,909
    )Prepaid and other current assets
    
    
    (5,618
    )
    
    
    168Accounts payable
    
    
    (3,193
    )
    
    
    32,098Accrued payroll and related expenses
    
    
    (21,889
    )
    
    
    12,253Accrued warranty
    
    
    2,554
    
    
    
    5,245Other accrued liabilities
    
    
    (825
    )
    
    
    (1,954
    )Income taxes payable
    
    
    12,412
    
    
    
    9,630Deferred profit
    
    
    1,095
    
    
    
    17,153Net cash provided by operating activities
    
    
    89,450
    
    
    
    30,124Cash flows from investing activities:Proceeds from sales of short-term investments
    
    
    43,750
    
    
    
    74,721Proceeds from maturities of short-term investments
    
    
    49,813
    
    
    
    132,799Purchases of short-term investments
    
    
    (161,356
    )
    
    
    (241,256
    )Capital expenditures
    
    
    (15,396
    )
    
    
    (5,306
    )Proceeds from sale of fixed assets
    
    
    2,591
    
    
    
    Decrease in other assets
    
    
    1,600
    
    
    
    2,261Decrease (increase) in restricted cash and cash equivalents
    
    
    5,302
    
    
    
    (204
    )Net cash used in investing activities
    
    
    (73,696
    )
    
    
    (36,985
    )Cash flows from financing activities:Proceeds from employee stock compensation plans
    
    
    8,310
    
    
    
    10,137(Payments on) proceeds from lines of credit, net
    
    
    (1,494
    )
    
    
    8,646Payments on long-term debt
    
    
    (5,288
    )

    
    
    Repurchase of common stock
    
    
    
    
    
    
    (15,265
    )Net cash provided by financing activities
    
    
    1,528
    
    
    
    3,518Effects of exchange rate changes on cash and cash equivalents
    
    
    964
    
    
    
    171Net increase (decrease) in cash and cash equivalents
    
    
    18,246
    
    
    
    (3,172
    )Cash and cash equivalents at the beginning of the period
    
    
    106,117
    
    
    
    497,178Cash and cash equivalents at the end of the period
    
    $
    124,363
    
    
    $
    494,006
 See accompanying notes to condensed consolidated financial statements. 5




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION AND STOCK-BASED COMPENSATION Basis of Presentation The accompanying condensed consolidated financial statements have been prepared in accordance with
U.S. generally accepted accounting principles for interim financial information and with the
instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. The interim
financial information is unaudited and does not include all of the information and footnotes
required by U.S. generally accepted accounting principles for complete financial statements. In the
opinion of management, all adjustments (consisting only of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for the quarter ended April
2, 2005 are not necessarily indicative of the results that may be expected for the year ending
December 31, 2005. For further information, please refer to the consolidated financial statements
and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31,
2004. The preparation of financial statements in conformity with U.S. generally accepted accounting
principles requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and the related disclosures of contingent assets and
liabilities. We evaluate our estimates on an ongoing basis, including those related to revenue
recognition, 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 other assumptions that are believed to be reasonable
under the current circumstances, the results of which form the basis for making judgments about the
carrying values of assets and liabilities that are not readily apparent from other sources. Our
intent is to accurately state our assets given facts known at the time of valuation. Our
assumptions may prove incorrect as facts change in the future. Actual results may differ from these
estimates under different assumptions or conditions. The accompanying condensed consolidated financial statements include our accounts and the accounts
of our wholly-owned subsidiaries after the elimination of all significant intercompany account
balances and transactions. Certain prior period balances have been reclassified to conform to the
current period presentation. 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 in
accordance with SFAS No. 141. Our consolidated financial statements for the period ended April 2,
2005 include the financial position, results of operations and cash flows of Peter Wolters.
Due to the divergence of Peter Wolters existing product lines and customer base from the
operating segment in which we primarily operate, we have included a new segment in our disclosures.
We refer to this segment as our Industrial Applications Group. 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. 6




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SFAS No. 123 requires the use of option pricing models, most of which 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 freely 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 since changes in the subjective input assumptions can materially
affect the fair value estimate, in our opinion, the existing models may not necessarily provide a
reliable single measure of the fair value of employee stock options. Had compensation expense been determined based on the fair value as determined by the Black-Scholes
model at the grant date for awards, consistent with the provisions of SFAS No. 123, we would have
reported pro forma net income and net income per share as follows (in thousands,
except per share data): Quarters EndedApril 2,
    
    
    March 27,2005
    
    
    2004Net income as reported
    
    $
    30,471
    
    
    $
    16,681Add:Intrinsic value method expense
included in reported net
income, net of related tax effects
    
    
    849
    
    
    
    978Less:Fair value method expense, net of
related tax effects
    
    
    (10,573
    )
    
    
    (13,803
    )Pro-forma net income
    
    $
    20,747
    
    
    $
    3,856Pro-forma basic and diluted net income
per share
    
    $
    0.15
    
    
    $
    0.03Basic net income per share
as reported
    
    $
    0.22
    
    
    $
    0.11Diluted net income per share
as reported
    
    $
    0.22
    
    
    $
    0.11
 The fair value of each stock option is estimated on the date of grant using the Black-Scholes
option-pricing model, with the following weighted-average assumptions for grants made in the
quarters ended April 2, 2005 and March 27, 2004, respectively: Quarters EndedApril 2,
    
    March 27,2005
    
    2004Dividend yield
    
    None
    
    NoneExpected volatility
    
    70%
    
    77%Risk free interest rate
    
    3.3%
    
    2.3%Expected lives
    
    3.7 years
    
    3.7 years
 The weighted-average fair value of stock options granted during the period was $14.46 and $17.89
for the quarters ended April 2, 2005 and March 27, 2004, respectively. The pro forma net income and net income per share data listed above include expense related to the
Employee Stock Purchase Plan, referred to herein as the Purchase Plan. The fair value of issuances
under the Purchase Plan is estimated using the Black-Scholes option-pricing model, with the
following weighted-average assumptions: Quarters EndedApril 2,
    
    March 27,2005
    
    2004Dividend yield
    
    None
    
    NoneExpected volatility
    
    40%
    
    45%Risk free interest rate
    
    2.1%
    
    1.3%Expected lives
    
    0.5 year
    
    0.5 year
 The weighted-average fair value of purchase rights was $6.96 and $10.59 for the quarters ended
April 2, 2005 and March 27, 2004, respectively. 7




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Recent Accounting Pronouncements On December 16, 2004, the Financial Accounting Standards Board (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. In April
2005, the Securities and Exchange Commission (SEC) deferred the effective date of Statement 123(R)
until the first fiscal year beginning after June 15, 2005, with early adoption permitted. We expect
to adopt Statement 123(R) on January 1, 2006. 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 precise 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 1 to our Condensed 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 years for such excess tax
deductions were zero in 2004 and 2003, and $19.4 million in 2002. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107. SAB 107 provides guidance
related to share-based payment transactions with non-employees, the transition from nonpublic to
public entity status, valuation methods (including assumptions such as expected volatility and
expected term), the accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation expense, non-GAAP financial
measures, first-time adoption of Statement 123R in an interim period, capitalization of
compensation cost related to share-based payment arrangements, the accounting for income tax
effects of share-based payment arrangements upon adoption of Statement 123R, the modification of
employee share options prior to adoption of Statement 123R and disclosures in Managements
Discussion and Analysis (MD&A) subsequent to adoption of Statement 123R. We are currently in the
process of assessing the impact of this guidance. 2. NET INCOME PER SHARE Basic net income per share is computed by dividing net income by the weighted-average number of
common shares outstanding during the period. For purposes of computing basic net income per share,
the weighted-average number of outstanding shares of common stock excludes shares of restricted
stock subject to repurchase. Diluted net income per share is computed using the weighted-average number of shares of common
stock outstanding, including shares of restricted common stock subject to repurchase and, when
dilutive, potential shares from stock options to purchase common stock using the treasury stock
method. The following table provides a reconciliation of the numerators and denominators of the basic and
diluted per share computations (in thousands, except for per share amounts): Quarters EndedApril 2,
    
    
    March 27,2005
    
    
    2004Numerator:Net income
    
    $
    30,471
    
    
    $
    16,681Denominator:Basic weighted-average shares outstanding
    
    
    139,890
    
    
    
    152,911Employee stock options and restricted stock
    
    
    1,209
    
    
    
    3,189Diluted weighted-average shares outstanding
    
    
    141,099
    
    
    
    156,100Basic net income per share
    
    $
    0.22
    
    
    $
    0.11Diluted net income per share
    
    $
    0.22
    
    
    $
    0.11
 8




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Options to purchase approximately 21.0 million and 11.3 million shares of common stock at a
weighted average exercise price of $35.31 and $42.09 per share were outstanding for the quarters
ended April 2, 2005 and March 27, 2004, respectively, but were not included in the computation of
diluted net income per common share because the respective exercise prices of these options were
greater than the average respective market prices of the common shares and, therefore, the effect
would be anti-dilutive. 3. OTHER INCOME, NET The components of other income, net within the consolidated statements of operations are as follows
(in thousands): Quarters EndedApril 2,
    
    
    March 27,2005
    
    
    2004Other income
    
    $
    118
    
    
    $
    843Other expense
    
    
    (125
    )
    
    
    (233
    )Foreign currency gain (loss), net
    
    
    416
    
    
    
    (316
    )Total other income, net
    
    $
    409
    
    
    $
    294
 4. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out) or market. As of the balance
sheet date, inventories consisted of the following (in thousands): April 2,
    
    
    December 31,2005
    
    
    2004Purchased and spare parts
    
    $
    187,141
    
    
    $
    192,935Work-in-process
    
    
    46,890
    
    
    
    54,586Finished goods
    
    
    12,825
    
    
    
    13,525Total inventories
    
    $
    246,856
    
    
    $
    261,046
 5. GOODWILL AND INTANGIBLE ASSETS Goodwill A summary of changes in goodwill during the quarters ended April 2, 2005 and March 27, 2004 is as
follows (in thousands): Quarters EndedApril 2, 2005
    
    
    March 27, 2004Industrial
    
    
    
    
    
    
    
    
    
    
    IndustrialSemiconductor
    
    
    Applications
    
    
    
    
    
    
    Semiconductor
    
    
    ApplicationsGroup
    
    
    Group
    
    
    Total
    
    
    Group
    
    
    Group
    
    
    TotalBalance, beginning of period
    
    $
    162,230
    
    
    $
    116,742
    
    
    $
    278,972
    
    
    $
    173,267
    
    
    $
    
    
    
    $
    173,267SpeedFam-IPEC adjustment
    
    
    (1,170
    )
    
    
    
    
    
    
    (1,170
    )
    
    
    
    
    
    
    
    
    
    
    Foreign currency translation
    
    
    
    
    
    
    (4,093
    )
    
    
    (4,093
    )
    
    
    
    
    
    
    
    
    
    
    Balance, end of period
    
    $
    161,060
    
    
    $
    112,649
    
    
    $
    273,709
    
    
    $
    173,267
    
    
    $
    
    
    
    $
    173,267
 During the quarter ended April 2, 2005, we reduced valuation allowances against certain net
operating loss carryforwards recorded during the acquisition of SpeedFam-IPEC in 2002. We
accordingly reversed $1.2 million against goodwill. The foreign currency translation effects for
the quarter ended April 2, 2005 resulted in a decrease to goodwill of $4.1 million. In connection to our purchase of Peter Wolters in June 2004, 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. Any escrow claims would impact the recorded goodwill amount. No
claims were made during the quarter ended April 2, 2005. We completed the annual goodwill impairment test in the fourth quarter of 2004 in accordance with
our policy. The first step of the test identifies when impairment may have occurred, while the
second step of the test measures the amount of the impairment, if any. 9




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The results of our impairment tests did not indicate impairment. There have been no significant
events or circumstances affecting the valuation of goodwill subsequent to our impairment test
performed in the fourth quarter of 2004. Intangible Assets The following tables provide details of our acquired intangible assets (in thousands): AccumulatedApril 2, 2005
    
    Gross
    
    
    Amortization
    
    
    NetPatents
    
    $
    4,197
    
    
    $
    (699
    )
    
    $
    3,498Developed technology
    
    
    27,719
    
    
    
    (8,051
    )
    
    
    19,668Trademark
    
    
    6,570
    
    
    
    (493
    )
    
    
    6,077Other intangible assets
    
    
    138
    
    
    
    (83
    )
    
    
    55Total
    
    $
    38,624
    
    
    $
    (9,326
    )
    
    $
    29,298
 AccumulatedDecember 31, 2004
    
    Gross
    
    
    Amortization
    
    
    NetPatents
    
    $
    4,197
    
    
    $
    (525
    )
    
    $
    3,672Developed technology
    
    
    28,095
    
    
    
    (6,928
    )
    
    
    21,167Trademark
    
    
    6,809
    
    
    
    (340
    )
    
    
    6,469Other intangible assets
    
    
    138
    
    
    
    (81
    )
    
    
    67Total
    
    $
    39,239
    
    
    $
    (7,874
    )
    
    $
    31,365
 Our estimated amortization expense for the identifiable intangible assets for each of the next five
fiscal years will be approximately $6.0 million for each of 2006 and 2007, $5.7 million for 2008,
$3.1 million for 2009 and $1.7 million for 2010. As of April 2, 2005, we have no identifiable
intangible assets with indefinite lives. 6. PRODUCT WARRANTY We record the estimated cost of warranty as a component of cost of sales upon system shipment. The
estimated cost 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 estimate, revisions to the estimated warranty liability may be required. We review the
actual product failure rates and material usage on a quarterly basis and adjust our warranty
liability as necessary. Changes in our accrued warranty liability were as follows (in thousands): Quarters EndedApril 2,
    
    
    March 27,2005
    
    
    2004Balance, beginning of period
    
    $
    45,526
    
    
    $
    28,805Warranties issued
    
    
    21,630
    
    
    
    16,634Settlements
    
    
    (20,304
    )
    
    
    (12,585
    )Changes in liability for
pre-existing warranties,
including expirations
    
    
    1,127
    
    
    
    1,196Balance, end of period
    
    $
    47,979
    
    
    $
    34,050
 7. RESTRUCTURING AND OTHER CHARGES As of April 2, 2005, substantially all actions under our 2004, 2003, 2002 and 2001 restructuring
plans had been completed, except for payments of future rent obligations of $39.5 million, which
are to be paid in cash through 2017. There were no significant changes in estimates on sublease
income related to these facilities during the quarter ended April 2, 2005. All restructuring and
other charges are related to the semiconductor segment. In 2004, we incurred a restructuring charge to align our research and development and manufacturing
operations with current business conditions. In the third quarter of 2003, we implemented a
restructuring plan to align our cost structure with business conditions. Additional restructuring
reserves recorded in 2002 were primarily related to exiting business activities of SpeedFam-IPEC
that were recognized by us as liabilities assumed in the purchase business combination. In 2001, we
implemented a restructuring plan that was 10




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driven by the decline in sales orders due to the contraction of the semiconductor capital equipment
market. The following table summarizes restructuring activity for the quarter ended April 2, 2005 (in
thousands): Asset
    
    
    
    
    
    
    AcquisitionFacilities
    
    
    Charges
    
    
    Severance
    
    
    Expense
    
    
    TotalBalance at December 31, 2004
    
    $
    41,681
    
    
    $
    163
    
    
    $
    160
    
    
    $
    198
    
    
    $
    42,202Cash payments
    
    
    (2,209
    )
    
    
    (52
    )
    
    
    (62
    )
    
    
    
    
    
    
    (2,323
    )Balance at April 2, 2005
    
    $
    39,472
    
    
    $
    111
    
    
    $
    98
    
    
    $
    198
    
    
    $
    39,879
 8. LONG-TERM OBLIGATIONS At April 2, 2005, we had borrowings of $150.3 million, denominated in Euros. These borrowings
consisted of $149.4 million and $0.9 million, with interest rates of 2.3% and 4.8%, respectively.
Certain borrowings are required to be secured by cash or marketable securities on deposit. Our
borrowings are due and payable on or before June 25, 2009. Amounts to secure these borrowings are
included within restricted cash on the consolidated balance sheets. 9. COMPREHENSIVE INCOME The following are the components of comprehensive income (in thousands): Quarters EndedApril 2,
    
    
    March 27,2005
    
    
    2004Net income
    
    $
    30,471
    
    
    $
    16,681Other comprehensive income:Foreign currency translation adjustments
    
    
    (2,744
    )
    
    
    925Realized gain on available-for-sale securities, net of tax
    
    
    
    
    
    
    (348
    )Unrealized (loss) gain on available-for-sale securities,
net of tax
    
    
    (1,288
    )
    
    
    649Comprehensive income
    
    $
    26,439
    
    
    $
    17,907
 The components of accumulated other comprehensive income, net of related tax, are as follows (in
thousands): April 2,
    
    
    December 31,2005
    
    
    2004Foreign currency translation adjustments
    
    $
    3,488
    
    
    $
    6,232Unrealized loss on available-for-sale securities
    
    
    (2,275
    )
    
    
    (987
    )Accumulated other comprehensive income
    
    $
    1,213
    
    
    $
    5,245
 10. PENSION PLAN On June 28, 2004, we acquired Peter Wolters AG, including its existing pension plan. The pension
balance at April 2, 2005 and December 31, 2004 were $6.8 million and $7.0 million, respectively.
The changes in the obligation consisted of interest cost, service cost, benefit payments and
currency translation adjustments, which were not significant. 11. RELATED PARTY TRANSACTIONS We lease an aircraft from NVLS I, LLC, a third-party entity wholly owned by Richard S. Hill, our
Chairman and Chief Executive Officer. Under the leasing agreement, we incurred rental expense of
approximately $0.1 million and $0.2 million for the quarters ended April 2, 2005 and March 27,
2004, 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 quarters ended April 2, 2005 and March 27, 2004. Mr.
Hill is also a member of the Board of Directors of LTX Corporation. We recorded sublease income
from LTX Corporation of approximately $0.4 million for each of the quarters ended April 2, 2005 and
March 27, 2004. 11




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On April 16, 2004, D. James Guzy retired from the Board of Directors and was named Director
Emeritus. Mr. Guzy is also a member of the Board of Directors of Intel Corporation, one of our
significant customers. During the quarters ended April 2, 2005 and March 27, 2004 sales to Intel
represented approximately 21% and 8% of our net sales, respectively. Intel also accounted for 12%
and 8% of our accounts receivable as of April 2, 2005 and December 31, 2004, respectively. During each of the quarters ended April 2, 2005 and March 27, 2004, Novellus employed, in
non-executive positions, three immediate family members of our executive officers. The aggregate
compensation amounts recognized for these immediate family members for each of the quarters ended
April 2, 2005 and March 27, 2004 was $0.1 million. From time to time, we have made secured and unsecured loans to our executive officers, vice
presidents and other key personnel. As of April 2, 2005, 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 non-executive vice presidents and other key personnel. As of April 2, 2005 and
December 31, 2004, the total outstanding balances of loans to non-executive vice presidents and
other key personnel was approximately $4.1 million and $5.0 million, respectively. Of the total
amount outstanding at April 2, 2005, $3.3 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. 12. LITIGATION 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 appeals process. 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. 13. 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 12




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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 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 the third quarter of 2004, all financial segment and product line information
required by SFAS No. 131 prior to the third quarter of 2004 can be found in the Condensed
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. Quarter Ended April 2, 2005(in thousands)IndustrialSemiconductor
    
    
    ApplicationsGroup
    
    
    Group
    
    
    ConsolidatedSales to unaffiliated customers
    
    $
    303,178
    
    
    $
    36,562
    
    
    $
    339,740Sales between reportable operating segments
    
    
    
    
    
    
    
    
    
    
    Total net sales
    
    $
    303,178
    
    
    $
    36,562
    
    
    $
    339,740Operating income
    
    $
    33,898
    
    
    $
    6,163
    
    
    $
    40,061Long-lived assets
    
    $
    450,964
    
    
    $
    16,427
    
    
    $
    467,391All other identifiable assets
    
    
    1,749,139
    
    
    
    195,742
    
    
    
    1,944,881Total assets
    
    $
    2,200,103
    
    
    $
    212,169
    
    
    $
    2,412,272
 
 ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS All statements included in this Quarterly Report on Form 10-Q, other than statements that are
purely historical are forward-looking statements within the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Words such as anticipate, expect, intend, plan,
believe, seek, estimate, and similar expressions may identify forward-looking statements,
which include, without limitation: our belief in the reasonableness under current circumstances of
estimates and assumptions underlying critical accounting policies; our intent to accurately state
our assets given facts known at the time of valuation; our estimated amortization expense for each
of the next five fiscal years; our plan for payment through 2017 of remaining rent obligations
under our restructuring plans; our belief that R&D investments have positioned us for future
growth; our plan to continue to focus on expanding our market presence in Asia; our belief that
significant additional growth potential exists in the Asia region over the long term; our continued
belief that significant investment in R&D is required to remain competitive; our intent to continue
to invest in new products and in the enhancement of our current product lines; managements belief
that the majority of the Companys deferred tax assets will be realized due to anticipated future
income; our expectation of offsetting effects of exchange rate changes on underlying hedged items
in foreign exchange contracts; our belief that our forward foreign exchange contracts do not
subject us to speculative risk that would otherwise result from changes in currency exchange rates;
our intention to release funds held in escrow to the former shareholders of Peter Wolters on June
25, 2005, in connection with our purchase of Peter Wolters in June 2004; our belief that our
current cash position, cash generated through operations and equity offerings, and available
borrowing capacity will be sufficient to meet our needs through the next twelve months; our belief
that the ultimate outcomes of the Plasma Physics, Solar Physics and Linear Technology Corporation
litigation matters and various other litigations that have arisen in the normal course of business
will not have a material adverse effect on our business, financial condition or results of
operations; and our intent to continue pursuing the legal defense of our propriety technology
primarily through patent and trade secret protection. Forward-looking statements are based on managements present expectations, beliefs, objectives,
intentions and strategies regarding the future, including, without limitation, those concerning
expected operating results, revenues and earnings and current and potential litigation. They are
not guarantees of future performance and are subject to risks and uncertainties that could cause
actual results to differ materially from results expressed or implied by the forward-looking
statements. These risks and uncertainties include but are not limited to: our failure to accurately
assess estimates and assumptions underlying our critical accounting policies, including 13




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assumptions as to identifiable intangible assets underlying our estimated amortization expense for
each of the next five fiscal years; availability of cash to meet our future rent obligations
remaining under our restructuring plans; our inability to develop viable products and realize
growth from R&D investments; a strategic shift away from expansion of our market presence in Asia
due to slower economic development or political instability in the region; our inability to
allocate substantial resources to R&D, new products and enhancement of our current product lines;
the insufficiency of the valuation allowance for deferred tax assets; the failure of foreign
exchange contracts to offset the effects of exchange rates as anticipated; exposure to speculative
risks that our foreign exchange contracts do not adequately protect against; unanticipated need for
additional liquid assets in the next twelve months; the possibility of claims for pre-acquisition
contingencies made against the funds held in escrow for the former shareholders of Peter Wolters
and the viability of those claims; our failure to accurately predict the effect of the ultimate
outcome of current litigation on our business, financial condition or results of operations;
inherent uncertainty in the outcome of litigation matters; and our potential inability to enforce
our patents and protect our trade secrets. The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional
risks and uncertainties set forth under the heading Risk Factors herein, and are based on
information available to us on the date hereof. We do not assume, and expressly disclaim, any
obligation to update this information, except as required under applicable law. Readers are
cautioned not to place undue reliance on forward-looking statements, which speak only as of the
date of this Quarterly Report on Form 10-Q. Readers should also consult the risk factors listed in
our Annual Report on Form 10-K for the year ended December 31, 2004 and in our other filings with
the Securities and Exchange Commission (SEC), including our Current Reports on Form 8-K and our
Annual Report to Shareholders. Introduction The following Managements Discussion and Analysis of Financial Condition and Results of Operations
(MD&A) is intended to provide readers with an understanding of the Company. The following are
included in our MD&A:  
    Overview of our Business and Industry;
    Results of Operations;
    Critical Accounting Policies;
    Liquidity and Capital Resources;
    Related Parties; and
    Risk Factors. Overview of Our Business and Industry Novellus 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. In 2001, Novellus expanded beyond deposition technologies into the area of wafer surface
preparation when we acquired GaSonics International Corporation, a manufacturer of systems used to
clean and prepare a wafer surface after the manufacturing steps that precede deposition. We also
acquired SpeedFam-IPEC, Inc., a manufacturer of chemical mechanical planarization (CMP) products in
2002. 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 14




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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 financial information for the periods indicated (in thousands, except per share
information): Quarterly Financial Data2005
    
    
    2004First
    
    
    First
    
    
    Second
    
    
    Third
    
    
    FourthQuarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    QuarterNet sales
    
    $
    339,740
    
    
    $
    262,862
    
    
    $
    338,219
    
    
    $
    415,935
    
    
    $
    340,272Gross profit
    
    
    153,869
    
    
    
    124,605
    
    
    
    169,680
    
    
    
    201,111
    
    
    
    169,734Net income
    
    
    30,471
    
    
    
    16,681
    
    
    
    37,811
    
    
    
    64,662
    
    
    
    37,536Diluted net income per share
    
    
    0.22
    
    
    
    0.11
    
    
    
    0.25
    
    
    
    0.45
    
    
    
    0.27Net orders
    
    
    301,594
    
    
    
    346,793
    
    
    
    397,598
    
    
    
    422,692
    
    
    
    331,347
 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, affect our net sales. In 2004, we
experienced a significant increase in demand for our products. In the first three quarters of
2004, we experienced sequential increases in 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, followed by a 9% decrease in net orders in the first quarter of 2005. The receipt of net orders in a particular quarter affects revenue in subsequent quarters. Net
orders turn into 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 the semiconductor industry, supply of
and demand for semiconductor devices, and competition in the semiconductor industry among suppliers
of similar products. Results of Operations
(dollars in thousands) Net Sales Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004Net sales
    
    $
    339,740
    
    
    $
    262,862
    
    
    $
    340,272International net sales %
    
    
    72
    %
    
    
    78
    %
    
    
    72
    %
 The increase in net sales of $76.9 million for the quarter ended April 2, 2005 from the prior
year period is primarily due to increased volume and from sales in our Industrial Applications
Group (IAG) of $36.6 million. Our IAG segment was formed subsequent to the acquisition of Peter
Wolters AG in June 2004. Sales from our IAG segment in the prior year period were insignificant.
The increase in volume was a result of increased capital spending by our customers as demand for
semiconductor devices improved. Geographical net sales as a percentage of total net sales were as follows (based upon the location
of the customers facilities): 15




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##### Table of Contents



Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004North America
    
    
    28
    %
    
    
    22
    %
    
    
    28
    %Europe
    
    
    9
    %
    
    
    8
    %
    
    
    11
    %Asia
    
    
    63
    %
    
    
    70
    %
    
    
    61
    %
 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 consider the Asia
region to consist of Korea, Japan, Singapore, China and Taiwan. We plan to continue to focus on
expanding our market presence in Asia, as we believe that significant additional growth potential
exists in this region over the long term. Gross Profit Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004Gross profit
    
    $
    153,869
    
    
    $
    124,605
    
    
    $
    169,734% of net sales
    
    
    45
    %
    
    
    47
    %
    
    
    50
    %
 Our gross profit from period to period is affected by the treatment of certain product sales
in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No.
104, Revenue Recognition. 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. The decrease in gross profit percentage in the quarter ended April 2, 2005 from the prior year
comparable periods is primarily attributable to product and geographical mix. Sales of inventory
previously written down resulted in a credit to cost of sales of approximately $0.5 million in the
quarter ended April 2, 2005, which positively impacted our gross profit by 0.1 percent. We are focused on improving our gross margins. This process involves working with our vendors to
minimize costs, reviewing our current and future anticipated facility requirements to determine if
facility reduction is necessary to achieve greater economies of scale, and continuing to outsource
to take full advantage of available highly efficient manufacturing. The effort to make meaningful
improvement in gross margin may take several quarters. Selling, General and Administrative (SG&A) Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004SG&A expense
    
    $
    51,760
    
    
    $
    42,403
    
    
    $
    55,439% of net sales
    
    
    15
    %
    
    
    16
    %
    
    
    16
    %
 SG&A expense includes compensation and benefits for corporate, financial, marketing, and
administrative personnel as well as travel expenses and professional fees. Also included are
expenses for rents, utilities, and depreciation and amortization related to the assets utilized by
these functions. The increase in SG&A expense, in absolute dollars, from last years first quarter is primarily due
to higher selling costs and the increased expense from our IAG segment, which was formed subsequent
to the acquisition of Peter Wolters AG in June 2004. We also incurred higher profit-sharing and
employee-related expenses during the quarter ended April 2, 2005. The decrease in SG&A expense as
a percentage of net sales is primarily due to an increase in net sales. The decrease in SG&A
expense from the fourth quarter of 2004 is a result of our cost containment efforts and the effect
of certain purchase accounting charges in the immediately preceding quarter that did not reoccur in
the first quarter of 2005. Research and Development (R&D) Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004R&D expense
    
    $
    62,048
    
    
    $
    58,957
    
    
    $
    61,453% of net sales
    
    
    18
    %
    
    
    22
    %
    
    
    18
    %
 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 investment in R&D over the past several years reflects 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. 16




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R&D expense as a percentage of net sales for the quarter ended April 2, 2005 decreased compared to
the respective prior-year periods, primarily due to an increase in net sales. The increase in R&D
expense in absolute dollars for the quarter ended April 2, 2005 from the prior-year period is from
our IAG segment, which was formed subsequent to the acquisition of Peter Wolter in June 2004,
increased usage of project materials and increased profit-sharing expense. Restructuring and Other Charges Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004Restructuring and other charges
    
    $
    
    
    
    $
    
    
    
    $
    2,407% of net sales
    
    
    
    %
    
    
    
    %
    
    Less than 1%
 We incurred no restructuring or other charges during the quarter ended April 2, 2005 or during
last years first quarter. During the fourth quarter of 2004, we incurred a severance charge of
$1.2 million and asset impairments of $1.2 million. Legal Settlement Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004Legal settlement
    
    $
    
    
    
    $
    2,500
    
    
    $
    % of net sales
    
    
    
    %
    
    
    1
    %
    
    
    
    %
 The quarter ended March 27, 2004 results included a $2.5 million legal settlement related to
the then-pending settlement of an overtime class action lawsuit filed by field service engineers.
No such charges were incurred in the comparable periods presented. Interest and Other Income, Net Quarters EndedApril 2, 2005
    
    
    March 27, 2004
    
    
    December 31, 2004Interest and other income, net
    
    $
    3,469
    
    
    $
    2,749
    
    
    $
    2,433% of net sales
    
    
    1
    %
    
    
    1
    %
    
    
    1
    %
 Interest and 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 the
quarter ended April 2, 2005 compared to the quarter ended March 27, 2004 is primarily due to higher
balances of interest-bearing cash and short-term investments. This increase was partially offset
by interest expense on long term debt of $0.9 million. Income Taxes Our effective tax rates were 30% for the quarter ended April 2, 2005 and 29% for the quarter ended
March 27, 2004. Our effective tax rate in 2005 differs from 2004 primarily because of reduced
benefits from the reduction of valuation allowances against certain deferred tax assets related to
foreign tax credits. Our future effective income tax rate depends on various factors, such as the
companys profits (losses) before taxes, tax legislation, the geographic composition of pre-tax
income, and non-deductible expenses incurred in connection with acquisitions. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting
principles 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 17




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We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, Revenue
Recognition, or SAB 104. 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:
delivery of the equipment and installation of the equipment/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 costs associated with equipment sales accounted for as
multiple-element arrangements are recognized upon shipment and
transfer of title. All revenue and associated costs for all other equipment
sales are recognized upon customer acceptance. Installation services are not essential to the functionality of the delivered equipment. In
accordance with 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 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. Our annual goodwill impairment test was completed 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 April 2, 2005, we had approximately $127.6 million of deferred tax
assets, net of a valuation allowance of $79.1 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 $42.8 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 18




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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, or SAB 100. 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 the Company 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 would 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. 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 2005 and 2004, these
hedging contracts were denominated primarily in the Japanese Yen, Taiwanese Dollar, and Korean Won.
The forward foreign exchange contracts we use are generally short-term in nature. The effect of
exchange rate changes on forward foreign exchange contracts is expected to offset the effect of
exchange rate changes on the underlying hedged items. We believe these 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 cash at April 2,
2005 consisted of $672.5 million of cash, cash equivalents and short-term investments. This amount
represents an increase of $84.8 million from $587.8 million at December 31, 2004. The increase was
due primarily to net cash provided by operating activities of $89.5 million. Net cash provided by operating activities during the quarter ended April 2, 2005 was $89.5 million.
This amount consisted primarily of $30.5 million provided by net income, adjusted for non-cash
items. The net changes in working capital accounts provided $37.4 million. Net cash used in investing activities for the quarter ended April 2, 2005 was $73.7 million, which
consisted primarily of purchases of short-term investments of $161.4 million, offset by proceeds
from short-term investment sales and maturities of $93.6 million. As of 19




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April 2, 2005, we had no significant commitments to purchase property or equipment. Net cash provided by financing activities for the quarter ended April 2, 2005 was $1.5 million.
This amount consisted of $6.8 million of net payments on lines of credit and long-term debt offset
by proceeds from employee stock compensation plans of $8.3 million. Our borrowings are generally secured by cash or marketable securities on deposit and included
within restricted cash on the consolidated balance sheet. As of April 2, 2005, the outstanding
balance of our long-term debt was $150.3 million. Borrowings under our credit arrangements are due
and payable on or before June 25, 2009. Our subsidiaries in Asia and Europe have short term credit facilities, including lines of credit,
with various banks with total borrowing capacity of $56.2 million. These credit facilities bear
interest at various rates, expire on various dates through 2006 and can be used for general
operating purposes. Borrowings of $1.6 million were outstanding under these credit facilities as of
April 2, 2005. In connection to our purchase of Peter Wolters in June 2004, 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. Any escrow claims would impact the recorded goodwill amount. No
claims were made during the quarter ended April 2, 2005. We believe that our current cash position, cash generated through operations and equity offerings,
and available borrowing capacity will be sufficient to meet our needs at least through the next
twelve months. Related Party Transactions We lease an aircraft from NVLS I, LLC, a third-party entity wholly owned by Richard S. Hill, our
Chairman and Chief Executive Officer. Under the leasing agreement, we incurred rental expense of
approximately $0.1 million and $0.2 million for the quarters ended April 2, 2005 and March 27,
2004, 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 quarters ended April 2, 2005 and March 27, 2004. Mr.
Hill is also a member of the Board of Directors of LTX Corporation. We recorded sublease income
from LTX Corporation of approximately $0.4 million for each of the quarters ended April 2, 2005 and
March 27, 2004. On April 16, 2004, D. James Guzy retired from the Board of Directors and was named Director
Emeritus. Mr. Guzy is also a member of the Board of Directors of Intel Corporation, one of our
significant customers. During the quarters ended April 2, 2005 and March 27, 2004 sales to Intel
represented approximately 21% and 8% of our net sales, respectively. Intel also accounted for 12%
and 8% of our accounts receivable as of April 2, 2005 and December 31, 2004, respectively. During each of the quarters ended April 2, 2005 and March 27, 2004, Novellus employed, in
non-executive positions, three immediate family members of our executive officers. The aggregate
compensation amounts recognized for these immediate family members for each of the quarters ended
April 2, 2005 and March 27, 2004 was $0.1 million. From time to time, we have made secured and unsecured loans to our executive officers, vice
presidents and other key personnel. As of April 2, 2005, 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 non-executive vice presidents and other key personnel. As of April 2, 2005 and
December 31, 2004, the total outstanding balances of loans to non-executive vice presidents and
other key personnel was approximately $4.1 million and $5.0 million, respectively. Of the total
amount outstanding at April 2, 2005, $3.3 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. Risk Factors Set forth below and elsewhere in this Quarterly Report on Form 10-Q 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 Quarterly Report. 20




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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.
In 2004, 2003, 2002 and 2001 we implemented restructuring plans to align our business with
fluctuating conditions, and future restructuring plans may be required to respond to accelerating
changes. Net orders and net sales may be adversely affected if we fail to respond to 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 and the first quarter of 2005. We cannot assure our investors that
our net sales and operating results will not be adversely affected if the current downturn in the
semiconductor industry continues, or if other downturns or slowdowns in the rate of capital
investment in the semiconductor industry occur in the future. The Semiconductor Industry is Intensely Competitive and Capital-Intensive We face substantial competition in the industry, from both potential new market entrants as well as
established competitors. Competing companies may have greater financial, marketing, technical or
other resources, and greater ability to respond to pricing pressures, 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. Heightened competition may also force price
reductions that could adversely affect our results of operations. 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 providing 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 21




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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. 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;
    Global or regional 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 regulatory or
trade 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 certain significant 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; 22




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
    Manufacturing difficulties;
    Customers deferring orders of our existing products due to new product announcements by us and/or our competitors;
    Competitive pricing pressures; and
    Overall business conditions in the semiconductor equipment industry. Changes in Tax Rates or Liabilities Could Affect Future Results We are subject to taxation in the U.S. and other foreign countries. Our future tax rates could be
affected by changes in the composition of earnings in countries with differing tax rates, changes
in the valuation of deferred tax assets and liabilities, or changes in the tax laws. We are also
subject to regular examination of our tax returns by the Internal Revenue Service and other tax
authorities. We regularly assess the likelihood of favorable or unfavorable outcomes resulting from
these examinations to determine the adequacy of our provision for income taxes. Although we believe
that our tax estimates are reasonable, there can be no assurance that any final determination will
not be materially different than the treatment reflected in our historical income tax provisions
and accruals. Acquisitions We have madeand may in the future makeacquisitions of or significant investments in businesses
with complementary products, services and/or technologies. Acquisitions involve numerous risks,
including, but not limited to:  
    Difficulties in integrating the operations, technologies, products and personnel of acquired companies;
    Lack of synergies or the inability to realize expected synergies;
    Revenue and expense levels of acquired entities differing from those anticipated at the time of the acquisitions;
    Difficulties in managing geographically dispersed operations;
    The potential loss of key employees, customers and strategic partners of acquired companies;
    Claims by terminated employees, shareholders of acquired companies or other third parties related to the transaction;
    The issuance of dilutive securities, assumption or incurrence of additional debt
obligations or expenses, or use of substantial portions of our cash;
    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 the establishment of our Industrial Applications Group 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 significant employees, customers or
suppliers, that are necessary to compete in or lead the market for high-precision machine
manufacturing 23




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tools. Our efforts to integrate and develop the Industrial Applications Group 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 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. Adverse outcomes in current or future legal disputes regarding patent and intellectual property
rights could result in the loss of our proprietary rights, subject the company to significant
liabilities to third parties, require us to seek licenses from third parties, or prevent us from
manufacturing or selling our products. However, we are not aware of any significant claim of
infringement by our products of any patent or proprietary rights of others. Regardless of the merit
of any 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 are
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. Our supply channels may be vulnerable to disruption. Any such disruption
that may result in a prolonged inability to obtain certain parts, or termination of supplier
relationships may adversely effect our operations and ability to meet customer demands. 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. Delays and shortages arising from our reliance on suppliers and subcontractors may
adversely affect our relationships with current and prospective customers and enable competitors to
penetrate our customer accounts. In addition, our ability to obtain competitive prices from
suppliers and subcontractors will in turn impact our ability to respond to pricing pressures from
competitors and customers, and our profitability. 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. 24




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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. 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. We are currently involved in a legal dispute in which certain
of our customers contend that we allegedly have indemnification obligations. It is not possible to
determine the maximum potential amount of liability under any indemnification obligations, whether
or not asserted, 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), whose effective date for public companies was amended by the Securities
and Exchange Commission in April 2005, we will be required to recognize, beginning in our first
fiscal quarter of 2006 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
profitability result in future
compensation charges. The option pricing models required by SFAS 123(R) were not developed for use
in valuing employee stock options and are based on highly subjective assumptions. Alternative
compensation arrangements that can replace stock option programs may also negatively impact
profitability. 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 SFAS 123R. 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 first
quarter of 2006, 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 25




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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 or will otherwise be unable to identify or
develop any commercially viable technology. In particular, these risks could arise from changes in
the financial condition or prospects of the companies in which investments are made, changes in
technological standards, changes in economic conditions, and changes in laws, regulations or fiscal
policies of jurisdictions in which investments are made. Investments 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 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For quantitative and qualitative disclosures about market risk affecting Novellus, see Item 7A:
Quantitative and Qualitative Disclosures about Market Risk in our Annual Report on Form 10-K, for
the fiscal year ended December 31, 2004. Our exposure related to market risk has not changed
materially since December 31, 2004. 
 ITEM 4: CONTROLS AND PROCEDURES Quarterly Evaluation of Our Disclosure Controls and Internal Controls As of the end of the period covered by this Quarterly Report on Form 10-Q, we evaluated the
effectiveness of the design and operation of our disclosure controls and procedures and our
internal controls and procedures for financial reporting. This controls evaluation was done under
the supervision and with the participation of management, including our Chief Executive Officer and
Chief Financial Officer. Rules adopted by the Securities and Exchange Commission, or the SEC,
require that in this section of the Quarterly Report on Form 10-Q, we present the conclusions of
the CEO and the CFO about the effectiveness of our disclosure controls and internal controls for
financial reporting based on and as of the date of the controls evaluation. CEO and CFO Certifications The certifications of the Chief Executive Officer and the Chief Financial Officer required in
accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are filed as exhibits to this
Quarterly Report on Form 10-Q. This section of the Quarterly Report on Form 10-Q is the information
concerning the controls evaluation referred to in the Section 302 certifications and this
information should be read in conjunction with the Section 302 certifications for a more complete
understanding of the topics presented. Disclosure Controls and Internal Controls for Financial Reporting Disclosure controls are procedures that are designed with the objective of ensuring that
information required to be disclosed in our reports filed under the Securities Exchange Act of
1934, or the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed,
summarized and reported within the time periods specified in the SECs rules and forms. Disclosure
controls are also designed with the objective of ensuring that such information is accumulated and
communicated to our management, including the Chief Executive Officer and Chief Financial Officer,
as appropriate to allow timely decisions regarding required disclosure. Internal controls for
financial reporting are procedures which are designed with the objective of providing reasonable
assurance that our transactions are properly authorized, our assets are safeguarded against
unauthorized or improper use and our transactions are properly recorded and reported, all to permit
the preparation of our financial statements in conformity with U.S. generally accepted accounting
principles. Limitations on the Effectiveness of Controls The Companys management, including the Chief Executive Officer and the Chief Financial Officer,
does 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 26




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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. Scope of the Controls Evaluation The evaluation of our disclosure controls and our internal controls for financial reporting by our
Chief Executive Officer and our Chief Financial Officer included a review of the controls
implemented by the Company and the effect of the controls on the information generated for use in
this Quarterly Report on Form 10-Q. In the course of the controls evaluation, we sought to identify
data errors, controls problems or acts of fraud and to confirm that appropriate corrective action,
including process improvements, were being undertaken. This type of evaluation will be done on a
quarterly basis so that the conclusions concerning controls effectiveness can be reported in our
Quarterly Reports on Form 10-Q and our Annual Report on Form 10-K. Our internal controls for
financial reporting are also evaluated on an ongoing basis by our outsourced internal audit
department and by other personnel in our finance department. The overall goals of these various
evaluation activities are to monitor our disclosure controls and our internal controls for
financial reporting and to make modifications as necessary; our intent in this regard is that the
disclosure controls and the internal controls for financial reporting will be maintained as dynamic
systems that change (including with improvements and corrections) as conditions warrant. Among other matters, we sought in our evaluation to determine whether there were any significant
deficiencies or material weaknesses in the Companys internal controls for financial reporting,
or whether the Company had identified any acts of fraud involving personnel who have a significant
role in the Companys internal controls for financial reporting. This information was important
both for the controls evaluation generally and because items 5 and 6 in the Section 302
certifications of the Chief Executive Officer and the Chief Financial Officer require that the
Chief Executive Officer and the Chief Financial Officer disclose that information to our Boards
Audit Committee and to our independent auditors and report on related matters in this section of
the Quarterly Report on Form 10-Q. In the professional auditing literature, significant
deficiencies are referred to as reportable conditions. These are control issues that could have
a significant adverse effect on the ability to record, process, summarize and report financial data
in the financial statements. A material weakness is defined in the auditing literature as a
particularly serious reportable condition where the internal control for financial reporting does
not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur
in amounts that would be material in relation to the financial statements and not be detected
within a timely period by employees in the normal course of performing their assigned functions. We
also sought to deal with other controls matters in the controls evaluation, and in each case if a
problem was identified, we considered what revision, improvement and/or correction to make in
accordance with our ongoing procedures. In accordance with SEC requirements, the Chief Executive
Officer and the Chief Financial Officer note that, during our most recent fiscal quarter, there
have been no changes in internal controls for financial reporting that have actually affected or
are reasonably likely to materially affect our internal controls for financial reporting. Conclusions Based upon the controls evaluation, our Chief Executive Officer and our Chief Financial Officer
have concluded that, subject to the limitations noted above, our disclosure controls are effective
to ensure that material information relating to the Company is made known to management, including
the Chief Executive Officer and the Chief Financial Officer, particularly during the period when
our periodic reports are being prepared, and that our internal controls for financial reporting are
effective to provide reasonable assurance that our financial statements are fairly presented in
conformity with U.S. generally accepted accounting principles. 
 PART II: OTHER INFORMATION 
 ITEM 1: LEGAL PROCEEDINGS The following identifies the litigation matters for which a material development has occurred
during the quarter ended April 2, 2005. For more detailed information on litigation matters
outstanding please see Note 13, Litigation in our Annual Report on Form 10-K for the year ended
December 31, 2004. Linear Technology Corporation 27




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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 appeals process. 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 5: OTHER INFORMATION (a) We have entered into employment arrangements with each of Fusen Chen, Senior Vice President,
Asia Operations, and Ginetto Addiego, Senior Vice President, Corporate Operations, both of whom
were determined to be executive officers of the company during the quarter ended April 2, 2005.
These employment arrangements may constitute material definitive agreements under Item 1.01 of
Form 8-K. A summary of the employment arrangements is attached as Exhibit 10.31 hereto. 
 ITEM 6: EXHIBITS (a) Exhibits  10.31
    Summary of Fusen Chen and Ginetto Addiego Executive Officer Compensation10.32
    Form of Novellus Plan Fiduciary Indemnification Agreement.31.1
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated May 6, 2005
in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.31.2
    Certification of John Chenault, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated May 6, 2005 in accordance with
18 U.S.C. 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated May 6, 2005
in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.32.2
    Certification of John Chenault, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated May 6, 2005 in accordance with
18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. 28




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NOVELLUS SYSTEMS, INC.By: /s/ John ChenaultJohn ChenaultVice President and Chief Financial Officer(Principal Financial Officer and Chief
Accounting Officer)May 6, 2005
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EXHIBIT INDEX *10.31
    
    Summary of Fusen Chen and Ginetto Addiego Executive Officer Compensation10.32
    
    Form of Novellus Plan Fiduciary Indemnification Agreement.31.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated May 6, 2005
in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of John Chenault, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated May 6, 2005 in accordance with
18 U.S.C. 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated May 6, 2005
in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of John Chenault, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated May 6, 2005 in accordance with
18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
   *
    
    Management contracts or compensatory plans or arrangements.