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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 September 25, 2004 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(State or other jurisdiction of
incorporation of organization)
    
    77-0024666(I.R.S. Employer Identification
Number)
 4000 North First Street, San Jose, California 95134 (Address of principal executive offices including zip code)
 (408) 943-9700 (Registrants telephone number, including area code)
 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 October 27, 2004, 139,789,533 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 SEPTEMBER 25, 2004 TABLE OF CONTENTS PagePart I: Financial InformationItem 1: Condensed Consolidated Financial StatementsCondensed Consolidated Statements of Operations for the three and nine months ended
September 25, 2004 and September 27, 2003
    
    
    3Condensed Consolidated Balance Sheets as of September 25, 2004 and December 31, 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended September 25,
2004 and September 27, 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2: Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Item 3: Quantitative and Qualitative Disclosures About Market Risk
    
    
    27Item 4: Controls and Procedures
    
    
    28Part II: Other InformationItem 1: Legal Proceedings
    
    
    29Item 2: Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    31Item 6: Exhibits
    
    
    31Signatures
    
    
    33EXHIBIT 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) Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Net sales
    
    $
    415,935
    
    
    $
    221,099
    
    
    $
    1,017,016
    
    
    $
    698,559Cost of sales
    
    
    214,824
    
    
    
    162,323
    
    
    
    521,620
    
    
    
    424,647Gross profit
    
    
    201,111
    
    
    
    58,776
    
    
    
    495,396
    
    
    
    273,912Operating expenses:Selling, general and administrative
    
    
    49,585
    
    
    
    40,123
    
    
    
    139,213
    
    
    
    127,197Research and development
    
    
    68,202
    
    
    
    59,858
    
    
    
    190,630
    
    
    
    173,374Restructuring and other charges
    
    
    (923
    )
    
    
    15,838
    
    
    
    (923
    )
    
    
    15,838Acquired in-process research and development
    
    
    
    
    
    
    
    
    
    
    6,124
    
    
    
    Legal settlement
    
    
    2,900
    
    
    
    2,691
    
    
    
    5,400
    
    
    
    2,691Total operating expenses
    
    
    119,764
    
    
    
    118,510
    
    
    
    340,444
    
    
    
    319,100Operating income (loss)
    
    
    81,347
    
    
    
    (59,734
    )
    
    
    154,952
    
    
    
    (45,188
    )Interest income
    
    
    2,809
    
    
    
    2,362
    
    
    
    8,043
    
    
    
    14,447Other income (loss), net
    
    
    6,917
    
    
    
    360
    
    
    
    7,328
    
    
    
    (536
    )Interest and other income, net
    
    
    9,726
    
    
    
    2,722
    
    
    
    15,371
    
    
    
    13,911Income (loss) before income taxes
    
    
    91,073
    
    
    
    (57,012
    )
    
    
    170,323
    
    
    
    (31,277
    )Provision (benefit) for income taxes
    
    
    26,411
    
    
    
    (22,224
    )
    
    
    51,169
    
    
    
    (15,791
    )Income (loss) before cumulative effect of a change in accounting
principle
    
    
    64,662
    
    
    
    (34,788
    )
    
    
    119,154
    
    
    
    (15,486
    )Cumulative effect of a change in accounting principle, net of tax
    
    
    
    
    
    
    (62,780
    )
    
    
    
    
    
    
    (62,780
    )Net income (loss)
    
    $
    64,662
    
    
    $
    (97,568
    )
    
    $
    119,154
    
    
    $
    (78,266
    )Net income (loss) per share:BasicIncome (loss) per share before cumulative effect of a
change in accounting principle
    
    $
    0.45
    
    
    $
    (0.23
    )
    
    $
    0.80
    
    
    $
    (0.10
    )Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    (0.41
    )
    
    
    
    
    
    
    (0.42
    )Basic net income (loss) per share
    
    $
    0.45
    
    
    $
    (0.64
    )
    
    $
    0.80
    
    
    $
    (0.52
    )DilutedIncome (loss) per share before cumulative effect of a
change in accounting principle
    
    $
    0.45
    
    
    $
    (0.23
    )
    
    $
    0.79
    
    
    $
    (0.10
    )Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    (0.41
    )
    
    
    
    
    
    
    (0.42
    )Diluted net income (loss) per share
    
    $
    0.45
    
    
    $
    (0.64
    )
    
    $
    0.79
    
    
    $
    (0.52
    )Shares used in basic per share calculation
    
    
    142,333
    
    
    
    151,280
    
    
    
    148,119
    
    
    
    150,221Shares used in diluted per share calculation
    
    
    143,574
    
    
    
    151,280
    
    
    
    150,353
    
    
    
    150,221
 See accompanying notes to condensed consolidated financial statements. 3




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CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands) September 25,
    
    December 31,2004
    
    2003 *(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    51,887
    
    
    $
    497,178Short-term investments
    
    
    458,499
    
    
    
    504,954Accounts receivable, net
    
    
    426,658
    
    
    
    231,760Inventories
    
    
    250,161
    
    
    
    199,100Deferred tax assets, net
    
    
    140,648
    
    
    
    126,901Prepaid and other current assets
    
    
    15,211
    
    
    
    12,095Total current assets
    
    
    1,343,064
    
    
    
    1,571,988Property and equipment, net
    
    
    486,229
    
    
    
    506,567Restricted cash and cash equivalents
    
    
    177,637
    
    
    
    2,861Goodwill
    
    
    277,922
    
    
    
    173,267Intangible and other assets
    
    
    113,581
    
    
    
    84,217Total assets
    
    $
    2,398,433
    
    
    $
    2,338,900LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    71,583
    
    
    $
    53,537Accrued payroll and related expenses
    
    
    72,998
    
    
    
    25,197Accrued warranty
    
    
    44,979
    
    
    
    28,805Other accrued liabilities
    
    
    55,079
    
    
    
    43,406Income taxes payable
    
    
    54,378
    
    
    
    10,293Deferred profit
    
    
    71,998
    
    
    
    46,821Current obligations under lines of credit
    
    
    5,399
    
    
    
    13,023Total current liabilities
    
    
    376,414
    
    
    
    221,082Long term debt
    
    
    154,925
    
    
    
    Other liabilities
    
    
    50,895
    
    
    
    45,958Total liabilities
    
    
    582,234
    
    
    
    267,040Shareholders equity:Common stock
    
    
    1,445,797
    
    
    
    1,565,926Retained earnings
    
    
    367,371
    
    
    
    501,362Accumulated other comprehensive income
    
    
    3,031
    
    
    
    4,572Total shareholders equity
    
    
    1,816,199
    
    
    
    2,071,860Total liabilities and shareholders equity
    
    $
    2,398,433
    
    
    $
    2,338,900
  *
    
    Amounts as of December 31, 2003 are derived from the December 31, 2003
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) Nine Months EndedSeptember 25,
    
    September 27,2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    119,154
    
    
    $
    (78,266
    )Adjustments to reconcile net income (loss) to net cash provided by operating activities:Gain on sale of an investment
    
    
    (353
    )
    
    
    Non-cash portion of restructuring and other charges
    
    
    (8,999
    )
    
    
    51,895Loss on extinguishment of debt
    
    
    
    
    
    
    616Loss on disposal of fixed assets
    
    
    1,188
    
    
    
    Depreciation and amortization
    
    
    64,660
    
    
    
    47,962Cumulative effect of a change in accounting principle, net of tax benefit
    
    
    
    
    
    
    62,780Deferred income taxes
    
    
    (12,732
    )
    
    
    (17,396
    )Stock-based compensation
    
    
    3,341
    
    
    
    3,055Changes in operating assets and liabilities:Accounts receivable
    
    
    (184,223
    )
    
    
    (28,446
    )Inventories
    
    
    (41,129
    )
    
    
    12,854Prepaid and other current assets
    
    
    (2,522
    )
    
    
    15,057Accounts payable
    
    
    13,248
    
    
    
    (2,215
    )Accrued payroll and related expenses
    
    
    37,656
    
    
    
    (2,982
    )Accrued warranty
    
    
    14,395
    
    
    
    (880
    )Other accrued liabilities
    
    
    8,104
    
    
    
    (7,880
    )Income taxes payable
    
    
    43,983
    
    
    
    (5,339
    )Deferred profit
    
    
    25,176
    
    
    
    (15,136
    )Net cash provided by operating activities
    
    
    80,947
    
    
    
    35,679Cash flows from investing activities:Proceeds from sales and maturities of short-term investments
    
    
    812,024
    
    
    
    1,102,611Purchases of short-term investments
    
    
    (765,216
    )
    
    
    (1,147,409
    )Capital expenditures
    
    
    (17,468
    )
    
    
    (23,867
    )Decrease (increase) in other assets
    
    
    (2,939
    )
    
    
    10,234Increase in restricted cash and cash equivalents
    
    
    (174,775
    )
    
    
    (2,861
    )Purchase of Peter Wolters AG, net of cash acquired
    
    
    (142,916
    )
    
    
    Net cash used in investing activities
    
    
    (291,290
    )
    
    
    (61,292
    )Cash flows from financing activities:Repayments of convertible subordinated notes
    
    
    
    
    
    
    (117,053
    )Proceeds from employee stock compensation plans
    
    
    21,222
    
    
    
    53,180(Payments on) proceeds from lines of credit, net
    
    
    (7,624
    )
    
    
    3,164Proceeds from long-term debt
    
    
    153,115
    
    
    
    Repurchase of common stock
    
    
    (401,661
    )
    
    
    (39
    )Net cash used in financing activities
    
    
    (234,948
    )
    
    
    (60,748
    )Net decrease in cash and cash equivalents
    
    
    (445,291
    )
    
    
    (86,361
    )Cash and cash equivalents at the beginning of the period
    
    
    497,178
    
    
    
    615,844Cash and cash equivalents at the end of the period
    
    $
    51,887
    
    
    $
    529,483
 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 three and nine months ended September
25, 2004 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2004. For further information, refer to the
consolidated financial statements and footnotes thereto included in our Annual
Report on Form 10-K for the year ended December 31, 2003. 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. 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 September 25, 2004
include the financial position, results of operations and cash flows of Peter
Wolters from June 28, 2004. We operate primarily in one segment, the manufacturing, marketing, and
servicing of semiconductor wafer fabrication equipment. Since we operate in one
segment, all segment-related financial information required by Statement of
Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of
an Enterprise and Related Information, or SFAS No. 131, is included in the
condensed consolidated financial statements. 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, and have adopted the disclosure-only provisions of SFAS
No. 123, Accounting for Stock-Based Compensation, 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
current market value. In the disclosure presented below and in our statement of operations, we
recognize stock-based compensation on the graded vesting method over the
vesting periods of the applicable stock purchase rights and stock options,
generally four years. The graded vesting method provides for vesting of
portions of the overall awards at interim dates and results in greater expense
recorded in earlier years than the straight-line method. SFAS No. 123 requires the use of option pricing models that were not developed
for use in valuing employee stock options. The Black-Scholes option-pricing
model was developed for use in estimating the fair value of short-lived
exchange-traded options that have no vesting restrictions and are fully
transferable. In addition, option-pricing models require the input of highly
subjective assumptions, including the options expected life and the price
volatility of the underlying stock. Because our employee stock options 6




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have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the opinion of management, the existing models do 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 (loss)
and net income (loss) per share as follows (in thousands, except per share
data): Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Net income (loss) as reported
    
    $
    64,662
    
    
    $
    (97,568
    )
    
    $
    119,154
    
    
    $
    (78,266
    )Add:Intrinsic value method expense
included in reported net
income, net of related tax effects
    
    
    998
    
    
    
    303
    
    
    
    2,977
    
    
    
    1,737Less:Fair value method expense, net of
related tax effects
    
    
    (11,240
    )
    
    
    (13,333
    )
    
    
    (39,071
    )
    
    
    (48,899
    )Pro-forma net income (loss)
    
    $
    54,420
    
    
    $
    (110,598
    )
    
    $
    83,060
    
    
    $
    (125,428
    )Pro-forma basic and diluted net income
(loss) per share
    
    $
    0.38
    
    
    $
    (0.73
    )
    
    $
    0.56
    
    
    $
    (0.83
    )Basic net income (loss) per share
as reported
    
    $
    0.45
    
    
    $
    (0.64
    )
    
    $
    0.80
    
    
    $
    (0.52
    )Diluted net income (loss) per share
as reported
    
    $
    0.45
    
    
    $
    (0.64
    )
    
    $
    0.79
    
    
    $
    (0.52
    )
 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 three and nine months ended September 25,
2004 and September 27, 2003: Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Dividend yield
    
    None
    
    None
    
    None
    
    NoneExpected volatility
    
    
    74
    %
    
    
    80
    %
    
    
    76
    %
    
    
    82
    %Risk free interest rate
    
    
    2.7
    %
    
    
    2.3
    %
    
    
    2.5
    %
    
    
    2.4
    %Expected lives
    
    3.7 years
    
    3.6 years
    
    3.5 years
    
    3.2 years
 The weighted-average fair value of stock options granted during the period was
$14.09 and $16.42 for the three and nine months ended September 25, 2004,
respectively, and $20.78 and $17.08 for the three and nine months ended
September 27, 2003, respectively. The pro forma net income (loss) and net income (loss) 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 on the date of issuance using the Black-Scholes
option-pricing model, with the following weighted-average assumptions: Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Dividend yield
    
    None
    
    None
    
    None
    
    NoneExpected volatility
    
    
    45
    %
    
    
    46
    %
    
    
    45
    %
    
    
    49
    %Risk free interest rate
    
    
    1.3
    %
    
    
    1.2
    %
    
    
    1.3
    %
    
    
    1.2
    %Expected lives
    
    .5 year
    
    .5 year
    
    .5 year
    
    .5 year
 The weighted-average fair value of purchase rights was $7.92 and $8.78 for the
three and nine months ended September 25, 2004, respectively, and $8.83 and
$8.74 for the three and nine months ended September 27, 2003, respectively. 2. BUSINESS COMBINATION 7




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On June 28, 2004, we acquired all of the outstanding stock of Peter Wolters AG,
a privately-held manufacturer of high-precision machine manufacturing tools
based in Rendsburg, Germany. The acquisition of Peter Wolters enables us to
diversify our product offerings. We funded the purchase price of the
acquisition, excluding transaction costs, with approximately $149.5 million of
borrowings under a credit facility. For further discussion regarding the credit
facility, see Note 9. Under the terms of the purchase agreement, we deposited
ten percent of the purchase price into escrow. The escrow amount will be
released to the former shareholders of Peter Wolters on June 25, 2005, to the
extent we have not made claims against the escrow for pre-acquisition
contingencies. The acquisition of Peter Wolters was accounted for as a business combination in
accordance with SFAS No. 141, Business Combinations. Tangible assets and
liabilities were recorded at their estimated fair value and the value of the
intangible assets acquired will be valued by us, with the assistance of
third-party appraisers, under the provisions of SFAS No. 142, Goodwill and
Other Intangible Assets. The preliminary purchase price was allocated to the fair value of assets
acquired and liabilities assumed as follows (in thousands): Cash consideration
    
    $
    149,512Estimated transaction costs
    
    
    2,100Total purchase price
    
    $
    151,612Developed technology
    
    $
    9,600Customer backlog
    
    
    2,400Trademark/Trade name
    
    
    6,100Goodwill
    
    
    104,221Deferred tax liability, net
    
    
    (8,306
    )Tangible assets acquired
    
    
    65,588Liabilities assumed
    
    
    (27,991
    )Total net assets acquired
    
    $
    151,612
 Intangible Assets As of the closing of our acquisition of Peter Wolters on
June 28, 2004, $18.1 million of the total purchase price was allocated to
intangible assets subject to amortization. Included in these intangible assets
are developed and core technologies, customer backlog, and trademark/trade name
rights with weighted average lives of 6.0, 0.5, and 10.0 years, respectively. Goodwill The potential value of the combined companies products and
technologies contributed to a purchase price that resulted in goodwill.
Goodwill represents the excess of the purchase price of an acquired business
over the fair value of the underlying net tangible and intangible assets.
Goodwill is not deductible for tax purposes and is not subject to amortization,
however, it is to be tested for impairment at least annually in accordance with
SFAS No. 142. Approximately $104.2 million of the total purchase price was
allocated to goodwill upon the closing of our acquisition of Peter Wolters on
June 28, 2004. Pro Forma Results- The following table represents the unaudited pro forma
consolidated results of operations, assuming the acquisition of Peter Wolters
was consummated as of the beginning of the periods presented. The unaudited pro
forma information has been prepared for comparative purposes only and may not
be indicative of what operating results would have been if the acquisition had
taken place at the beginning of the periods presented. In addition, the
unaudited pro forma information may not be indicative of future operating
periods. The combined operating results below consist of historical results of
Novellus and Peter Wolters for the three and nine months ended September 25,
2004 and September 27, 2003. The pro forma disclosure includes charges of
approximately $2.1 million, net of tax, in the nine month period ending
September 27, 2003 resulting from inventory written-up in purchase accounting
and the sell-through of customer backlog. The pro forma disclosure eliminates
charges of approximately $1.0 million, net of tax, related to these items from
the three months ended September 25, 2004. Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,(in thousands, except per share data)

    
    2004
    
    2003
    
    2004
    
    2003Net sales
    

    $
    415,935
    
    
    $
    236,873
    
    
    $
    1,056,284
    
    
    $
    742,992Income (loss) before extraordinary items
    
    $
    65,817
    
    
    $
    (34,936
    )
    
    $
    122,371
    
    
    $
    (18,157
    )Cumulative effect of accounting changes
    
    
    
    
    
    
    (62,780
    )
    
    
    
    
    
    
    (62,780
    )Net income (loss)
    
    $
    65,817
    
    
    $
    (97,716
    )
    
    $
    122,371
    
    
    $
    (80,937
    )Diluted net income (loss) per share
    
    $
    0.46
    
    
    $
    (0.65
    )
    
    $
    0.81
    
    
    $
    (0.54
    )
 8




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##### Table of Contents



3. NET INCOME (LOSS) PER SHARE Basic net income (loss) per share is computed by dividing net income (loss) by
the weighted-average number of common shares outstanding during the period. For
purposes of computing basic net income (loss) per share, the weighted-average
number of outstanding shares of common stock excludes shares of restricted
stock subject to repurchase. Diluted net income (loss) per share is computed using the weighted-average
number of shares of common stock outstanding, including shares of restricted
common stock subject to repurchase and, when dilutive, potential shares from
stock options to purchase common stock using the treasury stock method. 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): Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Numerator:Net income (loss)
    
    $
    64,662
    
    
    $
    (97,568
    )
    
    $
    119,154
    
    
    $
    (78,266
    )Denominator:Basic weighted-average shares outstanding
    
    
    142,333
    
    
    
    151,280
    
    
    
    148,119
    
    
    
    150,221Employee stock options and restricted stock
    
    
    1,241
    
    
    
    
    
    
    
    2,234
    
    
    
    Diluted weighted-average shares outstanding
    
    
    143,574
    
    
    
    151,280
    
    
    
    150,353
    
    
    
    150,221Basic net income (loss) per share
    
    $
    0.45
    
    
    $
    (0.64
    )
    
    $
    0.80
    
    
    $
    (0.52
    )Diluted net income (loss) per share
    
    $
    0.45
    
    
    $
    (0.64
    )
    
    $
    0.79
    
    
    $
    (0.52
    )
 Options to purchase approximately 20.4 million and 12.5 million shares of
common stock were outstanding for the three and nine months ended September 25,
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. For the three and nine
months ended September 27, 2003, all options to purchase common stock were
excluded from the computation of net loss per share as the effect would be
anti-dilutive during those periods. 4. INTEREST AND OTHER INCOME, NET The components of interest and other income, net within the consolidated
statements of operations are as follows (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Interest income
    
    $
    2,809
    
    
    $
    2,362
    
    
    $
    8,043
    
    
    $
    14,447Interest expense
    
    
    (937
    )
    
    
    (1
    )
    
    
    (1,048
    )
    
    
    (854
    )Litigation proceeds
    
    
    8,000
    
    
    
    
    
    
    
    8,000
    
    
    
    Other income
    
    
    146
    
    
    
    439
    
    
    
    1,123
    
    
    
    1,006Other expense
    
    
    (103
    )
    
    
    (78
    )
    
    
    (430
    )
    
    
    (215
    )Foreign currency gain (loss), net
    
    
    (189
    )
    
    
    228
    
    
    
    (317
    )
    
    
    (473
    )Total interest and other income, net
    
    $
    9,726
    
    
    $
    2,722
    
    
    $
    15,371
    
    
    $
    13,911
 5. 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): 9




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September 25,
    
    December 31,2004
    
    2003Purchased and spare parts
    
    $
    185,882
    
    
    $
    146,399Work-in-process
    
    
    50,102
    
    
    
    37,502Finished goods
    
    
    14,177
    
    
    
    15,199Total inventories
    
    $
    250,161
    
    
    $
    199,100
 6. GOODWILL AND INTANGIBLE ASSETS Goodwill A summary of changes in goodwill during the periods ended September 25, 2004
and September 27, 2003 are as follows (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Balance, beginning of period
    
    $
    173,267
    
    
    $
    163,136
    
    
    $
    173,267
    
    
    $
    163,136SpeedFam-IPEC adjustment
    
    
    (799
    )
    
    
    9,757
    
    
    
    (799
    )
    
    
    9,757Peter Wolters AG acquisition
    
    
    104,221
    
    
    
    
    
    
    
    104,221
    
    
    
    Foreign currency translation
    
    
    1,233
    
    
    
    
    
    
    
    1,233
    
    
    
    Balance, end of period
    
    $
    277,922
    
    
    $
    172,893
    
    
    $
    277,922
    
    
    $
    172,893
 As of December 31, 2003, we had goodwill of approximately $173.3 million. As a
result of the acquisition of Peter Wolters AG on June 28, 2004, we recorded
additional goodwill in the amount of $104.2 million, which is subject to
foreign currency translation effects. The related foreign currency translation
effects for the three months and nine months ended September 25, 2004 resulted
in an increase to goodwill of $1.2 million. In the third quarter of 2004, we
determined that a tax contingency accrual recorded during the acquisition of
SpeedFam-IPEC in 2002 was no longer required, and we accordingly reversed $0.8
million against goodwill. These movements during the third quarter of 2004
resulted in an ending balance of $277.9 million as of September 25, 2004. In September 2003, we recorded a net increase to goodwill of approximately $9.8
million. The increase in goodwill was a result of the reallocation of the
initial estimated purchase price for the acquisition of SpeedFam-IPEC and an
increase to the purchase price. Directors and officers liability insurance
was purchased for $1.3 million for the former directors and officers of
SpeedFam-IPEC, but was not included in our initial purchase price. The net
increase to goodwill was also the result of the write down of inventory for
$3.1 million related to inventory that was not properly valued as of the
acquisition date and an $11.0 million adjustment to the restructuring accrual
for a decrease in our estimated future sublease income on facilities leased by
SpeedFam-IPEC. This revised sublease income estimate was based on subsequent
knowledge obtained about real estate conditions that existed as of the
acquisition date. These increases were offset by the $6.1 million deferred tax
asset adjustment recorded as a result of the purchase price allocation
adjustments. We completed the annual goodwill impairment test in the fourth quarter of 2003
in accordance with our policy. The first step of the test identifies when
impairment may have occurred, while the second step of the test measures the
amount of the impairment, if any. The results of our impairment tests did not
indicate impairment. There have been no significant events or circumstances
affecting the valuation of goodwill subsequent to our impairment test performed
in the fourth quarter of 2003. Intangible Assets The following tables provide details of our acquired intangible assets (in
thousands): AccumulatedSeptember 25, 2004
    
    Gross
    
    Amortization
    
    NetPatents
    
    $
    15,877
    
    
    $
    (12,030
    )
    
    $
    3,847Developed technology
    
    
    27,094
    
    
    
    (5,715
    )
    
    
    21,379Customer backlog
    
    
    2,428
    
    
    
    (1,214
    )
    
    
    1,214Trademark
    
    
    6,172
    
    
    
    (154
    )
    
    
    6,018Other intangible assets
    
    
    1,160
    
    
    
    (1,101
    )
    
    
    59Total
    
    $
    52,731
    
    
    $
    (20,214
    )
    
    $
    32,517
 10




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##### Table of Contents



AccumulatedDecember 31, 2003
    
    Gross
    
    Amortization
    
    NetPatents
    
    $
    11,680
    
    
    $
    (10,912
    )
    
    $
    768Developed technology
    
    
    17,380
    
    
    
    (3,138
    )
    
    
    14,242Other intangible assets
    
    
    1,160
    
    
    
    (1,093
    )
    
    
    67Total
    
    $
    30,220
    
    
    $
    (15,143
    )
    
    $
    15,077
 Our estimated amortization expense for the identifiable intangible assets for
each of the next five fiscal years will be approximately $5.8 million for 2005
through 2007, $5.6 million for 2008 and $3.0 million for 2009. As of September
25, 2004, we have no identifiable intangible assets with indefinite lives. 7. 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. We follow the provisions of FIN 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, including
Indirect Indebtedness of Others, which requires changes to the accounting and
disclosure of guarantees, including product warranties. Changes in our accrued
warranty liability were as follows (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Balance, beginning of period
    
    $
    38,264
    
    
    $
    28,371
    
    
    $
    28,805
    
    
    $
    31,002Peter Wolters balance at acquisition
    
    
    2,367
    
    
    
    
    
    
    
    2,367
    
    
    
    Warranties issued
    
    
    22,589
    
    
    
    11,481
    
    
    
    59,926
    
    
    
    34,980Settlements
    
    
    (19,305
    )
    
    
    (11,175
    )
    
    
    (49,243
    )
    
    
    (38,031
    )Changes in liability for
pre-existing warranties, including
expirations
    
    
    1,064
    
    
    
    1,445
    
    
    
    3,124
    
    
    
    2,171Balance, end of period
    
    $
    44,979
    
    
    $
    30,122
    
    
    $
    44,979
    
    
    $
    30,122
 8. RESTRUCTURING AND OTHER CHARGES In 2001, we implemented a restructuring plan that was driven by the decline in
sales orders due to the contraction of the semiconductor capital equipment
market. 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 the third
quarter of 2003, we implemented a restructuring plan to align our cost
structure with business conditions. During the quarter ended September 25, 2004, we entered into a sublease for a
building that was previously included in our estimate of future costs to be
incurred under a previous restructuring plan. We have revised our estimate of
future expenses based primarily on this sublease and recorded a reduction in
the accrual. Additionally, in the third quarter of 2004, we determined that a
tax accrual recorded during the acquisition of SpeedFam-IPEC in 2002 was no
longer required and reversed $0.8 million of the accrual recorded in the
original purchase price allocation against goodwill. The following table summarizes restructuring activity for the nine months ended
September 25, 2004 (in thousands): AcquisitionFacilities
    
    Severance
    
    Expense
    
    TotalBalance at December 31, 2003
    
    $
    50,513
    
    
    $
    592
    
    
    $
    1,115
    
    
    $
    52,220Cash payments
    
    
    (2,234
    )
    
    
    (183
    )
    
    
    (90
    )
    
    
    (2,507
    )Balance at March 27, 2004
    
    
    48,279
    
    
    
    409
    
    
    
    1,025
    
    
    
    49,713Cash payments
    
    
    (1,425
    )
    
    
    (75
    )
    
    
    (9
    )
    
    
    (1,509
    )Balance at June 26, 2004
    
    
    46,854
    
    
    
    334
    
    
    
    1,016
    
    
    
    48,204Cash payments
    
    
    (1,843
    )
    
    
    (17
    )
    
    
    (17
    )
    
    
    (1,877
    )Adjustment
    
    
    (923
    )
    
    
    
    
    
    
    (799
    )
    
    
    (1,722
    )Balance at September 25, 2004
    
    $
    44,088
    
    
    $
    317
    
    
    $
    200
    
    
    $
    44,605
 11




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##### Table of Contents



As of September 25, 2004, substantially all actions under the 2003, 2002 and
2001 restructuring plans have been completed, except for payments of future
rent obligations of $44.1 million, which are to be paid in cash through 2017. 9. LONG-TERM OBLIGATIONS On June 28, 2004, we borrowed $153.1 million to fund the acquisition of Peter
Wolters AG and for general corporate purposes. The credit arrangement allows
for periodic borrowings in Euros, with an interest rate equal to the
Eurocurrency Rate plus 0.2% (2.32% at September 25, 2004). The outstanding
balance of $154.9 million is recorded as long term debt at September 25, 2004.
All borrowings are required to be secured by cash or marketable securities on
deposit and are due and payable on or before June 25, 2009. Amounts to secure
this borrowing totaling $173.1 million are included within restricted cash on
the consolidated balance sheets. 10. COMPREHENSIVE INCOME (LOSS) The following are the components of comprehensive income (loss) (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    64,662
    
    
    $
    (97,568
    )
    
    $
    119,154
    
    
    $
    (78,266
    )Other comprehensive income:Foreign currency translation adjustments
    
    
    (947
    )
    
    
    (462
    )
    
    
    (1,370
    )
    
    
    1,661Realized gain (loss) on available-for-sale securities, net of tax
    
    
    (12
    )
    
    
    
    
    
    
    (353
    )
    
    
    Unrealized gain on available-for-sale securities, net of tax
    
    
    1,043
    
    
    
    80
    
    
    
    182
    
    
    
    26Comprehensive income (loss)
    
    $
    64,746
    
    
    $
    (97,950
    )
    
    $
    117,613
    
    
    $
    (76,579
    )
 The components of accumulated other comprehensive income, net of related tax,
are as follows (in thousands): September 25,
    
    December 31,2004
    
    2003Foreign currency translation adjustments
    
    $
    3,315
    
    
    $
    4,685Unrealized loss on available-for-sale securities
    
    
    (284
    )
    
    
    (113
    )Accumulated other comprehensive income
    
    $
    3,031
    
    
    $
    4,572
 11. PENSION PLAN On June 28, 2004, we acquired Peter Wolters AG, including its existing pension
plan. Service and interest costs for the pension plan for the three months
ended September 25, 2004 were $0.1 million and $20,000, respectively. 12. 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 $234,000 and $664,000
for the three and nine months ended September 25, 2004, respectively, and
approximately $227,000 and $606,000 for the three and nine months ended
September 27, 2003, respectively. Mr. Hill is a member of the Board of Directors of LTX Corporation. We recorded
sublease income from LTX Corporation of approximately $351,000 for the three
months ended September 25, 2004 and September 27, 2003 and approximately
$1,052,000 for the nine months ended September 25, 2004 and September 27, 2003. 12




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During the quarter ended September 27, 2003, a member of our Board of
Directors, D. James Guzy, was also a member of the Board of Directors of Intel
Corporation, one of our significant customers. Mr. Guzy did not stand for
re-election to the Board of Directors at our 2004 Annual Meeting of
Shareholders and was named Director Emeritus as of April 16, 2004. Sales to
Intel represented approximately 10.0% for the three and nine months ended
September 27, 2003. Intel also accounted for 6.0% of our accounts receivable as
of December 31, 2003. From time to time, we have made secured relocation loans to our executive
officers, vice presidents and other key personnel. As of September 25, 2004, we
had no outstanding loans to our executive officers as defined by the Securities
and Exchange Commission. However, we had outstanding loans to non-executive
officers and other key personnel. As of September 25, 2004 and December 31,
2003, the total outstanding balances of loans to non-executive officers and
other key personnel were approximately $5.0 million and $5.7 million,
respectively. Of the total amount outstanding at September 25, 2004, $3.9
million was secured by collateral. 13. LITIGATION Applied Materials, Inc. On September 20, 2004, we settled all pending patent litigation between us and
Applied Materials, Inc. by entering into a Binding Memorandum of
Understanding, referred to herein as an MOU, with Applied. The MOU became
effective as of September 3, 2004. Background of the Litigation On June 13, 1997, we acquired the Thin Film Systems (TFS) business of Varian
Associates, Inc. On the same day, Applied sued Varian in the United States
District Court for the Northern District of California for alleged patent
infringement concerning several of its physical vapor deposition, or PVD,
patents (the Applied Patents). On June 23, 1997, we sued Applied in the United
States District Court for the Northern District of California, claiming
infringement by Applied of several of our PVD patents acquired from Varian in
the TFS business acquisition. On July 7, 1997, Applied amended its complaint
in its suit against Varian to add Novellus as a defendant. We requested that
the Court dismiss us as a defendant in this suit. The relief requested by Applied in both suits included a permanent injunction
against future infringement, damages for alleged past infringement and treble
damages for alleged willful infringement. Trial had been set to commence on
September 20, 2004. Settlement Under the terms of the MOU, all then pending patent litigation between us and
Applied was dismissed with prejudice. As part of the settlement, Applied
agreed to pay us $8.0 million and released us from all amounts owed or claimed to
be owed as of September 3, 2004 under a previous Settlement Agreement between
us dated May 4, 1997 (the TEOS Agreement), including Applieds claim that $3.5
million was owed by us. In addition, the MOU effected a change in the terms of
settlement under the TEOS Agreement to cause the license by Applied of U.S.
Patent No. 5,362,526 to us, and the cross-license of our CVD Patents and the
Applied CVD Patents (each as defined in the TEOS Agreement), in each case to be
fully-paid and royalty-free, except in limited circumstances. The MOU also
effected a change in the terms of settlement under the TEOS Agreement to
eliminate all rights of Applied to terminate the license based upon Novellus
merger or acquisition of or by other entities. Under the MOU, the parties also agreed to covenants not to sue each other for
specified periods, as well as notice and cure periods, each of which limits the
ability of the parties to bring patent infringement claims against the other
and the others customers, suppliers and distributors, regarding products
existing at September 3, 2004 and new products, subject to certain exceptions in
specified product areas and for certain suppliers to the parties. The MOU also
provides a general release of the patent claims covered by the MOU for periods
prior to September 3, 2004. Neither party admitted any liability in connection
with the settlement. For a detailed description of the specific terms and conditions of the MOU,
please refer to our Current Report on Form 8-K filed September 24, 2004 and the
attached Exhibit 99.1. The current quarter results include the cash receipt of $8.0 million and the
reversal of $8.1 million previously accrued as a result of the settlement of
litigation with Applied. 13




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Semitool, Inc. On October 11, 2004, we settled the pending patent litigation between us and
Semitool pursuant to the terms of a settlement agreement effective
October 8, 2004. Background of the Litigation On June 11, 2001, Semitool sued us for patent infringement in the United
States District Court for the District of Oregon. Semitool alleged that we
infringed one of Semitools patents related to copper electroplating. Semitool
sought an injunction against future infringement, damages for past
infringement, and treble damages for alleged willful infringement. On November
13, 2001, we countersued Semitool for patent infringement in the United States
District Court for the District of Oregon. We alleged that Semitool infringed
certain of our patents related to copper electroplating. We sought an
injunction against Semitool, damages for past infringement, and treble damages
for willful infringement by Semitool. Settlement On October 11, 2004, we entered into a settlement agreement with Semitool
that resolves all patent infringement claims at issue between us and Semitool.
We made a $2.9 million settlement payment to Semitool in accordance with the
terms of the settlement agreement. In addition, we agreed to covenants not to
sue Semitool for infringement of the four counterclaim patents we asserted in
the litigation based on acts prior to or after October 8, 2004 and Semitool
agreed to a covenant not to sue us for infringement of the patent Semitool
asserted in the litigation. This covenant not to sue is limited to the
activities where Semitool accused us of infringement prior to October 8, 2004.
The settlement agreement does not include any license of either partys
patents. Neither party admitted any liability in connection with the
settlement. Plasma Physics Corporation and Solar Physics Corporation On June 14, 2002, certain of our present and former customers  including
Agilent Technologies, Inc., Micron Technology, Inc., Agere Systems, Inc.,
National Semiconductor Corporation, Koninklijke Philips Electronics N.V., Texas
Instruments, Inc., ST Microelectronics, Inc., LSI Logic Corporation,
International Business Machines Corporation, Conexant Systems, Inc., Motorola,
Inc., Advanced Micro Devices, Inc. and Analog Devices Inc.  were sued for
patent infringement by Plasma Physics Corporation and Solar Physics
Corporation. We have not been sued by Plasma Physics, Solar Physics, or any
other party for infringement of any Plasma Physics or Solar Physics patent.
Certain defendants in the case, however, contend that we allegedly have
indemnification obligations and liability relating to these lawsuits. We
believe that these matters will not have a material adverse impact on our
business, financial condition, or results of operations. There can be no
assurance, however, that we will prevail in this lawsuit or in any other
lawsuit filed in connection with the alleged indemnification obligations. If
one or more parties were to prevail against us in such a suit and damages were
awarded, the adverse impact on our business, financial condition, or results of
operations could be material. 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 On March 12, 2002, Linear Technology Corporation filed a complaint against
Novellus, among other parties, in the Superior Court of the State of California
for the County of Santa Clara. The complaint sought damages (including punitive
damages), injunctions and declaratory relief for causes of action involving
alleged breach of contract, fraud, unfair competition and breach of warranty.
We filed a demurrer to Linears complaint, which the court granted on April 11,
2003, with leave to amend. On May 2, 2003, Linear filed a second amended
complaint. We filed a demurrer to Linears second amended complaint, which the
court granted on August 14, 2003, with leave to amend. On September 15, 2003,
Linear filed a third amended complaint. We filed a demurrer to Linears third
amended complaint, which the court granted on January 15, 2004, with leave to
amend. On January 28, 2004, Linear filed a fourth amended complaint. We filed a
demurrer to the fourth amended complaint on April 2, 2004. On July 7, 2004,
Linear filed a fifth amended complaint. We filed a demurrer to Linears fifth
amended complaint on September 3, 2004. On October 5, 2004, the Court granted
our demurrer on all causes of action without leave to amend. The Court has not
yet entered judgment in this case. Due to the uncertainty surrounding the
litigation process, we are unable to estimate a range of loss, if any, at this
time. Employment Litigation 14




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##### Table of Contents



On April 4, 2003, Thomas Graziani and others filed a class action lawsuit
against Novellus in the United States District Court for the District of
Oregon. On August 1, 2003, David Robinson and others filed a class action
lawsuit against Novellus in the United States District Court for the Northern
District of California, San Jose Division. Both lawsuits sought collective
and/or class action status for field service engineers who work for Novellus
and both lawsuits allege that field service engineers are entitled to
compensatory damages in the form of overtime pay, liquidated damages, interest
and attorneys fees and costs. At a mediation held on March 1, 2004, the
parties to both lawsuits agreed to a settlement to be documented on or before
April 2, 2004. Subsequently, the parties have agreed to the material terms of a
settlement, including a cap on exposure to Novellus of $2.5 million. On May 3,
2004, a fully executed agreement resolving these matters was filed with the
United States District Court for the Northern District of California. The court
approved the settlement on June 7, 2004. Novellus recorded a charge of $2.5
million during the three months ended March 27, 2004 related to the settlement. Other Litigation We are a defendant or plaintiff in various actions that arose in the normal
course of business. We believe that the ultimate disposition of these matters
will not have a material adverse effect on our business, financial condition or
results of operations. However, due to the uncertainty surrounding the
litigation process, we are unable to estimate a range of loss, if any, at this
time. 15




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ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements within
the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. All statements included in this Quarterly Report, other than statements
that are purely historical, are forward-looking statements. Words such as
anticipate, expect, intend, plan, believe, seek, estimate, and
similar expressions also identify forward-looking statements. Forward-looking
statements in this Quarterly Report include, without limitation: our estimated
amortization expense for each of the next five fiscal years; 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 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 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. Our expectations, beliefs, objectives, anticipations, intentions and strategies
regarding the future, including, without limitation, those concerning expected
operating results, revenues and earnings and current and potential litigation
are not guarantees of future performance and are subject to risks and
uncertainties that could cause actual results to differ materially from results
contemplated by the forward-looking statements including, but not limited to:
our failure to accurately evaluate the assumptions underlying our estimated
amortization expense for each of the next five fiscal years; shifting our focus
away from expansion of our market presence in Asia due to slower economic
development in the region; our inability to allocate substantial resources to
R&D, new products and enhancement of our current product lines; inaccuracies in
managements assessment of the amount of the Companys valuation allowance for
deferred tax assets; the inaccuracy of our beliefs regarding foreign exchange
contracts; our unanticipated need for additional liquid assets in the next
twelve months; 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 in this Item 2 of Part I, and are based on information available to us
on the date hereof. We assume no obligation to update any forward-looking
statements. Readers are cautioned not to place undue reliance on
forward-looking statements, which speak only as of the date of this Quarterly
Report on Form 10-Q. Readers should also consult the cautionary statements and
risk factors listed in our Annual Report on Form 10-K for the year ended
December 31, 2003 and in our other filings with the Securities and Exchange
Commission (SEC), including our Forms 10-Q and 8-K and our Annual Report to
Shareholders. 16




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##### Table of Contents



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 is a global supplier of semiconductor processing equipment used in the
fabrication of integrated circuits. We develop, manufacture, sell and service
equipment used by manufacturers of integrated circuits, or chips, who either
incorporate the chips in their own products or sell the chips to other
companies for use in electronic devices. Our goal is to use our expertise to
increase our market share and strengthen our position as a leading supplier of
semiconductor processing equipment. To accomplish this, we endeavor to provide
our customers with highly reliable products which help them compete effectively
in their business by reducing their costs and increasing their productivity. Our business depends on capital expenditures made by chip manufacturers, who in
turn are dependent on corporate and consumer demand for chips and the products
which use them. The industry in which we operate is driven by spending for
electronic products. As a consequence, our business is affected by growth or
contraction in the global economy as well as by the adoption of new
technologies. Demand for personal computers, the expansion of the Internet and
telecommunications industries, and the emergence of new applications in
consumer electronics have an impact on our business. In addition, the industry
is characterized by intense competition and rapidly changing technology. We
have continued to work closely with our customers and have made 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 focus on certain key quarterly financial data to manage our business. Net
sales, gross profit, net income (loss) and net income (loss) per share are the
primary measures we use to monitor performance. Net orders are used to forecast
and plan future operations. 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 Data2004
    
    2003First
    
    Second
    
    Third
    
    First
    
    Second
    
    Third
    
    FourthQuarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    QuarterNet sales
    
    $
    262,862
    
    
    $
    338,219
    
    
    $
    415,935
    
    
    $
    238,410
    
    
    $
    239,050
    
    
    $
    221,099
    
    
    $
    226,511Gross profit
    
    
    124,605
    
    
    
    169,680
    
    
    
    201,111
    
    
    
    109,814
    
    
    
    105,322
    
    
    
    58,776
    
    
    
    106,088Net income (loss)
    
    
    16,681
    
    
    
    37,811
    
    
    
    64,662
    
    
    
    11,872
    
    
    
    7,430
    
    
    
    (97,568
    )
    
    
    10,452Diluted net income (loss) per share
    
    
    0.11
    
    
    
    0.25
    
    
    
    0.45
    
    
    
    0.08
    
    
    
    0.05
    
    
    
    (0.64
    )
    
    
    0.07Net orders
    
    
    346,793
    
    
    
    397,598
    
    
    
    422,692
    
    
    
    241,825
    
    
    
    198,759
    
    
    
    220,775
    
    
    
    275,219
 17




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##### Table of Contents



The semiconductor equipment industry is subject to cyclical conditions, which
play a major role in the fluctuations in demand, as defined by net orders.
These fluctuations, in turn, affect our net sales. Net orders during the first
three quarters of 2003 were sequentially volatile with a 10% increase in the
first quarter, an 18% decrease in the second quarter, and an 11% increase in
the third quarter, reflecting uncertainty in the demand for semiconductor
devices. In the fourth quarter of 2003, we experienced a 25% sequential
increase in net orders. The net order growth in the fourth quarter was driven
primarily by strengthening demand for corporate and consumer electronic
devices, which resulted in an increase in our customers capacity utilization.
In addition, we experienced increased demand as a result of our customers
transition to 300 mm fabrication equipment. In the first, second and third
quarters of 2004, we experienced sequential increases of 26%, 15% and 6% in net
orders, respectively. The receipt of net orders in a particular quarter affects revenue in subsequent
quarters. Net orders turn to revenue either at shipment or upon customer
acceptance of the equipment. Our revenue recognition policy addresses the
distinction between revenue recognized upon shipment and revenue recognized
upon customer acceptance. Equipment generally ships within two or three months
of receiving the related order and if applicable, customer acceptance is
typically received three to six months after shipment. These time lines are
general estimates and actual times may vary depending on specific
circumstances. Results of Operations
(dollars in thousands) 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 September 25, 2004
include the financial position, results of operations and cash flows of Peter
Wolters from June 28, 2004. Net Sales Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003Net sales
    
    $
    415,935
    
    
    $
    221,099
    
    
    $
    338,219
    
    
    $
    1,017,016
    
    
    $
    698,559International net sales %
    
    
    78
    %
    
    
    67
    %
    
    
    79
    %
    
    
    78
    %
    
    
    62
    %
 The increase in net sales of $194.8 million for the three months ended
September 25, 2004 from the prior year period is primarily due to increased
volume. The increase in volume was a result of increased capital spending by
our customers as demand for semiconductor devices increased. Geographical net sales as a percentage of total net sales were as follows
(based upon the location of the customers facilities): Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003North America
    
    
    22
    %
    
    
    33
    %
    
    
    21
    %
    
    
    22
    %
    
    
    38
    %Europe
    
    
    11
    %
    
    
    10
    %
    
    
    6
    %
    
    
    9
    %
    
    
    10
    %Asia
    
    
    67
    %
    
    
    57
    %
    
    
    73
    %
    
    
    69
    %
    
    
    52
    %
 The increase in international net sales (sales outside North America) as a
percentage of net sales for the three months ended September 25, 2004 over the
prior year is predominantly due to an increase in net sales in the Asia region
compared to the net sales of North America. We consider the Asia region to
consist of Korea, Japan, Singapore, China and Taiwan. A significant portion of
our net sales is generated in Asia, primarily because a substantial portion of
the worlds semiconductor manufacturing capacity is located there. We plan to
continue to focus on expanding our market presence in Asia, as we believe that
significant additional growth potential exists in this region over the long
term. Gross Profit Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003Gross profit
    
    $
    201,111
    
    
    $
    58,776
    
    
    $
    169,680
    
    
    $
    495,396
    
    
    $
    273,912% of net sales
    
    
    48.4
    %
    
    
    26.6
    %
    
    
    50.2
    %
    
    
    48.7
    %
    
    
    39.2
    %
 Our gross profit from period to period is affected by the treatment of certain
product sales in accordance with Securities and Exchange 18




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##### Table of Contents



Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue
Recognition, which superseded the earlier related guidance in SAB No. 101,
Revenue Recognition in Financial Statements, or SAB 101. For these sales, we
recognize all of a products cost upon shipment even though a portion of a
products revenue may be deferred until final payment is due, typically upon
customer acceptance. The decline in gross profit percentage in the three and nine months ended
September 27, 2003 is primarily due to our $44.0 million write-down of
inventory. In the third quarter of 2003, changes in the industry and our
worldwide distribution system resulted in revisions to forecasted demand. These
changes resulted in a portion of our inventory becoming excess or obsolete.
Without this charge, gross margin for the three and nine months ended September
27, 2003 would have been 46%. The increase in gross profit percentage in the
three months ended September 25, 2004 from the prior year comparable periods is
also attributable to product mix and to increased absorption of our fixed
overhead costs from higher shipment levels. Sales of inventory previously
written down resulted in a credit to cost of sales of approximately $2.8
million in the three months ended September 25, 2004, which positively impacted
our gross profit by seven-tenths of one percent. In the second quarter of
2004, sales of inventory previously written down resulted in a credit to cost
of sales of approximately $3.6 million, which positively impacted our gross
profit by one percent. In the comparable prior year periods, sales of
previously reserved inventory did not have a material effect on the margin in
absolute dollars or as a percentage of net sales. Selling, General and Administrative (SG&A) Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003SG&A expense
    
    $
    49,585
    
    
    $
    40,123
    
    
    $
    47,225
    
    
    $
    139,213
    
    
    $
    127,197% of net sales
    
    
    12
    %
    
    
    18
    %
    
    
    14
    %
    
    
    14
    %
    
    
    18
    %
 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 expenses, in absolute dollars, is primarily due to the
consolidation of Peter Wolters AG and higher selling costs, as well as higher
profit sharing and employee-related expenses. This increase was partially
offset by a credit to SG&A of $8.1 million for the reversal of amounts
previously accrued in connection with our legal settlement with Applied
Materials, Inc. The decrease in SG&A expense as a percentage of net sales is
primarily due to an increase in net sales. Research and Development (R&D) Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003R&D expense
    
    $
    68,202
    
    
    $
    59,858
    
    
    $
    63,471
    
    
    $
    190,630
    
    
    $
    173,374% of net sales
    
    
    16
    %
    
    
    27
    %
    
    
    19
    %
    
    
    19
    %
    
    
    25
    %
 R&D expense includes compensation and benefits for our research and development
personnel, project materials, chemicals and other direct expenses incurred in
product and technology development. Also included are expenses for equipment
repairs and maintenance, rents, utilities, depreciation, and amortization
expense associated with patents and purchased technologies. Our significant
investments in R&D over the past several years reflect our strong commitment to
the continuous improvement of our current product lines and the development of
new products and technologies. 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. R&D expense as a percentage of net sales for the three and nine months ended
September 25, 2004 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 three and nine months ended September 25, 2004 from
the prior-year period is a result of the consolidation of Peter Wolters AG,
increased usage of project materials and increased profit sharing expense. Restructuring and Other Charges Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003Restructuring and other charges
    
    $
    (923
    )
    
    $
    15,838
    
    
    $
    
    
    
    $
    (923
    )
    
    $
    15,838% of net sales
    
    
    
    %
    
    
    8
    %
    
    
    
    %
    
    
    
    %
    
    
    3
    %
 19




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The reversal of $0.9 million during the quarter ended September 25, 2004 is
primarily related to a revision in future estimated sublease income in
connection with a facility related charge in a previous restructuring. The $15.8 million restructuring and other charges in the three and nine months
ended September 27, 2003 consisted of $7.9 million for asset write-offs
(including fixed assets and purchased technology), $4.1 million for facilities
and $3.8 million for severance. The asset write-offs, facilities charges, and
severance charges were recorded in connection with activities undertaken to
align our cost structure with current business conditions. Legal Settlement Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003Legal settlement
    
    $
    2,900
    
    
    $
    2,691
    
    
    $
    
    
    
    $
    5,400
    
    
    $
    2,691% of net sales
    
    
    1
    %
    
    
    1
    %
    
    
    
    %
    
    
    1
    %
    
    
    
    %
 The current quarter results included a $2.9 million legal settlement related to
the Semitool litigation matter. For the quarter ended September 27, 2003, we
incurred a charge of $2.7 million. No such legal charges were incurred in the
second quarter of 2004. During the quarter ended March 27, 2004, we incurred a
charge totaling $2.5 million related to the settlement of a class action
lawsuit by field service engineers relating to overtime compensation. Acquired in-process research and development Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003Acquired in-process research
and development
    
    $
    
    
    
    $
    
    
    
    $
    6,124
    
    
    $
    6,124
    
    
    $
    % of net sales
    
    
    
    %
    
    
    
    %
    
    
    2
    %
    
    
    1
    %
    
    
    
    %
 During the quarter ended June 26, 2004, we incurred a charge totaling $6.1
million for acquired in-process research and development in connection with the
acquisition of Angstron Systems, Inc. We incurred no such charges in the other
periods presented. Interest and Other Income, Net Three Months Ended
    
    Nine Months EndedSeptember 25, 2004
    
    September 27, 2003
    
    June 26, 2004
    
    September 25, 2004
    
    September 27, 2003Interest and other income, net
    
    $
    9,726
    
    
    $
    2,722
    
    
    $
    2,896
    
    
    $
    15,371
    
    
    $
    13,911% of net sales
    
    
    2
    %
    
    
    1
    %
    
    
    1
    %
    
    
    2
    %
    
    
    2
    %
 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 three months ended September 25, 2004 compared to the
three months ended September 27, 2003 is primarily due to the cash receipt of
$8.0 million in connection with the settlement of the Applied Materials, Inc.
litigation. This was partially offset by interest expense on long term debt of
$0.9 million and lower balances of interest-bearing cash and short-term
investments and lower interest rates in the first three quarters of 2004. Lower
cash and investment balances resulted mainly from repurchases of our common
stock during the nine months ended September 25, 2004. The exercise of our
purchase option on properties previously leased under synthetic leases during
the quarter ended September 27, 2003 reduced our interest income by $6.0
million for the nine months ended September 25, 2004 as compared to the
prior-year period. Income Taxes Our effective tax rates were 29% and 39% for the three months ended September
25, 2004 and September 27, 2003. Our effective tax rates on income excluding
the in-process R&D charge, which is non-deductible, were 29% and 50% for the
nine months ended September 25, 2004 and September 27, 2003, respectively. The
difference in the effective tax rate in 2004 as compared to 2003 is primarily
due to the benefit of tax credits against the expected provision for income
taxes in 2004 versus the benefit of tax credits in relation to a loss in 2003.
Our future effective income tax rate depends on various factors, such as our
income (loss) before taxes, potential changes in tax legislation, the
geographic composition of pre-tax income and non-deductible expenses incurred
in connection with acquisitions. 20




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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 We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104,
Revenue Recognition, or SAB 104, which superseded the earlier related
guidance in SAB 101. We recognize revenue when persuasive evidence of an
arrangement exists, delivery has occurred or services have been rendered, the
sellers price is fixed or determinable, and collectibility is reasonably
assured. Certain of our equipment sales are accounted for as multiple-element
arrangements. A multiple-element arrangement is a transaction which may involve
the delivery or performance of multiple products, services, or rights to use
assets, and performance may occur at different points in time or over different
periods of time. Our equipment sales generally have two elements: 1) delivery
of the equipment and 2) installation of the equipment and customer acceptance.
If we have met defined customer acceptance experience levels with both the
customer and the specific type of equipment, we recognize revenue for the
equipment element upon shipment and transfer of title, with the installation
and acceptance element recognized at customer acceptance. All other equipment
sales are recognized upon customer acceptance. Installation services are not essential to the functionality of the delivered
equipment. As provided for in EITF 00-21, Revenue Arrangements with Multiple
Deliverables, we allocate revenue based on the residual method as a fair value
has been established for installation services. However, since final payment is
not typically billable until customer acceptance, we defer revenue for the
final payment until customer acceptance. Revenue related to sales of spare parts is recognized upon shipment. Revenue
related to maintenance and service contracts is recognized ratably over the
duration of the contracts. Unearned maintenance and service contract revenue is
included in other accrued liabilities. Inventory Valuation We periodically assess the recoverability of all inventories, including raw
materials, work-in-process, finished goods, and spare parts, to determine
whether adjustments for impairment are required. Inventory that is obsolete or
in excess of our forecasted usage is written down to its estimated realizable
value based on assumptions about future demand and market conditions. If actual
demand is lower than our forecast, additional inventory write-downs may be
required. Goodwill and Other Intangible Assets We account for goodwill and other intangible assets in accordance with
Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets, or SFAS No. 142. SFAS No. 142 requires that goodwill and
identifiable intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually. SFAS No. 142
also requires that intangible assets with estimable useful lives be amortized
over their respective estimated useful lives to their estimated residual
values, and reviewed for impairment in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. We review our long-lived assets, including goodwill and other intangible
assets, for impairment at least annually or whenever events or changes in
circumstances indicate that the carrying amount of these assets may not be
recoverable. According to our policy, we completed goodwill impairment tests in
the third and fourth quarters of 2003. The test performed in the third quarter
was completed in 21




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##### Table of Contents



connection with our restructuring plan implemented in that quarter. Our annual
goodwill impairment test was completed in the fourth quarter of 2003. 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 September 25, 2004, we had
approximately $171.4 million of deferred tax assets, net of a valuation
allowance of $75.0 million principally related to acquired net operating loss
carryforwards and foreign tax credits that are not realizable until 2006 and
beyond. The valuation allowance includes $38.0 million related to acquired
deferred tax assets of SpeedFam-IPEC, which will be credited to goodwill when
realized, and $26.5 million related to stock option deductions, which will be
credited to equity when realized. Management believes the majority of deferred
tax assets will be realized due to anticipated future income. We have
considered future taxable income and ongoing prudent and feasible tax planning
strategies in assessing the need for the valuation allowance. If in the future
we determine that we would not be able to realize all or part of our net
deferred tax assets, an increase to the valuation allowance for deferred tax
assets would decrease income in the period in which such determination is made. Warranty Obligations Our warranty policy generally states that we will provide warranty coverage for
a predetermined amount of time on systems and modules for material and labor to
repair and service the equipment. We record the estimated cost of warranty
coverage to cost of sales upon system shipment. The estimated cost of warranty
is determined by the warranty term, as well as the average historical labor and
material costs for a specific product. Should actual product failure rates or
material usage differ from our estimates, revisions to the estimated warranty
liability may be required. These revisions could have a positive or negative
impact on gross profit. We review the actual product failure rates and material
usage rates on a quarterly basis and adjust our warranty liability as
necessary. Restructuring and Impairment Charges Restructuring activities initiated prior to December 31, 2002 were recorded in
accordance with Emerging Issues Task Force Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity (Including Certain Costs Incurred in a Restructuring), and
restructuring activities after December 31, 2002 were recorded under the
provisions of SFAS No. 146, Accounting for Costs Associated with Exit or
Disposal Activities, or SFAS No. 146; SFAS No. 112, Employers Accounting for
Postemployment Benefits; and SAB 100, Restructuring and Impairment Charges,
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
2004 and 2003, these hedging contracts were denominated primarily in the
Japanese Yen, Taiwanese Dollar, and Korean Won. The forward foreign exchange
contracts we use are 22




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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 September 25, 2004 consisted of $510.4 million of
cash, cash equivalents and short-term investments. This amount represents a
decrease of $491.7 million from $1,002.1 million at December 31, 2003. The
decrease was due primarily to the repurchase of common stock for $401.7
million, offset by net cash provided by operating activities of $80.9 million. Net cash provided by operating activities during the nine months ended
September 25, 2004 was $80.9 million. This amount consisted primarily of $119.2
million provided by net income, adjusted for non-cash items. The net changes in
working capital accounts used $85.3 million. Net cash used in investing activities for the nine months ended September 25,
2004 was $291.3 million, which consisted primarily of purchases of short-term
investments of $765.2 million, offset by proceeds from short-term investment
sales and maturities of $812.0 million. As of September 25, 2004, we had no
significant commitments to purchase property or equipment, except for
additional capital expenditures to enhance the functionality of our enterprise
resource management system. Net cash used in financing activities for the nine months ended September 25,
2004 was $234.9 million, primarily for the repurchase of common stock for
$401.7 million and net payments on lines of credit of $7.6 million, offset by
the proceeds from employee stock compensation plans of $21.2 million and
proceeds from long-term debt of $153.1 million. Effective June 25, 2004, two of our European subsidiaries entered into a credit
arrangement that allowed for borrowing up to $153.1 million. On June 28, 2004,
we borrowed the entire amount available to fund the acquisition of Peter
Wolters AG and for general corporate purposes. Borrowings are secured by cash
or marketable securities on deposit and included within restricted cash on the
consolidated balance sheet. As of September 25, 2004, the entire principal
amount of the loan was outstanding. All borrowings under the credit
arrangement are due and payable on or before June 25, 2009. Our subsidiaries in Asia and Europe have lines of credit with various banks
with total borrowing capacity of $53.5 million. The lines of credit bear
interest at various rates, expire on various dates through June 2009 and can be
used for general operating purposes. Borrowings of $5.6 million were
outstanding under these credit facilities as of September 25, 2004. 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 $234,000 and $664,000
for the three and nine months ended September 25, 2004, respectively, and
approximately $227,000 and $606,000 for the three and nine months ended
September 27, 2003, respectively. Mr. Hill is a member of the Board of Directors of LTX Corporation. We recorded
sublease income from LTX Corporation of approximately $351,000 for the three
months ended September 25, 2004 and September 27, 2003 and approximately
$1,052,000 for the nine months ended September 25, 2004 and September 27, 2003. During the quarter ended September 27, 2003, a member of our Board of
Directors, D. James Guzy, was also a member of the Board of Directors of Intel
Corporation, one of our significant customers. Mr. Guzy did not stand for
re-election to the Board of Directors at our 2004 Annual Meeting of
Shareholders and was named Director Emeritus as of April 16, 2004. Sales to
Intel represented approximately 10.0% for the three and nine months ended
September 27, 2003. Intel also accounted for 6.0% of our accounts receivable as
of December 31, 2003. 23




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From time to time, we have made secured relocation loans to our executive
officers, vice presidents and other key personnel. As of September 25, 2004, we
had no outstanding loans to our executive officers as defined by the Securities
and Exchange Commission. However, we had outstanding loans to non-executive
officers and other key personnel. As of September 25, 2004 and December 31,
2003, the total outstanding balances of loans to non-executive officers and
other key personnel were approximately $5.0 million and $5.7 million,
respectively. Of the total amount outstanding at September 25, 2004, $3.9
million was secured by collateral. 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. Cyclical Downturns in the Semiconductor Industry Our business depends predominantly on the capital expenditures of semiconductor
manufacturers, which in turn depend on current and anticipated market demand
for integrated circuits and the products that use them. The semiconductor
industry has historically been very cyclical and has experienced periodic
downturns that have had a material adverse effect on the demand for
semiconductor processing equipment, including equipment that we manufacture and
market. During periods of reduced and declining demand, we must be able to
quickly and effectively align our costs with prevailing market conditions, as
well as motivate and retain key employees. In particular, our inventory levels
during periods of reduced demand have at times reached higher-than-necessary
levels relative to the current levels of production demand. We cannot provide
any assurance that we may not be required to make inventory valuation
adjustments in future periods. During periods of rapid growth, we must be able
to acquire and/or develop sufficient manufacturing capacity to meet customer
demand, and hire and assimilate a sufficient number of qualified people. We
cannot give assurances that our net sales and operating results will not be
adversely affected if the current downturn in the semiconductor industry
continues, or if other downturns or slowdowns in the rate of capital investment
in the semiconductor industry occur in the future. Competitive and Capital-Intensive Nature of the Semiconductor Industry We face substantial competition in the industry, from both potential new market
entrants as well as established competitors. Some companies may have greater
financial, marketing, technical or other resources than we do, as well as
broader product lines, greater customer service capabilities, or larger and
more established sales organizations and customer bases. Remaining competitive
in the market depends in part upon our ability to develop new and enhanced
systems and to introduce them at competitive prices on a timely basis. Our
customers must incur substantial expenditures to install and integrate capital
equipment into their semiconductor production lines. Once a manufacturer has
selected a vendors capital equipment for a particular product line, the
manufacturer is likely to continue with the selected equipment vendor for that
specific application at that location. Accordingly, we may experience
difficulty in selling a product to a particular customer for a significant
period of time after that customer has selected a competitors product. In
addition, sales of our systems depend in significant part upon a prospective
customers decision to increase or expand manufacturing capacity  both of
which typically involve a significant capital commitment. From time to time, we
have experienced delays in finalizing system sales following initial system
qualification. Due to these and other factors, our systems typically have a
lengthy sales cycle, during which we may expend substantial funds and
management effort. Rapidly Changing Technology We devote a significant portion of our personnel and financial resources to
research and development programs, and we seek to maintain close relationships
with our customers in order to remain responsive to their product needs. As is
typical in the semiconductor capital equipment market, we have experienced
delays from time to time in the introduction of and certain technical and
manufacturing difficulties with certain of our products and product
enhancements. In addition, we may experience delays and technical and
manufacturing difficulties in future introductions or volume production of our
new systems or enhancements. Our success in developing, introducing and selling new and enhanced systems
depends upon a variety of factors, including product selection, timely and
efficient completion of product design and development and implementation of
manufacturing and assembly processes, product performance in the field, and
effective sales and marketing. There can be no assurance that we will be
successful in selecting, developing, manufacturing and marketing new products,
or in enhancing our existing products. In addition, we could incur substantial
unanticipated costs to ensure the functionality and reliability of our future
product introductions early in their product life cycles. If new products have
reliability or quality problems, reduced orders, or higher manufacturing costs,
delays in collecting 24




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accounts receivable and additional service and warranty expenses may result.
Any of these events could materially adversely affect our business, financial
condition or results of operations. International Operations Export sales currently account for a significant portion of our net sales. This
trend is expected to continue in the foreseeable future. As a result, a
significant portion of our sales is subject to certain risks, including, but
not limited to:  
    
    Tariffs and other trade barriers;
    
    Challenges in staffing and managing foreign operations;
    
    Difficulties in managing foreign distributors;
    
    Potentially adverse tax consequences;
    
    Imposition of legislation and regulations relating to the import or
export of semiconductor products, either by the United States or other
countries;
    
    Periodic economic downturns;
    
    Political instability; and
    
    Fluctuations in interest and foreign currency exchange rates,
creating the need to enter into forward foreign exchange contracts to
hedge against the short-term impact of foreign currency fluctuations,
specifically yen-denominated transactions. There can be no assurance that any of these factors or the adoption of
restrictive policies will not have a material adverse effect on our business,
financial condition or results of operations. In addition, each region in the
global semiconductor equipment market exhibits unique market characteristics
that can cause capital equipment investment patterns to vary significantly from
period to period. We derive a substantial portion of our revenues from
customers in Asia. Any negative economic developments in Asia could result in
the cancellation or delay by Asian customers of orders for our products, which
could adversely affect our business, financial condition or results of
operations. Variability of Quarterly Operating Results We have experienced and expect to continue experiencing significant
fluctuations in our quarterly operating results. These fluctuations are due to
a number of factors that include, but are not limited to:  
    
    Building our systems according to forecast, and not using limited
backlog information, which hinders our ability to plan production and
inventory levels;
    
    Failure to receive anticipated orders in time to permit shipment during the quarter;
    
    Customers rescheduling or canceling shipments;
    
    Manufacturing difficulties;
    
    Customers deferring orders of our existing products due to new product announcements by us and/or our competitors;
    
    Overall business conditions in the semiconductor equipment industry; and
    
    Variations in quarterly operating results or changes in analysts
earnings estimates which may subject the price of our common stock to
wide fluctuations and possible rapid increases or decreases in a short
time period. Acquisitions 25




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We have madeand may in the future makeacquisitions of or significant
investments in businesses with complementary products, services and/or
technologies. Acquisitions involve numerous risks, including, but not limited
to:  
    
    Difficulties in integrating the operations, technologies, products and personnel of acquired companies;
    
    Lack of synergies or the inability to realize expected synergies;
    
    Revenue and expense levels of acquired entities differing from those anticipated at the time of the acquisitions;
    
    Difficulties in managing geographically dispersed operations;
    
    The potential loss of key employees, customers and strategic partners of acquired companies;
    
    Diversion of managements attention from normal daily operations of the business; and
    
    The impairment of acquired intangible assets as a result of
technological advancements, or worse-than-expected performance of
acquired companies. Acquisitions are inherently risky, and we cannot provide any assurance that our
previous or future acquisitions will be successful. The inability to
effectively manage the risks associated with previous or future acquisitions
could materially and adversely affect our business, financial condition or
results of operations. 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. In addition, we believe
that sales to certain of our customers will decrease in the near future as they
complete current purchasing requirements for new or expanded fabrication
facilities. Although the composition of the group comprising our largest
customers varies from year to year, the loss of a significant customer or any
reduction in orders from any significant customer  including reductions due to
customer departures from recent buying patterns, as well as economic or
competitive conditions in the semiconductor industry  could adversely affect
our business, financial condition or results of operations. Intellectual Property We intend to continue to seek legal protection, primarily through patents and
trade secrets, for our proprietary technology. There can be no assurance that
patents will be issued from any pending applications, or that any claims
allowed from existing or pending patents will be sufficiently broad to protect
our proprietary technology. There is also no guarantee that any patents we hold
will not be challenged, invalidated or circumvented, or that the rights granted
thereunder will provide competitive advantages to us. We also cannot provide
assurance that the confidentiality agreements we enter into with employees,
consultants and other parties will not be breached. We are currently involved in a number of legal disputes regarding patent and
other intellectual property rights. Except as set forth in Part II: Other
Information, Item 1: Legal Proceedings in this document, we are not aware of
any significant claim of infringement by our products of any patent or
proprietary rights of others. Adverse outcomes in current or future legal
disputes could result in the loss of our proprietary rights, subject the
Company to significant liabilities to third parties, require us to seek
licenses from third parties, or prevent us from manufacturing or selling our
products. Any of these circumstances could have a material adverse effect on
our business, financial condition or results of operations. Supply Shortages We use numerous suppliers to obtain parts, components and sub-assemblies for
the manufacture and support of our products. Although we make reasonable
efforts to ensure that such parts are available from multiple suppliers,
certain key parts may only be obtained from single or limited sources. These
suppliers are in some cases thinly capitalized, independent companies who
derive a significant amount of their business from us and/or a small group of
other companies in the semiconductor industry. We seek to 26




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reduce our dependence on this limited group of suppliers. However, disruption
or termination of certain of these suppliers may occur. Such disruptions could
have an adverse effect on our operations. A prolonged inability to obtain
certain parts could have a material adverse effect on our business, financial
condition or results of operations, and could result in our inability to meet
customer demands on time. Compliance with Internal Control Attestation and Outside Audit Firm
Independence Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our
year ending December 31, 2004, we will be required to include in our annual
report our assessment of the effectiveness of our internal control over
financial reporting and our audited financial statements as of the end of 2004.
Furthermore, our independent registered public accounting firm will be required
to attest to whether our assessment of the effectiveness of our internal
control over financial reporting is fairly stated in all material respects and
separately report on whether it believes we maintained, in all material
respects, effective internal control over financial reporting as of December
31, 2004. If we fail to timely complete our assessment, or if our independent
registered public accounting firm cannot timely attest to our assessment, we
could be subject to regulatory sanctions and a loss of public confidence in our
internal control. In addition, any failure to implement required new or
improved controls, or difficulties encountered in their implementation, could
harm our operating results or cause us to fail to timely meet our regulatory
reporting obligations. Our independent registered public accounting firm communicates with us
at least annually regarding any relationships between the firm and Novellus
that, in the firms professional judgment, might have a bearing on the firms
independence with respect to Novellus. If our
independent registered public accounting firm finds that it cannot confirm that
it is independent of Novellus based on existing securities laws and
registered public accounting firm independence standards, we could experience
delays or otherwise fail to meet our regulatory reporting obligations. In this regard, our independent registered public accounting firm has
advised us that its affiliate offices in 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 our registered
public accounting firm, are assessing the impact of this matter on our
accounting firms independence with respect to Novellus. Third-Party Indemnification From time to time, in the normal course of business, we indemnify third parties
with whom we enter into contractual relationships, including customers,
lessors, and parties to other transactions with us, with respect to certain
matters. We have agreed, under certain conditions, to hold these third parties
harmless against specified losses, such as those arising from a breach of
representations or covenants, other third party claims that our products when
used for their intended purposes infringe the intellectual property rights of
such other third parties or other claims made against certain parties. It is
not possible to determine the maximum potential amount of liability under these
indemnification obligations due to our limited history of prior indemnification
claims and the unique facts and circumstances that are likely to be involved in
each particular claim. Historically, payments made by us under these
obligations have not been material. Changes in Accounting Standards For Stock Option Plans The Financial Accounting Standards Board is encouraging all companies to treat
the value of stock options granted to employees as an expense. The U.S.
Congress and other governmental and regulatory authorities have also considered
requiring companies to expense stock options. If this change were to become
mandatory, we and other companies would be required to record a compensation
expense equal to the value of each stock option granted. This expense would
likely be recognized over the vesting period of the stock option. Currently, we
are generally not required to record compensation expenses in connection with
stock option grants. If we are required to expense stock option grants, it
would reduce the attractiveness of granting stock options because the
additional expense associated with these grants would reduce our profitability.
However, stock options are 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. Accordingly, in the event we
are required to expense stock option grants, our profitability would be
reduced, as would our ability to use stock options as an employee recruitment
and retention tool. 
 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,
2003. Our exposure related to market risk has not changed materially since
December 31, 2003. 27




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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 accounting principles generally accepted in the
United States of America. 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 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 28




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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
accounting principles generally accepted in the United States of America. 
 PART II: OTHER INFORMATION 
 ITEM 1: LEGAL PROCEEDINGS The following identifies the litigation matters for which a material
development has occurred during the three months ended September 25, 2004. For
more detailed information on litigation matters outstanding please see Note 11,
Litigation in our Annual Report on Form 10-K for the year ended December 31,
2003 and Item 1 Legal Proceedings of Part II of our Quarterly Reports on Form
10-Q for the quarters ended March 27, 2004 and June 26, 2004. Applied Materials, Inc. On September 20, 2004, we settled all pending patent litigation between us and
Applied Materials, Inc. by entering into a Binding Memorandum of
Understanding, referred to herein as an MOU, with Applied. The MOU became
effective as of September 3, 2004. Background of the Litigation On June 13, 1997, we acquired the Thin Film Systems (TFS) business of Varian
Associates, Inc. On the same day, Applied sued Varian in the United States
District Court for the Northern District of California for alleged patent
infringement concerning several of its physical vapor deposition, or PVD,
patents (the Applied Patents). On June 23, 1997, we sued Applied in the United
States District Court for the Northern District of California, claiming
infringement by Applied of several of our PVD patents acquired from Varian in
the TFS business acquisition. On July 7, 1997, Applied amended its complaint
in its suit against Varian to add Novellus as a defendant. We requested that
the Court dismiss us as a defendant in this suit. 29




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The relief requested by Applied in both suits included a permanent injunction
against future infringement, damages for alleged past infringement and treble
damages for alleged willful infringement. Trial had been set to commence on
September 20, 2004. Settlement Under the terms of the MOU, all then pending patent litigation between us and
Applied was dismissed with prejudice. As part of the settlement, Applied
agreed to pay us $8.0 million and released us from all amounts owed or claimed to
be owed as of September 3, 2004 under a previous Settlement Agreement between
us dated May 4, 1997 (the TEOS Agreement), including Applieds claim that $3.5
million was owed by us. In addition, the MOU effected a change in the terms of
settlement under the TEOS Agreement to cause the license by Applied of U.S.
Patent No. 5,362,526 to us, and the cross-license of our CVD Patents and the
Applied CVD Patents (each as defined in the TEOS Agreement), in each case to be
fully-paid and royalty-free, except in limited circumstances. The MOU also
effected a change in the terms of settlement under the TEOS Agreement to
eliminate all rights of Applied to terminate the license based upon Novellus
merger or acquisition of or by other entities. Under the MOU, the parties also agreed to covenants not to sue each other for
specified periods, as well as notice and cure periods, each of which limits the
ability of the parties to bring patent infringement claims against the other
and the others customers, suppliers and distributors, regarding products
existing at September 3, 2004 and new products, subject to certain exceptions in
specified product areas and for certain suppliers to the parties. The MOU also
provides a general release of the patent claims covered by the MOU for periods
prior to September 3, 2004. Neither party admitted any liability in connection
with the settlement. For a detailed description of the specific terms and conditions of the MOU,
please refer to our Current Report on Form 8-K filed September 24, 2004 and the
attached Exhibit 99.1. The current quarter results include the cash receipt of $8.0 million and the
reversal of $8.1 million previously accrued as a result of the settlement of
litigation with Applied. Semitool, Inc. On October 11, 2004, we settled the pending patent litigation between us and
Semitool, Inc. pursuant to the terms of a settlement agreement effective
October 8, 2004. Background of the Litigation On June 11, 2001, Semitool sued us for patent infringement in the United
States District Court for the District of Oregon. Semitool alleged that we
infringed one of Semitools patents related to copper electroplating. Semitool
sought an injunction against future infringement, damages for past
infringement, and treble damages for alleged willful infringement. On November
13, 2001, we countersued Semitool for patent infringement in the United States
District Court for the District of Oregon. We alleged that Semitool infringed
certain of our patents related to copper electroplating. We sought an
injunction against Semitool, damages for past infringement, and treble damages
for willful infringement by Semitool. Settlement On October 11, 2004, we entered into a settlement agreement with Semitool
that resolves all patent infringement claims at issue between us and Semitool.
We made a $2.9 million settlement payment to Semitool in accordance with the
terms of the settlement agreement. In addition, we agreed to covenants not to
sue Semitool for infringement of the four counterclaim patents we asserted in
the litigation based on acts prior to or after October 8, 2004 and Semitool
agreed to a covenant not to sue us for infringement of the patent Semitool
asserted in the litigation. This covenant not to sue is limited to the
activities where Semitool accused us of infringement prior to October 8, 2004.
The settlement agreement does not include any license of either partys
patents. Neither party admitted any liability in connection with the
settlement. Linear Technology Corporation On March 12, 2002, Linear Technology Corporation filed a complaint against
Novellus, among other parties, in the Superior Court of the State of California
for the County of Santa Clara. The complaint sought damages (including punitive
damages), injunctions and declaratory relief for causes of action involving
alleged breach of contract, fraud, unfair competition and breach of warranty.
We filed a demurrer to Linears complaint, which the court granted on April 11,
2003, with leave to amend. On May 2, 2003, Linear filed a 30




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second amended complaint. We filed a demurrer to Linears second amended
complaint, which the court granted on August 14, 2003, with leave to amend. On
September 15, 2003, Linear filed a third amended complaint. We filed a demurrer
to Linears third amended complaint, which the court granted on January 15,
2004, with leave to amend. On January 28, 2004, Linear filed a fourth amended
complaint. We filed a demurrer to the fourth amended complaint on April 2,
2004. On July 7, 2004, Linear filed a fifth amended complaint. We filed a
demurrer to Linears fifth amended complaint on September 3, 2004. On October
5, 2004, the Court granted our demurrer on all causes of action without leave
to amend. The Court has not yet entered judgment in this case. Due to the
uncertainty surrounding the litigation process, we are unable to estimate a
range of loss, if any, at this time. 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 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS TotalNumber of
    
    ApproximateShares
    
    Dollar ValuePurchased
    
    of Sharesas Part of
    
    that May YetTotal
    
    
    
    
    
    Publicly
    
    Be PurchasedNumber of
    
    Average Price
    
    Announced
    
    Under theShares
    
    Paid per
    
    Plans or
    
    Plans orPeriod
    
    Purchased
    
    Share
    
    Programs
    
    ProgramsJanuary 1, 2004 to January 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    February 1, 2004 to February 28, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $500.0 millionFebruary 29, 2004 to March 27, 2004
    
    
    500,000
    
    
    $
    30.53
    
    
    
    500,000
    
    
    $484.7 millionMarch 28, 2004 to May 1, 2004
    
    
    5,409,429
    
    
    $
    30.41
    
    
    
    5,409,429
    
    
    $320.2 millionMay 2, 2004 to May 29, 2004
    
    
    90,571
    
    
    $
    28.57
    
    
    
    90,571
    
    
    $317.6 millionMay 30, 2004 to June 26, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $317.6 millionJune 27, 2004 to July 31, 2004
    
    
    5,500,000
    
    
    $
    27.12
    
    
    
    5,500,000
    
    
    $168.4 millionAugust 1, 2004 to August 28, 2004
    
    
    2,104,125
    
    
    $
    24.17
    
    
    
    2,104,125
    
    
    $117.5 millionAugust 29, 2004 to September 25, 2004
    
    
    810,000
    
    
    $
    23.63
    
    
    
    810,000
    
    
    $1,098.4 millionTotal
    
    
    14,414,125
    
    
    $
    27.86
    
    
    
    14,414,125
    
    
    $1,098.4 million
 On February 23, 2004 we announced that our Board of Directors had approved a
stock repurchase plan that authorized the repurchase of up to $500.0 million of
our outstanding common stock through February 13, 2007. On September 20, 2004
we announced that our Board of Directors had authorized an additional $1.0
billion for repurchase of our outstanding common stock through September 14,
2009. We may repurchase shares from time to time in the open market, through
block trades or otherwise. The repurchases may be commenced or suspended at any
time or from time to time without prior notice depending on prevailing market
conditions and other factors. 
 ITEM 6: EXHIBITS (a) Exhibits 31.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated November
4, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated November 4, 2004 in
accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
 31




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##### Table of Contents



32.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated November
4, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated November 4, 2004 in
accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
 32




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##### Table of Contents



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/ Kevin S. RoyalKevin S. RoyalVice President and Chief Financial Officer(Principal Financial Officer and ChiefAccounting Officer)November 4, 2004
 33




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##### Table of Contents



EXHIBIT INDEX 31.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated November
4, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated November 4, 2004 in
accordance with 18 U.S.C. 1350, as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated November
4, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated November 4, 2004 in
accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
 34