##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from            to
 Commission File Number 000-17157
 NOVELLUS SYSTEMS, INC.
 (Exact name of Registrant as specified in its charter)
 California
    
    77-0024666(State or other jurisdiction of
    
    (I.R.S. Employer Identificationincorporation or organization)
    
    Number)
 4000 North First Street, San Jose, California 95134  (Address of principal executive offices including zip code)
 (408) 943-9700  (Registrants telephone number, including area code)
 þ o
  þ o o
 o þ




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##### 



NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2006
 TABLE OF CONTENTS
 PagePart I: Financial InformationItem 1: Condensed Consolidated Financial StatementsCondensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and October 1, 2005
    
    
    3Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and October 1, 2005
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2: Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3: Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4: Controls and Procedures
    
    
    29Part II: Other InformationItem 1: Legal Proceedings
    
    
    30Item 1A: Risk Factors
    
    
    31Item 2: Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    38Item 6: Exhibits
    
    
    38SignaturesEXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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##### Table of Contents



PART I: FINANCIAL INFORMATION
 
 ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 NOVELLUS SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share amounts)
 (Unaudited)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    October 1, 2005
    
    
    September 30, 2006
    
    
    October 1, 2005Net sales
    
    $
    444,032
    
    
    $
    338,878
    
    
    $
    1,220,011
    
    
    $
    1,008,203Cost of sales
    
    
    217,507
    
    
    
    191,684
    
    
    
    621,182
    
    
    
    549,578Gross profit
    
    
    226,525
    
    
    
    147,194
    
    
    
    598,829
    
    
    
    458,625Operating expenses:Selling, general and administrative
    
    
    67,664
    
    
    
    53,365
    
    
    
    192,457
    
    
    
    155,450Research and development
    
    
    60,645
    
    
    
    61,263
    
    
    
    187,726
    
    
    
    186,823Restructuring and other charges
    
    
    
    
    
    
    3,361
    
    
    
    12,629
    
    
    
    3,287Legal settlement
    
    
    
    
    
    
    
    
    
    
    3,250
    
    
    
    Total operating expenses
    
    
    128,309
    
    
    
    117,989
    
    
    
    396,062
    
    
    
    345,560Operating income
    
    
    98,216
    
    
    
    29,205
    
    
    
    202,767
    
    
    
    113,065Interest income, net
    
    
    6,044
    
    
    
    4,596
    
    
    
    16,244
    
    
    
    11,943Other income (loss), net
    
    
    3,530
    
    
    
    (2,191
    )
    
    
    7,020
    
    
    
    (2,395
    )Interest and other income, net
    
    
    9,574
    
    
    
    2,405
    
    
    
    23,264
    
    
    
    9,548Income before provision for income taxes and cumulative
effect of a change in accounting principle
    
    
    107,790
    
    
    
    31,610
    
    
    
    226,031
    
    
    
    122,613Provision for income taxes
    
    
    37,770
    
    
    
    8,195
    
    
    
    79,537
    
    
    
    35,496Income before cumulative effect of a change in
accounting principle
    
    
    70,020
    
    
    
    23,415
    
    
    
    146,494
    
    
    
    87,117Cumulative effect of a change in accounting principle,
net
of tax of $594
    
    
    
    
    
    
    
    
    
    
    948
    
    
    
    Net income
    
    $
    70,020
    
    
    $
    23,415
    
    
    $
    147,442
    
    
    $
    87,117Net income per share:Basic:Income before cumulative effect of a change in
accounting principle
    
    $
    0.57
    
    
    $
    0.17
    
    
    $
    1.16
    
    
    $
    0.63Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    0.01
    
    
    
    Basic net income per share
    
    $
    0.57
    
    
    $
    0.17
    
    
    $
    1.17
    
    
    $
    0.63Diluted:Income before cumulative effect of a change in
accounting principle
    
    $
    0.57
    
    
    $
    0.17
    
    
    $
    1.15
    
    
    $
    0.62Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    0.01
    
    
    
    Diluted net income per share
    
    $
    0.57
    
    
    $
    0.17
    
    
    $
    1.16
    
    
    $
    0.62Shares used in basic per share calculations
    
    
    122,150
    
    
    
    137,848
    
    
    
    126,125
    
    
    
    138,602Shares used in diluted per share calculations
    
    
    123,357
    
    
    
    138,895
    
    
    
    127,177
    
    
    
    139,646
  3




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##### Table of Contents



NOVELLUS SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (In thousands)
 September 30,
    
    
    December 31,2006
    
    
    2005 *(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    83,499
    
    
    $
    40,403Short-term investments
    
    
    579,289
    
    
    
    608,837Accounts receivable, net
    
    
    410,512
    
    
    
    397,534Inventories
    
    
    198,425
    
    
    
    193,787Deferred tax assets, net
    
    
    90,682
    
    
    
    88,563Assets held for sale
    
    
    22,088
    
    
    
    Prepaid and other current assets
    
    
    14,750
    
    
    
    34,388Total current assets
    
    
    1,399,245
    
    
    
    1,363,512Property and equipment, net
    
    
    369,839
    
    
    
    423,749Restricted cash and cash equivalents
    
    
    144,857
    
    
    
    140,212Goodwill
    
    
    259,838
    
    
    
    255,584Intangibles and other assets
    
    
    112,326
    
    
    
    107,192Total assets
    
    $
    2,286,105
    
    
    $
    2,290,249LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    82,086
    
    
    $
    83,710Accrued payroll and related expenses
    
    
    72,386
    
    
    
    57,450Accrued warranty
    
    
    57,520
    
    
    
    54,553Other accrued liabilities
    
    
    56,107
    
    
    
    58,271Income taxes payable
    
    
    7,417
    
    
    
    5,898Deferred profit
    
    
    74,506
    
    
    
    68,718Current obligations under lines of credit
    
    
    24,681
    
    
    
    15,744Total current liabilities
    
    
    374,703
    
    
    
    344,344Long-term debt
    
    
    127,010
    
    
    
    124,858Other non-current liabilities
    
    
    43,469
    
    
    
    41,764Total liabilities
    
    
    545,182
    
    
    
    510,966Shareholders equity:Common stock
    
    
    1,343,133
    
    
    
    1,393,805Retained earnings
    
    
    395,622
    
    
    
    388,015Accumulated other comprehensive income (loss)
    
    
    2,168
    
    
    
    (2,537
    )Total shareholders equity
    
    
    1,740,923
    
    
    
    1,779,283Total liabilities and shareholders equity
    
    $
    2,286,105
    
    
    $
    2,290,249
 
 *
    
    Amounts as of December 31, 2005 are derived from the December 31, 2005 audited financial
statements  4




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##### Table of Contents



NOVELLUS SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
 (Unaudited)
 Nine Months EndedSeptember 30,
    
    
    October 1,2006
    
    
    2005Cash flows from operating activities:Net income
    
    $
    147,442
    
    
    $
    87,117Adjustments to reconcile net income to net cash provided by operating activities:Loss on disposal of fixed assets
    
    
    1,834
    
    
    
    663Non-cash portion of restructuring and other charges
    
    
    10,199
    
    
    
    8,538Depreciation and amortization
    
    
    53,754
    
    
    
    62,772Deferred income taxes
    
    
    1,488
    
    
    
    9,963Stock-based compensation
    
    
    26,760
    
    
    
    2,700Tax benefit from equity awards
    
    
    18,297
    
    
    
    Excess tax benefit from stock-based compensation
    
    
    (11,067
    )
    
    
    Cumulative effect of a change in accounting principle
    
    
    (1,542
    )
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    (11,484
    )
    
    
    38,089Inventories
    
    
    (13,275
    )
    
    
    31,328Prepaid and other assets
    
    
    14,575
    
    
    
    (4,800
    )Accounts payable
    
    
    (2,009
    )
    
    
    (17,019
    )Accrued payroll and related expenses
    
    
    18,137
    
    
    
    (6,151
    )Accrued warranty
    
    
    2,764
    
    
    
    3,812Other accrued liabilities
    
    
    (2,197
    )
    
    
    (4,407
    )Income taxes payable
    
    
    4,422
    
    
    
    5,038Deferred profit
    
    
    5,710
    
    
    
    (1,091
    )Net cash provided by operating activities
    
    
    263,808
    
    
    
    216,552Cash flows from investing activities:Proceeds from sales of short-term investments
    
    
    384,113
    
    
    
    277,839Proceeds from maturities of short-term investments
    
    
    154,711
    
    
    
    125,674Purchases of short-term investments
    
    
    (505,103
    )
    
    
    (614,906
    )Capital expenditures
    
    
    (28,255
    )
    
    
    (35,691
    )Proceeds from sale of property and equipment
    
    
    626
    
    
    
    2,676Decrease (increase) in other assets
    
    
    (353
    )
    
    
    (1,694
    )Decrease (increase) in restricted cash and cash equivalents
    
    
    (4,645
    )
    
    
    28,163Net cash provided by (used in) investing activities
    
    
    1,094
    
    
    
    (217,939
    )Cash flows from financing activities:Proceeds from employee stock compensation plans
    
    
    11,747
    
    
    
    26,920Proceeds from lines of credit, net
    
    
    9,207
    
    
    
    3,207Payments on long-term debt
    
    
    (6,955
    )
    
    
    (19,838
    )Repurchases of common stock
    
    
    (249,864
    )
    
    
    (82,791
    )Excess tax benefit from stock-based compensation
    
    
    11,067
    
    
    
    Net cash provided by (used in) financing activities
    
    
    (224,798
    )
    
    
    (72,502
    )Effects of exchange rate changes on cash and cash equivalents
    
    
    2,992
    
    
    
    6,303Net change in cash and cash equivalents
    
    
    43,096
    
    
    
    (67,586
    )Cash and cash equivalents at beginning of period
    
    
    40,403
    
    
    
    106,117Cash and cash equivalents at end of period
    
    $
    83,499
    
    
    $
    38,531
  5




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##### Table of Contents



NOVELLUS SYSTEMS, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 1. BASIS OF PRESENTATION
 Basis of Presentation
    Allowance for Doubtful Accounts
  Derivatives
  Cash Flow Hedging 
 6




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##### Table of Contents



Balance as of July 1, 2006
    
    $
    1,820Net change on cash flow hedges
    
    
    184Reclassification to cost of sales
    
    
    (958
    )Balance as of September 30, 2006  net gain
    
    $
    1,046
  Net Investment Hedging 
 Non-Designated Hedges 
 Recent Accounting Pronouncements
 Inventory
Costs, an amendment of ARB No. 43, Chapter 4
 Accounting for
Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43
 Accounting for Uncertainty in Income
Taxesan Interpretation of FASB Statement No. 109
 Fair Value Measurements
 7




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##### Table of Contents



Employers Accounting for Defined Benefit Pension
and Other Postretirement Plans
 2. NET INCOME PER SHARE
    Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Numerator:Net income
    
    $
    70,020
    
    
    $
    23,415
    
    
    $
    147,442
    
    
    $
    87,117Denominator:Basic weighted-average shares outstanding
    
    
    122,150
    
    
    
    137,848
    
    
    
    126,125
    
    
    
    138,602Employee stock options and other
    
    
    1,207
    
    
    
    1,047
    
    
    
    1,052
    
    
    
    1,044Diluted weighted-average shares outstanding
    
    
    123,357
    
    
    
    138,895
    
    
    
    127,177
    
    
    
    139,646Basic net income per share
    
    $
    0.57
    
    
    $
    0.17
    
    
    $
    1.17
    
    
    $
    0.63Diluted net income per share
    
    $
    0.57
    
    
    $
    0.17
    
    
    $
    1.16
    
    
    $
    0.62
  3. STOCK-BASED COMPENSATION
 Adoption of SFAS 123(R )
  8




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##### Table of Contents



Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30, 2006
    
    
    September 30, 2006Cost of sales
    
    $
    400
    
    
    $
    1,246Selling, general and administrative
    
    
    5,516
    
    
    
    16,545Research and development
    
    
    2,741
    
    
    
    8,466Stock-based
compensation expense before income taxes
(1)
    
    
    8,657
    
    
    
    26,257Income tax benefit
    
    
    (3,333
    )
    
    
    (10,109
    )Total stock-based compensation expense after income taxes
    
    $
    5,324
    
    
    $
    16,148
 
 (1)
    
    Amount includes $1.7 million and $5.2 million related to restricted stock awards for the three
and nine months ended September 30, 2006, respectively.  9




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##### Table of Contents



Three Months Ended September 30, 2006
    
    
    Nine Months Ended September 30, 2006SFAS 123(R)
    
    
    As
    
    
    SFAS 123(R)
    
    
    AsAdjustments
    
    
    Reported
    
    
    Adjustments
    
    
    ReportedIncome from operations
    
    $
    (6,788
    )
    
    $
    98,216
    
    
    $
    (20,919
    )
    
    $
    202,767Income before income taxes
    
    
    (6,788
    )
    
    
    107,790
    
    
    
    (20,919
    )
    
    
    226,031Income before cumulative effect of a change in
accounting principle, net of tax
    
    
    (4,175
    )
    
    
    70,020
    
    
    
    (12,865
    )
    
    
    146,494Net Income
    
    
    (4,175
    )
    
    
    70,020
    
    
    
    (11,917
    )
    
    
    147,442Basic earnings per sharePrior to cumulative effect of a change in accounting
principle
    
    $
    (0.03
    )
    
    $
    0.57
    
    
    $
    (0.10
    )
    
    $
    1.16Cumulative effect of a change in accounting
principle
    
    
    
    
    
    
    
    
    
    
    0.01
    
    
    
    0.01$
    (0.03
    )
    
    $
    0.57
    
    
    $
    (0.09
    )
    
    $
    1.17Diluted earnings per sharePrior to cumulative effect of a change in accounting
principle
    
    $
    (0.03
    )
    
    $
    0.57
    
    
    $
    (0.10
    )
    
    $
    1.15Cumulative effect of a change in accounting
principle
    
    
    
    
    
    
    
    
    
    
    0.01
    
    
    
    0.01$
    (0.03
    )
    
    $
    0.57
    
    
    $
    (0.09
    )
    
    $
    1.16
    Three Months
    
    
    Nine MonthsEnded
    
    
    EndedOctober 1, 2005
    
    
    October 1, 2005Net income as reported
    
    $
    23,415
    
    
    $
    87,117Add:Intrinsic value method expense included in reported net
income, net of related tax effects
    
    
    306
    
    
    
    1,890Less:Fair value method expense, net of related tax effects
    
    
    (6,853
    )
    
    
    (25,592
    )Pro-forma net income
    
    $
    16,868
    
    
    $
    63,415Pro-forma basic net income per share
    
    $
    0.12
    
    
    $
    0.46Pro-forma diluted net income per share
    
    $
    0.12
    
    
    $
    0.45Basic net income per share as reported
    
    $
    0.17
    
    
    $
    0.63Diluted net income per share as reported
    
    $
    0.17
    
    
    $
    0.62
 10




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Valuation and Other Assumptions for Stock Options
 Valuation and Amortization Method
 Expected Term.
 Expected Volatility.
 Risk-Free Interest Rate.
 Dividends.
 Forfeitures.
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    September 30,
    
    October 1,2006
    
    2005
    
    2006
    
    2005Risk-free interest rate
    
    
    4.9
    %
    
    
    3.6
    %
    
    
    4.9
    %
    
    
    3.4
    %Expected volatility
    
    
    49.9
    %
    
    
    69.0
    %
    
    
    49.5
    %
    
    
    70.0
    %Expected term
    
    4.3 years
    
    3.7 years
    
    4.3 years
    
    3.7 yearsExpected dividends
    
    None
    
    None
    
    None
    
    None
  11




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##### Table of Contents



Stock Options
  Weighted-AverageNumber
    
    
    
    
    
    
    Remainingof
    
    
    Weighted-Average
    
    
    Contractual
    
    
    AggregateShares
    
    
    Exercise Price
    
    
    Term (in Years)
    
    
    Intrinsic ValueOutstanding at January 1, 2006
    
    
    24,137
    
    
    $
    31.79Grants
    
    
    479
    
    
    
    24.58Exercises
    
    
    (461
    )
    
    
    17.03Forfeitures or expirations
    
    
    (2,073
    )
    
    
    34.13Outstanding at September 30, 2006
    
    
    22,082
    
    
    $
    31.73
    
    
    
    6.0
    
    
    $
    26,441Vested and expected to vest at September 30, 2006
    
    
    21,462
    
    
    $
    31.90
    
    
    
    5.3
    
    
    $
    25,150Exercisable at September 30, 2006
    
    
    16,762
    
    
    $
    33.46
    
    
    
    5.3
    
    
    $
    17,516
    Restricted Stock Awards
  Number
    
    Weighted-Averageof
    
    Grant DateShares
    
    Fair ValueUnvested restricted stock at January 1, 2006
    
    
    1,197
    
    
    $
    27.58Granted
    
    
    71
    
    
    
    23.73Vested
    
    
    (70
    )
    
    
    30.78Forfeited
    
    
    (70
    )
    
    
    27.77Unvested restricted stock at September 30, 2006
    
    
    1,128
    
    
    $
    27.13
  12




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##### Table of Contents



ESPP
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    September 30,
    
    October 1,2006
    
    2005
    
    2006
    
    2005Risk-free interest rate
    
    5.0%
    
    2.3%
    
    5.0%
    
    2.2%Expected volatility
    
    32.0%
    
    33.0%
    
    32.0%
    
    36.0%Expected term
    
    6 months
    
    6 months
    
    6 months
    
    6 monthsExpected dividends
    
    None
    
    None
    
    None
    
    None
   4. OTHER INCOME (LOSS), NET
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Other income
    
    $
    1,926
    
    
    $
    212
    
    
    $
    3,083
    
    
    $
    441Other expense
    
    
    (292
    )
    
    
    (303
    )
    
    
    (563
    )
    
    
    (434
    )Foreign currency gain (loss), net
    
    
    1,896
    
    
    
    (2,100
    )
    
    
    4,500
    
    
    
    (2,402
    )Total other income (loss), net
    
    $
    3,530
    
    
    $
    (2,191
    )
    
    $
    7,020
    
    
    $
    (2,395
    )
 5. INVENTORIES
  September 30,
    
    
    December 31,2006
    
    
    2005Purchased and spare parts
    
    $
    157,653
    
    
    $
    152,763Work-in-process
    
    
    31,817
    
    
    
    27,110Finished goods
    
    
    8,955
    
    
    
    13,914Total inventories
    
    $
    198,425
    
    
    $
    193,787
 13




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##### Table of Contents



6. GOODWILL AND INTANGIBLE ASSETS
 Goodwill
  2006IndustrialSemiconductor
    
    
    ApplicationsGroup
    
    
    Group
    
    
    TotalBalance at December 31, 2005
    
    $
    150,664
    
    
    $
    104,920
    
    
    $
    255,584SpeedFam-IPEC adjustment
    
    
    (3,510
    )
    
    
    
    
    
    
    (3,510
    )Foreign currency translation
    
    
    
    
    
    
    7,764
    
    
    
    7,764Balance at September 30, 2006
    
    $
    147,154
    
    
    $
    112,684
    
    
    $
    259,838
 2005IndustrialSemiconductor
    
    
    ApplicationsGroup
    
    
    Group
    
    
    TotalBalance at December 31, 2004
    
    $
    162,230
    
    
    $
    116,742
    
    
    $
    278,972SpeedFam-IPEC adjustment
    
    
    (3,510
    )
    
    
    
    
    
    
    (3,510
    )Peter Wolters adjustment
    
    
    
    
    
    
    1,946
    
    
    
    1,946Foreign currency translation
    
    
    
    
    
    
    (12,010
    )
    
    
    (12,010
    )Balance at October 1, 2005
    
    $
    158,720
    
    
    $
    106,678
    
    
    $
    265,398
   Intangible Assets
  AccumulatedSeptember 30, 2006
    
    Gross
    
    
    Amortization
    
    
    NetPatents
    
    $
    4,197
    
    
    $
    (1,725
    )
    
    $
    2,472Developed technology
    
    
    28,652
    
    
    
    (15,226
    )
    
    
    13,426Trademark
    
    
    6,452
    
    
    
    (1,452
    )
    
    
    5,000Other intangible assets
    
    
    138
    
    
    
    (97
    )
    
    
    41Total
    
    $
    39,439
    
    
    $
    (18,500
    )
    
    $
    20,939
 AccumulatedDecember 31, 2005
    
    Gross
    
    
    Amortization
    
    
    NetPatents
    
    $
    4,201
    
    
    $
    (1,225
    )
    
    $
    2,976Developed technology
    
    
    28,042
    
    
    
    (11,422
    )
    
    
    16,620Trademark
    
    
    6,065
    
    
    
    (903
    )
    
    
    5,162Other intangible assets
    
    
    161
    
    
    
    (99
    )
    
    
    62Total
    
    $
    38,469
    
    
    $
    (13,649
    )
    
    $
    24,820
 14




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##### Table of Contents



7. ACQUISITION
    Cash consideration
    
    $
    6,369Estimated transaction costs
    
    
    435Total purchase price
    
    $
    6,804Assets acquired
    
    $
    18,548Liabilities assumed
    
    
    (11,744
    )Total net assets acquired
    
    $
    6,804
 8. PRODUCT WARRANTY
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Balance, beginning of period
    
    $
    60,083
    
    
    $
    50,493
    
    
    $
    54,553
    
    
    $
    45,526Warranties issued
    
    
    20,488
    
    
    
    15,059
    
    
    
    65,274
    
    
    
    57,609Settlements
    
    
    (20,731
    )
    
    
    (22,729
    )
    
    
    (61,726
    )
    
    
    (63,032
    )Changes in liability for pre-existing warranties, including expirations
    
    
    (2,320
    )
    
    
    6,182
    
    
    
    (581
    )
    
    
    8,902Balance, end of period
    
    $
    57,520
    
    
    $
    49,005
    
    
    $
    57,520
    
    
    $
    49,005
 15




---



##### Table of Contents



9. RESTRUCTURING AND OTHER CHARGES
      Facility
    
    
    AssetExit Costs
    
    
    Impairments
    
    
    Severance
    
    
    TotalBalance at December 31, 2005
    
    $
    27,239
    
    
    $
    
    
    
    $
    863
    
    
    $
    28,102Restructuring charges
    
    
    6,235
    
    
    
    10,199
    
    
    
    51
    
    
    
    16,485Cash payments
    
    
    (2,408
    )
    
    
    
    
    
    
    (484
    )
    
    
    (2,892
    )Non-cash adjustment
    
    
    1,161
    
    
    
    (10,199
    )
    
    
    
    
    
    
    (9,038
    )Adjustment of prior restructuring costs
    
    
    (3,856
    )
    
    
    
    
    
    
    
    
    
    
    (3,856
    )Balance at April 1, 2006
    
    
    28,371
    
    
    
    
    
    
    
    430
    
    
    
    28,801Cash payments
    
    
    (2,491
    )
    
    
    
    
    
    
    (13
    )
    
    
    (2,504
    )Balance at July 1, 2006
    
    
    25,880
    
    
    
    
    
    
    
    417
    
    
    
    26,297Cash payments
    
    
    (2,687
    )
    
    
    
    
    
    
    (47
    )
    
    
    (2,734
    )Balance at September 30, 2006
    
    $
    23,193
    
    
    $
    
    
    
    $
    370
    
    
    $
    23,563
  16




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##### Table of Contents



10. LONG-TERM OBLIGATIONS
   11. COMPREHENSIVE INCOME
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income
    
    $
    70,020
    
    
    $
    23,415
    
    
    $
    147,442
    
    
    $
    87,117Other comprehensive income (loss):Foreign currency translation adjustments, net of tax
    
    
    2,631
    
    
    
    (1,657
    )
    
    
    3,599
    
    
    
    (5,695
    )Unrealized gain (loss) on marketable securities, net of tax
    
    
    120
    
    
    
    (24
    )
    
    
    2,152
    
    
    
    (575
    )Unrealized gain (loss) on derivative instruments, net of tax
    
    
    769
    
    
    
    (2,699
    )
    
    
    (1,046
    )
    
    
    2,259Comprehensive income
    
    $
    73,540
    
    
    $
    19,035
    
    
    $
    152,147
    
    
    $
    83,106
  September 30,
    
    
    December 31,2006
    
    
    2005Foreign currency translation adjustments, net of tax
    
    $
    2,952
    
    
    $
    (647
    )Unrealized gain (loss) on marketable securities, net of tax
    
    
    262
    
    
    
    (1,890
    )Unrealized gain (loss) on derivative instruments, net of tax
    
    
    (1,046
    )
    
    
    Accumulated other comprehensive income (loss)
    
    $
    2,168
    
    
    $
    (2,537
    )
 12. PENSION PLAN
  17




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##### Table of Contents



13. RELATED PARTY TRANSACTIONS
      14. LITIGATION
 Derivative Litigation
 Teitelbaum
v. Hill et al. and Alaska Electrical Pension Fund v. Hill et al. Teitelbaum v. Hill et al. and Alaska Electrical Pension Fund v. Hill et al. In re Novellus Systems Inc. Derivative Litigation
 Linear Technology Corporation
  18




---



##### Table of Contents



Other Litigation
   15. OPERATING SEGMENTS
    Three Months Ended September 30, 2006
    
    
    Nine Months Ended September 30, 2006Industrial
    
    
    
    
    
    
    
    
    
    
    IndustrialSemiconductor
    
    
    Applications
    
    
    
    
    
    
    Semiconductor
    
    
    ApplicationsGroup
    
    
    Group
    
    
    Total
    
    
    Group
    
    
    Group
    
    
    TotalSales to unaffiliated customers
    
    $
    418,055
    
    
    $
    25,977
    
    
    $
    444,032
    
    
    $
    1,142,480
    
    
    $
    77,531
    
    
    $
    1,220,011Operating income
    
    $
    96,549
    
    
    $
    1,667
    
    
    $
    98,216
    
    
    $
    197,362
    
    
    $
    5,405
    
    
    $
    202,767Long-lived assets
    
    $
    352,535
    
    
    $
    17,304
    
    
    $
    369,839
    
    
    $
    352,535
    
    
    $
    17,304
    
    
    $
    369,839All other identifiable assets
    
    
    1,718,766
    
    
    
    197,500
    
    
    
    1,916,266
    
    
    
    1,718,766
    
    
    
    197,500
    
    
    
    1,916,266Total assets
    
    $
    2,071,301
    
    
    $
    214,804
    
    
    $
    2,286,105
    
    
    $
    2,071,301
    
    
    $
    214,804
    
    
    $
    2,286,105
 Three Months Ended October 1, 2005
    
    
    Nine Months Ended October 1, 2005Industrial
    
    
    
    
    
    
    
    
    
    
    IndustrialSemiconductor
    
    
    Applications
    
    
    
    
    
    
    Semiconductor
    
    
    ApplicationsGroup
    
    
    Group
    
    
    Total
    
    
    Group
    
    
    Group
    
    
    TotalSales to unaffiliated customers
    
    $
    313,389
    
    
    $
    25,489
    
    
    $
    338,878
    
    
    $
    923,911
    
    
    $
    84,292
    
    
    $
    1,008,203Operating income
    
    $
    26,763
    
    
    $
    2,442
    
    
    $
    29,205
    
    
    $
    100,357
    
    
    $
    12,708
    
    
    $
    113,065Long-lived assets
    
    $
    424,031
    
    
    $
    16,886
    
    
    $
    440,917
    
    
    $
    424,031
    
    
    $
    16,886
    
    
    $
    440,917All other identifiable assets
    
    
    1,764,418
    
    
    
    169,616
    
    
    
    1,934,034
    
    
    
    1,764,418
    
    
    
    169,616
    
    
    
    1,934,034Total assets
    
    $
    2,188,449
    
    
    $
    186,502
    
    
    $
    2,374,951
    
    
    $
    2,188,449
    
    
    $
    186,502
    
    
    $
    2,374,951
 19




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##### Table of Contents



ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 Cautionary Note Regarding Forward-Looking Statements
   20




---



##### Table of Contents



Introduction
  
    
    Overview of our Business and Industry;
    
    Results of Operations;
    
    Critical Accounting Policies;
    
    Liquidity and Capital Resources; and
    
    Risk Factors.
 Overview of Our Business and Industry
    21




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##### Table of Contents



Quarterly Financial Data2006
    
    2005Third
    
    Second
    
    First
    
    Fourth
    
    Third
    
    Second
    
    FirstQuarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    QuarterNet sales
    
    $
    444,032
    
    
    $
    410,073
    
    
    $
    365,906
    
    
    $
    332,268
    
    
    $
    338,878
    
    
    $
    329,585
    
    
    $
    339,740Gross profit
    
    $
    226,525
    
    
    $
    204,764
    
    
    $
    167,540
    
    
    $
    140,501
    
    
    $
    147,194
    
    
    $
    157,562
    
    
    $
    153,869Net income
    
    $
    70,020
    
    
    $
    52,705
    
    
    $
    24,717
    
    
    $
    22,990
    
    
    $
    23,415
    
    
    $
    33,231
    
    
    $
    30,471Diluted net income per share
    
    $
    0.57
    
    
    $
    0.42
    
    
    $
    0.19
    
    
    $
    0.17
    
    
    $
    0.17
    
    
    $
    0.24
    
    
    $
    0.22Net orders
    
    $
    470,322
    
    
    $
    457,545
    
    
    $
    416,710
    
    
    $
    351,018
    
    
    $
    286,929
    
    
    $
    309,214
    
    
    $
    301,594
   Results of Operations
 Adoption of SFAS 123(R)
   Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    July 1, 2006
    
    
    October 1, 2005
    
    
    September 30, 2006
    
    
    October 1, 2005(1)
    
    
    (3)
    
    
    (2)
    
    
    (1)
    
    
    (2)Cost of sales
    
    $
    400
    
    
    $
    538
    
    
    $
    76
    
    
    $
    1,246
    
    
    $
    473Selling, general and administrative
    
    
    5,516
    
    
    
    5,590
    
    
    
    225
    
    
    
    16,545
    
    
    
    1,390Research and development
    
    
    2,741
    
    
    
    2,664
    
    
    
    136
    
    
    
    8,466
    
    
    
    837Stock-based compensation expense before income taxes
    
    $
    8,657
    
    
    $
    8,792
    
    
    $
    437
    
    
    $
    26,257
    
    
    $
    2,700
 
 (1)
    
    Amounts include amortization expense related to stock options of $6.3 million and $19.2
million, ESPP of $0.5 million and $1.7 million, and restricted stock awards of $1.7 million
and $5.2 million for the three and nine months ended September 30, 2006, respectively.(2)
    
    Amounts include amortization expense related to restricted stock awards of $0.4 million
and $2.7 million for the three and nine months ended October 1, 2005, respectively.(3)
    
    Amounts include amortization expense related to stock options of $6.5 million, ESPP of
$0.6 million, and restricted stock awards of $1.7 million. 22




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##### Table of Contents



Net Sales
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)Net sales
    
    $
    444,032
    
    
    $
    410,073
    
    
    $
    338,878
    
    
    $
    1,220,011
    
    
    $
    1,008,203International net sales %
    
    
    76
    %
    
    
    71
    %
    
    
    75
    %
    
    
    72
    %
    
    
    74
    %
   Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005North America
    
    
    24
    %
    
    
    29
    %
    
    
    25
    %
    
    
    28
    %
    
    
    26
    %Europe
    
    
    9
    %
    
    
    9
    %
    
    
    13
    %
    
    
    8
    %
    
    
    10
    %Asia
    
    
    67
    %
    
    
    62
    %
    
    
    62
    %
    
    
    64
    %
    
    
    64
    %
  Gross Profit
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)Gross profit
    
    $
    226,525
    
    
    $
    204,764
    
    
    $
    147,194
    
    
    $
    598,829
    
    
    $
    458,625% of net sales
    
    
    51
    %
    
    
    50
    %
    
    
    43
    %
    
    
    49
    %
    
    
    45
    %
    23




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##### Table of Contents



Selling, General and Administrative (SG&A)
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)SG&A expense
    
    $
    67,664
    
    
    $
    66,311
    
    
    $
    53,365
    
    
    $
    192,457
    
    
    $
    155,450% of net sales
    
    
    15
    %
    
    
    16
    %
    
    
    16
    %
    
    
    16
    %
    
    
    15
    %
  Research and Development (R&D)
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)R&D expense
    
    $
    60,645
    
    
    $
    63,298
    
    
    $
    61,263
    
    
    $
    187,726
    
    
    $
    186,823% of net sales
    
    
    14
    %
    
    
    15
    %
    
    
    18
    %
    
    
    15
    %
    
    
    19
    %
  Restructuring and Other Charges
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)Restructuring and other charges
    
    $
    
    
    
    $
    
    
    
    $
    3,361
    
    
    $
    12,629
    
    
    $
    3,287% of net sales
    
    
    
    %
    
    
    
    %
    
    
    1
    %
    
    
    1
    %
    
    Less than 1
    %
    24




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##### Table of Contents



Legal Settlement
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)Legal settlement
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    3,250
    
    
    $
    % of net sales
    
    
    
    %
    
    
    
    %
    
    
    
    %
    
    Less than 1
    %
    
    
    
    %
   Interest and Other Income, Net
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    July 1, 2006
    
    October 1, 2005
    
    September 30, 2006
    
    October 1, 2005(in thousands, except percentages)Interest and other income, net
    
    $
    9,574
    
    
    $
    7,611
    
    
    $
    2,405
    
    
    $
    23,264
    
    
    $
    9,548% of net sales
    
    
    2
    %
    
    
    2
    %
    
    
    1
    %
    
    
    2
    %
    
    
    1
    %
  Income Taxes
  Critical Accounting Policies
  25




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##### Table of Contents



Revenue Recognition
     Inventory Valuation
  Goodwill and Other Intangible Assets
  Deferred Tax Assets
  26




---



##### Table of Contents



Warranty Obligations
  Accounting for Stock-Based Compensation
    27




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##### Table of Contents



Restructuring and Impairment Charges
    Foreign Exchange Contracts
  Cash Flow Hedging 
 Net Investment Hedging 
 Non-Designated Hedges 
 28




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##### Table of Contents



Liquidity and Capital Resources
          
 ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 ITEM 4: CONTROLS AND PROCEDURES
 Quarterly Evaluation of Our Disclosure Controls and Internal Controls
  29




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##### Table of Contents



CEO and CFO Certifications
  Disclosure Controls and Internal Controls for Financial Reporting
  Limitations on the Effectiveness of Controls
  Scope of the Controls Evaluation
  Conclusions
  
 PART II: OTHER INFORMATION
 
 ITEM 1: LEGAL PROCEEDINGS
  30




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##### Table of Contents



Derivative Litigation
 Teitelbaum v.
Hill et al. and Alaska Electrical Pension Fund v. Hill et al. Teitelbaum
v. Hill et al. and Alaska Electrical Pension Fund v. Hill et al. In re Novellus Systems Inc. Derivative Litigation
 Other Litigation
  
 ITEM 1A: RISK FACTORS
   Cyclical downturns in the semiconductor industry negatively impact demand for our equipment.
  The competitive and capital-intensive nature of the semiconductor industry increases the
difficulty of maintaining and capturing market share.
  31




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##### Table of Contents



Our quarterly operating results and stock price are unpredictable.
  
    
    Building our systems according to forecast, instead of limited backlog information, which hinders our ability to plan
production and inventory levels;
 
    
    Unpredictability of demand for and variability of mix of our
products in our forecast, which can cause unexpected inventory adjustments in a particular period;
 
    
    Variability in manufacturing yields;
 
    
    Failure to receive anticipated orders in time to permit shipment during the quarter;
 
    
    Timing and cancellation of customer orders and shipments, including deferring orders of our existing products due to
new product announcements by us and/or our competitors;
 
    
    Changing demand for and sales of lower-margin products relative to higher-margin products;
 
    
    Competitive pricing pressures;
 
    
    The effect of revenue recognized upon acceptance with little or no associated costs; and
 
    
    Fluctuation in warranty costs.
 We face risks related to concentration of net sales.
  Rapid technological change in the semiconductor industry requires substantial research and
development expenditures and responsiveness to customer needs.
   32




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##### Table of Contents



We are exposed to the risks of global operations.
  
    
    Tariffs and other trade barriers;
 
    
    Challenges in staffing and managing foreign operations and providing prompt and effective field support to our
customers outside of the United States;
 
    
    Difficulties in managing foreign distributors;
 
    
    Potentially adverse tax consequences, including withholding tax rules that may limit the repatriation of our earnings,
and higher effective income tax rates in foreign countries where we conduct business;
 
    
    Governmental controls, either by the United States or other countries, that restrict our business overseas or the
import or export of semiconductor products, or increase the cost of our operations;
 
    
    Longer payment cycles and difficulties in collecting accounts receivables outside of the United States;
 
    
    Inadequate protection or enforcement of our intellectual property and other legal rights in foreign jurisdictions;
 
    
    Global or regional economic downturns;
 
    
    Geo-political instability, natural disasters, acts of war or terrorism; 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 currency fluctuations, specifically transactions denominated in
Japanese yen. Exchange rate volatility may also increase the cost of our exported products for international customers
and inhibit demand.
  We face risks associated with acquisitions.
  
    
    Difficulties in integrating the operations, technologies, products and personnel of acquired companies;
 
    
    Lack of synergies or the inability to realize expected synergies and cost-savings;
 
    
    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;
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
    
    Claims by terminated employees, shareholders of acquired companies or other third parties related to the transaction;
 
    
    The issuance of dilutive securities, assumption or incurrence of additional debt obligations or expenses, or use of
substantial portions of our cash;
 
    
    Diversion of managements attention from normal daily operations of the business; and
 
    
    The impairment of acquired intangible assets as a result of technological advancements, or worse-than-expected
performance of acquired companies.
  Changes in tax rates or liabilities could negatively impact our future results.
  
    
    Changes in the regulatory environment;
 
    
    Changes in accounting and tax standards or practices; and
 
    
    Overall business conditions in the semiconductor equipment industry.
 Supply shortages could affect our ability to meet customer demands.
  We are subject to litigation proceedings that could adversely affect our business.
 Intellectual Property Litigation
  Derivative Litigation
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Other Litigation
  We are exposed to risks associated with our diversification strategy.
  The loss of key employees could harm our business and operations.
  We are exposed to risks associated with our investment activities.
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We face risks related to intellectual property.
    We are exposed to risks related to our indemnification of third parties.
  We face risks related to changes in accounting standards for stock option plans.
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If our outside audit firm does not maintain its independence, we may be unable to meet our
regulatory reporting obligations.
   We are exposed to risks associated with outsourcing activities.
  Corporate governance and financial reporting compliance requirements may lead to increased
costs and difficulty in attracting qualified executive officers and directors.
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ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 Repurchase of Company Securities
 TotalNumber of
    
    ApproximateShares
    
    Dollar ValuePurchased
    
    of Sharesas Part of
    
    that May yetTotal
    
    Average
    
    Publicly
    
    be PurchasedNumber
    
    Price
    
    Announced
    
    Under theof Shares
    
    Paid
    
    Plans or
    
    Plans orPeriod
    
    Purchased(1)
    
    Per Share
    
    Programs
    
    ProgramsJuly 2, 2006 to August 5, 2006
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $623.3millionAugust 6, 2006 to September 2, 2006
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $623.3millionSeptember 3, 2006 to September 30, 2006
    
    
    437,400
    
    
    $
    22.77
    
    
    
    437,400
    
    
    $613.3millionTotal
    
    
    437,400
    
    
    $
    22.77
    
    
    
    437,400
    
    
    $613.3million
 
 (1)
    
    All shares were purchased pursuant to a publicly announced plan.  
 ITEM 6: EXHIBITS
  31.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated November
9, 2006 in accordance with Rules 13a-14(a) and 15d-14(a) of the
Securities Exchange Act, as amended, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of William H. Kurtz, Executive Vice President and Chief
Financial Officer of Novellus Systems, Inc. dated November 9, 2006 in
accordance with Rules 13a-14(a) and 15d-14(a) of the Securities
Exchange Act, as amended, 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
9, 2006 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 William H. Kurtz, Executive Vice President and Chief
Financial Officer of Novellus Systems, Inc. dated November 9, 2006 in
accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
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SIGNATURES
  NOVELLUS SYSTEMS, INC.By: /s/ William H. KurtzWilliam H. KurtzExecutive Vice President and Chief Financial Officer(Principal Financial Officer)November 9, 2006
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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
9, 2006 in accordance with Rules 13a-14(a) and 15d-14(a) of the
Securities Exchange Act, as amended, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of William H. Kurtz, Executive Vice President and
Chief Financial Officer of Novellus Systems, Inc. dated November 9,
2006 in accordance with Rules 13a-14(a) and 15d-14(a) of the
Securities Exchange Act, as amended, 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
9, 2006 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 William H. Kurtz, Executive Vice President and
Chief Financial Officer of Novellus Systems, Inc. dated November 9,
2006 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.