##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One)(X)
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 26, 2004 OR (  )
    
    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 (X) NO (  ) Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES (X) NO (  ) As of July 29, 2004, 142,773,205 shares of the Registrants common stock, no
par value, were issued and outstanding.




---



NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED JUNE 26, 2004 TABLE OF CONTENTS PagePart I: Financial InformationItem 1: Condensed Consolidated Financial StatementsCondensed Consolidated Statements of Operations for the three and six months ended June 26, 2004 and June 28, 2003
    
    
    3Condensed Consolidated Balance Sheets as of June 26, 2004 and December 31, 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the six months ended June 26, 2004 and June 28, 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2: Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3: Quantitative and Qualitative Disclosures About Market Risk
    
    
    25Item 4: Controls and Procedures
    
    
    25Part II: Other InformationItem 1: Legal Proceedings
    
    
    27Item 2: Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    28Item 4: Submission of Matters to a Vote of Security Holders
    
    
    28Item 6: Exhibits and Reports on Form 8-K
    
    
    29Signatures
    
    
    30EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




---



##### Table of Contents



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
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    June 26, 2004
    June 28, 2003Net sales
    
    $
    338,219
    
    
    $
    239,050
    
    
    $
    601,081
    
    
    $
    477,460Cost of sales
    
    
    168,539
    
    
    
    133,728
    
    
    
    306,796
    
    
    
    262,324Gross profit
    
    
    169,680
    
    
    
    105,322
    
    
    
    294,285
    
    
    
    215,136Operating expenses:Selling, general and administrative
    
    
    47,225
    
    
    
    44,444
    
    
    
    89,628
    
    
    
    87,075Research and development
    
    
    63,471
    
    
    
    56,509
    
    
    
    122,428
    
    
    
    113,515Acquired in-process research and development
    
    
    6,124
    
    
    
    
    
    
    
    6,124
    
    
    
    Legal settlement
    
    
    
    
    
    
    
    
    
    
    2,500
    
    
    
    Total operating expenses
    
    
    116,820
    
    
    
    100,953
    
    
    
    220,680
    
    
    
    200,590Operating income
    
    
    52,860
    
    
    
    4,369
    
    
    
    73,605
    
    
    
    14,546Interest income
    
    
    2,733
    
    
    
    5,905
    
    
    
    5,233
    
    
    
    12,086Other income (loss), net
    
    
    163
    
    
    
    (368
    )
    
    
    412
    
    
    
    (897
    )Interest and other income (loss), net
    
    
    2,896
    
    
    
    5,537
    
    
    
    5,645
    
    
    
    11,189Income before income taxes
    
    
    55,756
    
    
    
    9,906
    
    
    
    79,250
    
    
    
    25,735Provision for income taxes
    
    
    17,945
    
    
    
    2,476
    
    
    
    24,758
    
    
    
    6,433Net income
    
    $
    37,811
    
    
    $
    7,430
    
    
    $
    54,492
    
    
    $
    19,302Net income per share:Basic net income per share
    
    $
    0.25
    
    
    $
    0.05
    
    
    $
    0.36
    
    
    $
    0.13Diluted net income per share
    
    $
    0.25
    
    
    $
    0.05
    
    
    $
    0.35
    
    
    $
    0.13Shares used in basic per share calculation
    
    
    149,112
    
    
    
    149,950
    
    
    
    151,012
    
    
    
    149,692Shares used in diluted per share calculation
    
    
    151,386
    
    
    
    153,034
    
    
    
    153,743
    
    
    
    152,631
 See accompanying notes to condensed consolidated financial statements. 3




---



##### Table of Contents



CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
 June 26,
    
    December 31,2004
    
    2003 *(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    314,415
    
    
    $
    497,178Short-term investments
    
    
    564,030
    
    
    
    504,954Accounts receivable, net
    
    
    330,190
    
    
    
    231,760Inventories
    
    
    220,747
    
    
    
    199,100Deferred tax assets, net
    
    
    145,889
    
    
    
    126,901Prepaid and other current assets
    
    
    14,744
    
    
    
    12,095Total current assets
    
    
    1,590,015
    
    
    
    1,571,988Property and equipment, net
    
    
    479,592
    
    
    
    506,567Goodwill
    
    
    173,267
    
    
    
    173,267Intangible and other assets
    
    
    95,590
    
    
    
    87,078Total assets
    
    $
    2,338,464
    
    
    $
    2,338,900LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    72,455
    
    
    $
    53,537Accrued payroll and related expenses
    
    
    40,842
    
    
    
    25,197Accrued warranty
    
    
    38,264
    
    
    
    28,805Other accrued liabilities
    
    
    47,093
    
    
    
    43,406Income taxes payable
    
    
    39,078
    
    
    
    10,293Deferred profit
    
    
    84,238
    
    
    
    46,821Current obligations under lines of credit
    
    
    8,056
    
    
    
    13,023Total current liabilities
    
    
    330,026
    
    
    
    221,082Other liabilities
    
    
    42,304
    
    
    
    45,958Total liabilities
    
    
    372,330
    
    
    
    267,040Shareholders equity:Common stock
    
    
    1,527,955
    
    
    
    1,565,926Retained earnings
    
    
    435,232
    
    
    
    501,362Accumulated other comprehensive income
    
    
    2,947
    
    
    
    4,572Total shareholders equity
    
    
    1,966,134
    
    
    
    2,071,860Total liabilities and shareholders equity
    
    $
    2,338,464
    
    
    $
    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




---



##### Table of Contents



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
 (unaudited)
 Six Months EndedJune 26,
    
    June 28,2004
    
    2003Cash flows from operating activities:Net income
    
    $
    54,492
    
    
    $
    19,302Adjustments to reconcile net income to net cash provided by operating activities:Gain on sale of an investment
    
    
    (365
    )
    
    
    Loss on extinguishment of debt
    
    
    
    
    
    
    616Depreciation and amortization
    
    
    41,694
    
    
    
    25,716Deferred income taxes
    
    
    (18,630
    )
    
    
    1,284Stock-based compensation
    
    
    1,979
    
    
    
    2,334Income tax benefits from employee stock option plans
    
    
    
    
    
    
    8,870Changes in operating assets and liabilities:Accounts receivable
    
    
    (98,430
    )
    
    
    (20,353
    )Inventories
    
    
    (31,852
    )
    
    
    14,859Prepaid and other current assets
    
    
    (2,204
    )
    
    
    13,292Accounts payable
    
    
    18,894
    
    
    
    (15,726
    )Accrued payroll and related expenses
    
    
    19,467
    
    
    
    (6,787
    )Accrued warranty
    
    
    9,459
    
    
    
    (2,631
    )Other accrued liabilities
    
    
    (298
    )
    
    
    (11,936
    )Income taxes payable
    
    
    28,785
    
    
    
    (8,126
    )Deferred profit
    
    
    37,416
    
    
    
    (594
    )Net cash provided by operating activities
    
    
    60,407
    
    
    
    20,120Cash flows from investing activities:Proceeds from sales and maturities of short-term investments
    
    
    597,504
    
    
    
    659,484Purchases of short-term investments
    
    
    (656,215
    )
    
    
    (676,998
    )Capital expenditures
    
    
    (11,438
    )
    
    
    (17,528
    )Decrease (increase) in other assets
    
    
    (3,661
    )
    
    
    10,743Net cash used in investing activities
    
    
    (73,810
    )
    
    
    (24,299
    )Cash flows from financing activities:Repayments of convertible subordinated notes
    
    
    
    
    
    
    (117,053
    )Proceeds from employee stock compensation plans
    
    
    17,977
    
    
    
    35,260Payments on lines of credit, net
    
    
    (4,967
    )
    
    
    Repurchase of common stock
    
    
    (182,370
    )
    
    
    (39
    )Net cash used in financing activities
    
    
    (169,360
    )
    
    
    (81,832
    )Net decrease in cash and cash equivalents
    
    
    (182,763
    )
    
    
    (86,011
    )Cash and cash equivalents at the beginning of the period
    
    
    497,178
    
    
    
    615,844Cash and cash equivalents at the end of the period
    
    $
    314,415
    
    
    $
    529,833
 See accompanying notes to condensed consolidated financial statements. 5




---



##### Table of Contents



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 six months ended June 26,
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. 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. 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 the Companys employee stock
options 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 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): 6




---



##### Table of Contents



Three Months Ended
    
    Six Months EndedJune 26,
    
    June 28,
    
    June 26,
    
    June 28,2004
    
    2003
    
    2004
    
    2003Net income as reported
    
    $
    37,811
    
    
    $
    7,430
    
    
    $
    54,492
    
    
    $
    19,302Add:Intrinsic value method expense
included in reported net
income, net of related tax effects
    
    
    1,001
    
    
    
    938
    
    
    
    1,979
    
    
    
    1,422Less:Fair value method expense, net of
related tax effects
    
    
    (14,028
    )
    
    
    (17,520
    )
    
    
    (27,831
    )
    
    
    (34,462
    )Pro-forma net income (loss)
    
    $
    24,784
    
    
    $
    (9,152
    )
    
    $
    28,640
    
    
    $
    (13,738
    )Pro-forma basic and diluted net income
(loss) per share
    
    $
    0.17
    
    
    $
    (0.06
    )
    
    $
    0.19
    
    
    $
    (0.09
    )Basic net income per share
as reported
    
    $
    0.25
    
    
    $
    0.05
    
    
    $
    0.36
    
    
    $
    0.13Diluted net income per share
as reported
    
    $
    0.25
    
    
    $
    0.05
    
    
    $
    0.35
    
    
    $
    0.13
 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 six months ended June 26, 2004 and
June 28, 2003: Three Months Ended
    
    Six Months EndedJune 26,
    
    June 28,
    
    June 26,
    
    June 28,2004
    
    2003
    
    2004
    
    2003Dividend yield
    
    None
    
    None
    
    None
    
    NoneExpected volatility
    
    76%
    
    82%
    
    76%
    
    82%Risk free interest rate
    
    2.5%
    
    2.5%
    
    2.5%
    
    2.5%Expected lives
    
    3.5 years
    
    3.6 years
    
    3.5 years
    
    3.6 years
 The weighted-average fair value of stock options granted during the period was
$16.38 and $16.77 for the three and six months ended June 26, 2004,
respectively, and $14.39 and $15.74 for the three and six months ended June 28,
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
    
    Six Months EndedJune 26,
    
    June 28,
    
    June 26,
    
    June 28,2004
    
    2003
    
    2004
    
    2003Dividend yield
    
    None
    
    None
    
    None
    
    NoneExpected volatility
    
    45%
    
    50%
    
    45%
    
    50%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 six months ended June 26, 2004, respectively, and $6.82 and $8.71 for
the three and six months ended June 28, 2003, respectively. 2. ASSET PURCHASE TRANSACTION In April 2004, we acquired Angstron Systems, Inc. (Angstron), a developer of
atomic layer deposition technology for advanced semiconductor manufacturing for
total consideration of approximately $9.8 million, including transaction costs
of approximately $0.3 million. We evaluated the business combination criteria
within Statement of Financial Accounting Standards (SFAS) No. 141, Business
Combinations and, after consideration of these criteria and the criteria
included within Emerging Issues Task Force (EITF) No. 98-3 Determining Whether
a Nonmonetary Transaction Involves Receipt of Productive Assets or of a
Business, determined that the purchase of Angstron represented a purchase of
assets rather than a business combination, and accordingly, the tangible assets
acquired and liabilities assumed were recorded at their estimated fair values
at the date of acquisition. The intangible assets acquired were valued by us
with the assistance of a third-party appraiser under the provisions of SFAS No.
142, Goodwill and Other 7




---



##### Table of Contents



Intangible Assets. A portion of the purchase price has been allocated to
existing technology and acquired in-process research and development (IPR&D).
The assets were identified and valued through analysis of data provided to a
third-party appraiser concerning developmental products, their stage of
development, the time and resources needed to complete them, their expected
income generating ability, target markets and associated risks. Those developmental projects that had not reached technological feasibility and
had no alternative future use were classified as IPR&D and expensed in the
second quarter of fiscal 2004. The nature of the efforts required to develop
the IPR&D into commercially viable products principally relates to the
completion of all planning, designing, prototyping, verification and testing
activities that are necessary to establish that the products can be produced to
meet their design specifications, including functions, features and technical
performance requirements. The purchase price was allocated to the fair value of assets acquired and
liabilities assumed as follows (in thousands): Cash consideration
    
    $
    9,500Estimated transaction costs
    
    
    320Total purchase price
    
    $
    9,820Patents
    
    
    4,197Acquired in-process research and development (IPR&D)
    
    
    6,124Deferred tax liability, net
    
    
    (267
    )Tangible assets acquired
    
    
    265Liabilities assumed
    
    
    (499
    )Total net assets acquired
    
    $
    9,820
 3. NET INCOME PER SHARE Basic net income per share is computed by dividing net income by the
weighted-average number of common shares outstanding during the period. For
purposes of computing basic net income per share, the weighted-average number
of outstanding shares of common stock excludes shares of restricted stock
subject to repurchase. Diluted net income per share is computed using the weighted-average number of
shares of common stock outstanding, including shares of restricted common stock
subject to repurchase and, when dilutive, potential shares from stock options
to purchase common stock using the treasury stock method. The following table provides a reconciliation of the numerators and
denominators of the basic and diluted per share computations (in thousands,
except for per share amounts): Three Months Ended
    
    Six Months EndedJune 26,
    
    June 28,
    
    June 26,
    
    June 28,2004
    
    2003
    
    2004
    
    2003Numerator:Net income
    
    $
    37,811
    
    
    $
    7,430
    
    
    $
    54,492
    
    
    $
    19,302Denominator:Basic weighted-average shares outstanding
    
    
    149,112
    
    
    
    149,950
    
    
    
    151,012
    
    
    
    149,692Employee stock options and restricted stock
    
    
    2,274
    
    
    
    3,084
    
    
    
    2,731
    
    
    
    2,939Diluted weighted-average shares outstanding
    
    
    151,386
    
    
    
    153,034
    
    
    
    153,743
    
    
    
    152,631Basic net income per share
    
    $
    0.25
    
    
    $
    0.05
    
    
    $
    0.36
    
    
    $
    0.13Diluted net income per share
    
    $
    0.25
    
    
    $
    0.05
    
    
    $
    0.35
    
    
    $
    0.13
 Options to purchase approximately 12.3 million and 9.3 million shares of common
stock at a weighted-average exercise price of $41.14 and $43.02 per share were
outstanding as of June 26, 2004 and June 28, 2003, 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. 8




---



##### Table of Contents



4. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out) or market. As
of the balance sheet date, inventories consisted of the following (in
thousands): June 26,
    
    December 31,2004
    
    2003Purchased and spare parts
    
    $
    161,723
    
    
    $
    146,399Work-in-process
    
    
    50,578
    
    
    
    37,502Finished goods
    
    
    8,446
    
    
    
    15,199Total inventories
    
    $
    220,747
    
    
    $
    199,100
 5. GOODWILL AND INTANGIBLE ASSETS Goodwill As of June 26, 2004 and December 31, 2003, we had goodwill of approximately
$173.3 million. 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): AccumulatedJune 26, 2004
    
    Gross
    
    Amortization
    
    NetPatents
    
    $
    15,877
    
    
    $
    (11,897
    )
    
    $
    3,980Other intangible assets
    
    
    18,540
    
    
    
    (5,684
    )
    
    
    12,856Total
    
    $
    34,417
    
    
    $
    (17,581
    )
    
    $
    16,836
 AccumulatedDecember 31, 2003
    
    Gross
    
    Amortization
    
    NetPatents
    
    $
    11,680
    
    
    $
    (10,912
    )
    
    $
    768Other intangible assets
    
    
    18,540
    
    
    
    (4,231
    )
    
    
    14,309Total
    
    $
    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 $3.6 million, $3.6
million, $3.6 million, $3.4 million and $0.7 million, respectively. As of June
26, 2004, we have no identifiable intangible assets with indefinite lives. 6. PRODUCT WARRANTY We record the estimated cost of warranty as a component of cost of sales upon
system shipment. The estimated cost is determined by the warranty term as well
as the average historical labor and material costs for a specific product.
Should actual product failure rates or material usage differ from our estimate,
revisions to the estimated warranty liability may be required. We review the
actual product failure rates and material usage on a quarterly basis and adjust
our warranty liability as necessary. We have adopted 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): 9




---



##### Table of Contents



Three Months Ended
    
    Six Months EndedJune 26,
    
    June 28,
    
    June 26,
    
    June 28,2004
    
    2003
    
    2004
    
    2003Balance, beginning of period
    
    $
    34,050
    
    
    $
    30,857
    
    
    $
    28,805
    
    
    $
    31,002Warranties issued
    
    
    21,566
    
    
    
    11,311
    
    
    
    38,200
    
    
    
    24,225Settlements
    
    
    (17,352
    )
    
    
    (13,797
    )
    
    
    (29,937
    )
    
    
    (26,856
    )Changes in liability
for pre-existing
warranties, including
expirations
    
    
    
    
    
    
    
    
    
    
    1,196
    
    
    
    Balance, end of period
    
    $
    38,264
    
    
    $
    28,371
    
    
    $
    38,264
    
    
    $
    28,371
 7. 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. The following table summarizes restructuring activity for the six months ended
June 26, 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
    
    
    $
    48,204
 As of June 26, 2004, substantially all actions under the 2003, 2002 and 2001
restructuring plans have been completed, except for payments of future rent
obligations of $46.9 million, which are to be paid in cash through 2017. There
were no significant changes in estimates on sublease income related to these
facilities during the quarter ended June 26, 2004. 8. LONG-TERM OBLIGATIONS On June 25, 2004, two subsidiaries, Novellus Systems BV and Johanna 34
Vermogensverwaltungs GmbH, entered into a credit arrangement that allows for
the borrowing of up to 127.5 million Euro. The credit arrangement allows for
periodic borrowings, with an interest rate equal to the Eurocurrency Rate plus
0.2%. Future borrowings are required to be secured by cash or marketable
securities on deposit and are due and payable on or before June 25, 2009. As
of June 26, 2004, no amounts were outstanding under the credit arrangement. On
June 28, 2004, we borrowed the entire amount available to fund the acquisition
of Peter Wolters AG and for general corporate purposes. For further discussion
regarding the acquisition, see Note 12. 9. COMPREHENSIVE INCOME The following are the components of comprehensive income (in thousands): Three Months Ended
    
    Six Months EndedJune 26,
    
    June 28,
    
    June 26,
    
    June 28,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    37,811
    
    
    $
    7,430
    
    
    $
    54,492
    
    
    $
    19,302Foreign currency translation adjustments
    
    
    (1,348
    )
    
    
    3,285
    
    
    
    (423
    )
    
    
    2,123Realized gain on available-for-sale securities, net of tax
    
    
    (17
    )
    
    
    
    
    
    
    (365
    )
    
    
    Unrealized gain (loss) on available-for-sale securities, net of tax
    
    
    (1,486
    )
    
    
    79
    
    
    
    (837
    )
    
    
    (54
    )Comprehensive income
    
    $
    34,960
    
    
    $
    10,794
    
    
    $
    52,867
    
    
    $
    21,371
 The components of accumulated other comprehensive income, net of related tax,
are as follows (in thousands): 10




---



##### Table of Contents



June 26,
    
    December 31,2004
    
    2003Foreign currency translation adjustments
    
    $
    4,262
    
    
    $
    4,685Unrealized loss on available-for-sale securities
    
    
    (1,315
    )
    
    
    (113
    )Accumulated other comprehensive income
    
    $
    2,947
    
    
    $
    4,572
 10. RELATED PARTY TRANSACTIONS In the second quarter of 2002, we began leasing an aircraft from NVLS I, LLC, a
third-party entity wholly owned by Richard S. Hill, our Chairman and Chief
Executive Officer. Under the leasing agreement, we incurred rental expense of
approximately $198,000 and $430,000 for the three and six months ended June 26,
2004, respectively, and approximately $240,000 and $379,000 for the three and
six months ended June 28, 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 June 26, 2004 and June 28, 2003 and approximately $701,000 for the
six months ended June 26, 2004 and June 28, 2003. During the quarter ended June 26, 2004, 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 9.2% and 8.6% of our net sales for the three and six months ended
June 26, 2004 and 14.0% for the three and six months ended June 28, 2003. Intel
also accounted for 7.0% and 6.0% of our accounts receivable as of June 26, 2004
and December 31, 2003, respectively. From time to time, we have made secured relocation loans to our executive
officers, vice presidents and key personnel. As of June 26, 2004, we did not
have any outstanding loans to our executive officers as defined by the
Securities and Exchange Commission. However, we did have outstanding loans to
non-executive officers and key personnel. As of June 26, 2004 and December 31,
2003, the total outstanding balances of loans to non-executive officers and key
personnel were approximately $5.2 million and $5.7 million, respectively. Of
the total amount outstanding at June 26, 2004, $4.1 million was secured by
collateral. 11. LITIGATION Applied Materials, Inc. On June 13, 1997, we agreed to purchase the Thin Film Systems (TFS) business of
Varian Associates, Inc. On the same day, Applied Materials, Inc. sued Varian in
the United States District Court for the Northern District of California for
alleged patent infringement concerning several of its physical vapor
deposition, or PVD, patents (the Applied Patents). On June 23, 1997, we sued Applied in the United States District Court for the
Northern District of California, claiming infringement by Applied of several of
our PVD patents acquired from Varian in the TFS purchase. Applied has filed
counterclaims in this suit, alleging that we infringed the Applied Patents. We
are seeking an injunction against future infringement by Applied, damages for
past infringement and treble damages for alleged willful infringement. On July 7, 1997, Applied amended its complaint in its suit against Varian to
add Novellus as a defendant. We have requested that the Court dismiss us as a
defendant in this suit. The Court has not yet ruled on the request or required
us to file an answer in this lawsuit. The relief requested by Applied in both suits includes a permanent injunction
against future infringement, damages for alleged past infringement and treble
damages for alleged willful infringement. Trial is currently set to commence on
September 20, 2004. Applied has recently indicated, however, that it will not
be seeking any relief against us in this trial. We believe that we have meritorious claims against Applied. We also believe
that there are meritorious defenses to Applieds allegations, including the
defense that our operations and products (including TFS products and systems)
do not infringe the Applied Patents, and that the Applied Patents are invalid,
unenforceable or both. As a result of court rulings adverse to Applied, and in
light of certain indemnity obligations undertaken by Varian, which include
reimbursement of certain legal expenses and a portion of any losses incurred
from this litigation, we do not believe that Applieds claims will have a
material adverse effect on our business, financial condition or results of
operations. 11




---



##### Table of Contents



Semitool, Inc. On June 11, 2001, Semitool, Inc. sued Novellus for patent infringement in the
United States District Court for the District of Oregon. In this lawsuit,
Semitool alleges that Novellus infringes one of Semitools patents related to
copper electroplating. Semitool seeks an injunction against future infringement
by Novellus, damages for past infringement, and treble damages for alleged
willful infringement. On November 13, 2001, we countersued Semitool for patent infringement in the
United States District Court for the District of Oregon. We allege that
Semitool infringes certain Novellus patents related to copper electroplating.
We seek an injunction against Semitool, damages for past infringement, and
treble damages for willful infringement by Semitool. The Court has issued claim construction orders regarding all of the
patents-in-suit, and discovery has closed. The Court denied Semitools motion
for summary judgment of invalidity against U.S. Patent No. 6,074,544 and
granted Semitools motion for summary judgment of invalidity against U.S.
Patent No. 6,110,346. The Court granted Semitools motion for partial summary
judgment of no direct infringement of U.S. Patent No. 6,074,544, granted in
part and denied in part Semitools motion for partial summary judgment of no
direct infringement of U.S. Patent No. 6,162,344, and has not yet ruled on
Semitools motion for partial summary judgment of no indirect infringement of
U.S. Patents 6,074,544, 6,110,346, and 6,162,344. The case is presently
scheduled to proceed to trial in November of 2004. We believe that we have
meritorious claims against Semitool and meritorious defenses to Semitools
claims against us, and that this litigation will not have a material adverse
impact on our business, financial condition, or results of operations. However,
the outcome of patent disputes is often affected by uncertainty in the
resolution of complex issues of fact and law. If Semitool were to prevail
against us, the adverse effect on our business, financial condition, or results
of operations could be material. However, due to the uncertainty surrounding
the litigation process, we are unable to estimate a range of loss, if any, at
this time. Plasma Physics Corporation and Solar Physics Corporation On June 14, 2002, certain of our present and former customers  including
Agilent Technologies, Inc., Micron Technology, Inc., Agere Systems, Inc.,
National Semiconductor Corporation, Koninklijke Philips Electronics N.V., Texas
Instruments, Inc., ST Microelectronics, Inc., LSI Logic Corporation,
International Business Machines Corporation, Conexant Systems, Inc., Motorola,
Inc., Advanced Micro Devices, Inc. and Analog Devices Inc.  were sued for
patent infringement by Plasma Physics Corporation and Solar Physics
Corporation. We have not been sued by Plasma Physics, Solar Physics, or any
other party for infringement of any Plasma Physics or Solar Physics patent.
Certain defendants in the case, however, contend that we allegedly have
indemnification obligations and liability relating to these lawsuits. We
believe that these matters will not have a material adverse impact on our
business, financial condition, or results of operations. There can be no
assurance, however, that we will prevail in the above lawsuit or in any other
lawsuit filed in connection with the alleged indemnification obligations. If
one or more parties were to prevail against us in such a suit and damages were
awarded, the adverse impact on our business, financial condition, or results of
operations could be material. 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) and injunctions for causes of actions involving alleged breach of
contract, fraud, unfair competition, breach of warranty, and declaratory
relief. We filed a demurrer to Linears complaint, which the court granted on
April 11, 2003, with leave to amend. On May 2, 2003, Linear filed a second
amended complaint. We filed a demurrer to Linears second amended complaint,
which the court granted on August 14, 2003, with leave to amend. On September
15, 2003, Linear filed a third amended complaint. We filed a demurrer to
Linears third amended complaint, which the court granted on January 15, 2004,
with leave to amend. 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 have not
yet filed a response to this complaint. This litigation is in its early stages and is therefore inherently difficult to
assess. We believe that this litigation will not have a material adverse impact
on our business, financial condition, or results of operations. However, the
outcome of patent disputes is often affected by uncertainty in the resolution
of complex issues of fact and law. If Linear were to prevail against us, the
adverse effect on our business, financial condition, or results of operations
could be material. However, due to the uncertainty surrounding the litigation
process, we are unable to estimate a range of loss, if any, at this time. 12




---



##### Table of Contents



Employment Litigation On April 4, 2003, Thomas Graziani, et al. filed a class action lawsuit against
Novellus in the United States District Court for the District of Oregon. On
August 1, 2003, David Robinson, et al. filed a class action lawsuit against
Novellus in the United States District Court for the Northern District of
California, San Jose Division. Both lawsuits 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. 12. SUBSEQUENT EVENTS On June 28, 2004, we acquired Rendsburg, Germany-based Peter Wolters AG, a
privately-held manufacturer of high-precision machine manufacturing tools. The
Company funded the purchase price of the acquisition, excluding transaction
costs, with approximately 124.5 million Euro of borrowings under a credit
facility. For further discussion regarding the credit facility, see Note 8.
In connection with the credit facility, the Company also entered into a
Guarantee and Collateral Agreement, dated June 25, 2004. The acquisition of Peter Wolters AG will be accounted for as a business
combination in accordance with SFAS No. 141, Business Combinations. Tangible
assets and liabilities will be 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. In the period from June 27, 2004 to July 27, 2004 we repurchased approximately
5.2 million shares of our common stock at an average repurchase price of
$27.20. 13




---



##### Table of Contents



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 assessment of
the accounting treatment of our acquisition of Peter Wolters AG; our belief
that our investments in research and development during the recent global
recession have positioned us for growth in the coming year; 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 Applied Materials, Inc., Semitool, Inc., 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; our belief that we have meritorious claims and defenses
in the Applied and Semitool litigation matters; 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; changes in
accounting standards to be applied to business combinations and valuation of
intangible assets; our misallocation of resources to technology that fails to
generate customer interest in the coming year; 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. 14




---



##### 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 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 reduce costs, increase
productivity and remain competitive. Our business depends on capital expenditures made by chip manufacturers, who in
turn are dependent on corporate and consumer demand for chips and the devices
which use them. The industry in which we operate is driven by spending for
electronic products. As a consequence, our business is directly affected by
growth or contraction in the global economy as well as by the adoption of new
technologies. Demand for personal computers, the expansion of the Internet and
telecommunications industries, and the emergence of new applications in
consumer electronics have a direct impact on our business. In addition, the
industry is characterized by intense competition and rapidly changing
technology. During the recent global recession, we continued to work closely
with our customers and made substantial investments in research and development
in order to continue delivering innovative products which enhanced productivity
for our customers and utilize the latest technology. We believe these
investments have positioned us for growth in the coming year. We focus on certain key quarterly financial data to manage our business. Net
sales, gross profit, net income (loss) and net income (loss) per share are the
primary measures we use to monitor performance. Net orders are used to forecast
and plan future operations. Net orders consist of current period orders less
current period cancellations. The following table sets forth certain quarterly
financial information for the periods indicated: Quarterly Financial Data2004
    
    2003First
    
    Second
    
    First
    
    Second
    
    Third
    
    FourthQuarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    QuarterNet sales
    
    $
    262,862
    
    
    $
    338,219
    
    
    $
    238,410
    
    
    $
    239,050
    
    
    $
    221,099
    
    
    $
    226,511Gross profit
    
    
    124,605
    
    
    
    169,680
    
    
    
    109,814
    
    
    
    105,322
    
    
    
    58,776
    
    
    
    106,088Net income (loss)
    
    
    16,681
    
    
    
    37,811
    
    
    
    11,872
    
    
    
    7,430
    
    
    
    (97,568
    )
    
    
    10,452Diluted net income (loss) per share
    
    
    0.11
    
    
    
    0.25
    
    
    
    0.08
    
    
    
    0.05
    
    
    
    (0.64
    )
    
    
    0.07Net orders
    
    
    346,793
    
    
    
    397,598
    
    
    
    241,825
    
    
    
    198,759
    
    
    
    220,775
    
    
    
    275,219
 15




---



##### 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 300mm fabrication equipment. In the first and second quarters of
2004, we experienced sequential increases of 26% and 15% 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 six to eight months after shipment. These time lines are
general estimates and actual times may vary depending on specific
circumstances. Results of Operations
(dollars in thousands) Net Sales Three Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003Net sales
    
    $
    338,219
    
    
    $
    239,050
    
    
    $
    262,862
    
    
    $
    601,081
    
    
    $
    477,460International net sales %
    
    
    79
    %
    
    
    66
    %
    
    
    78
    %
    
    
    79
    %
    
    
    61
    %
 The increase in net sales of $99.2 million for the three months ended June 26,
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 began to increase. Geographical net sales as a percentage of total net sales were as follows
(based upon the location of the customers facilities): Three Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003North America
    
    
    21
    %
    
    
    34
    %
    
    
    22
    %
    
    
    21
    %
    
    
    39
    %Europe
    
    
    6
    %
    
    
    12
    %
    
    
    8
    %
    
    
    7
    %
    
    
    10
    %Asia
    
    
    73
    %
    
    
    54
    %
    
    
    70
    %
    
    
    72
    %
    
    
    51
    %
 The increase in international net sales (sales outside North America) as a
percentage of net sales for the three months ended June 26, 2004 over the prior
year is predominantly due to an increase in net sales in the Asia region
(primarily Korea, Japan, and Taiwan) compared to net sales in North America. 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
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003Gross profit
    
    $
    169,680
    
    
    $
    105,322
    
    
    $
    124,605
    
    
    $
    294,285
    
    
    $
    215,136% of net sales
    
    
    50
    %
    
    
    44
    %
    
    
    47
    %
    
    
    49
    %
    
    
    45
    %
 Our gross profit from period to period is affected by the treatment of certain
product sales in accordance with Securities and Exchange Commission (SEC) Staff
Accounting Bulletin (SAB) No. 104, Revenue Recognition, 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 increase in gross profit percentage in the three months ended June 26, 2004
from the prior quarter and the prior year comparable 16




---



##### Table of Contents



periods is primarily attributable to product mix and to increased absorption of
our fixed overhead costs from higher shipment levels. During the quarter, we sold inventory acquired from our SpeedFam-IPEC
acquisition. This inventory was valued based on current market conditions at
December 6, 2002, the acquisition date. In the current quarter, we were able
to sell this inventory for more than the estimated value, which resulted in a
benefit to cost of sales of approximately $3.6 million in the three months
ended June 26, 2004. Without the sale of this
inventory, our gross margin would have been approximately 49% for the three
months ended June 26, 2004. In the prior quarter and the comparable prior year
period, sales of previously written down 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
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003SG&A expense
    
    $
    47,225
    
    
    $
    44,444
    
    
    $
    42,403
    
    
    $
    89,628
    
    
    $
    87,075% of net sales
    
    
    14
    %
    
    
    19
    %
    
    
    16
    %
    
    
    15
    %
    
    
    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 higher
selling costs, as well as higher profit sharing and employee-related expenses.
The decrease in SG&A expense as a percentage of net sales is primarily due to
increased volumes in net sales. Research and Development (R&D) Three Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003R&D expense
    
    $
    63,471
    
    
    $
    56,509
    
    
    $
    58,957
    
    
    $
    122,428
    
    
    $
    113,515% of net sales
    
    
    19
    %
    
    
    24
    %
    
    
    22
    %
    
    
    20
    %
    
    
    24
    %
 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 six months ended
June 26, 2004 decreased compared to the respective prior-year periods primarily
due to increased volumes in net sales. The increase in R&D expense in absolute
dollars for the three and six months ended June 26, 2004 from the prior-year
period is a result of increased headcount, higher salaries and fringe benefits. Legal Settlement Three Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003Legal settlement
    
    $
    
    
    
    $
    
    
    
    $
    2,500
    
    
    $
    2,500
    
    
    $
    % of net sales
    
    
    0
    %
    
    
    0
    %
    
    
    1
    %
    
    
    1
    %
    
    
    0
    %
 During the quarter ended March 27, 2004, we incurred a charge totaling $2.5
million related to the settlement of an overtime class action lawsuit by field
service engineers. No charges were incurred during the quarter ended June 26,
2004. We incurred no such legal charges in the comparable periods. Acquired in-process research and development Three Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003Acquired in-process
research and
development
    
    $
    6,124
    
    
    $
    
    
    
    $
    
    
    
    $
    6,124
    
    
    $
    % of net sales
    
    
    2
    %
    
    
    0
    %
    
    
    0
    %
    
    
    1
    %
    
    
    0
    %
 During the quarter ended June 26, 2004, we incurred a charge totaling $6.1
million for acquired in-process research and development 17




---



##### Table of Contents



in connection with the acquisition of Angstron Systems, Inc. We incurred no
such charges in the comparable periods. Interest and Other Income, Net Three Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    March 27, 2004
    
    June 26, 2004
    
    June 28, 2003Interest and other income, net
    
    $
    2,896
    
    
    $
    5,537
    
    
    $
    2,749
    
    
    $
    5,645
    
    
    $
    11,189% of net sales
    
    
    1
    %
    
    
    2
    %
    
    
    1
    %
    
    
    1
    %
    
    
    2
    %
 Interest and other income, net, includes interest income, interest expense and
other non-operating items. The decrease in interest and other income, net, in
absolute dollars for the three months ended June 26, 2004 compared to the three
months ended June 28, 2003 is primarily due to lower balances of
interest-bearing cash and short-term investments, lower interest rates in the
first two quarters of 2004, and change in accounting for our synthetic leases.
Lower cash and investment balances resulted mainly from the exercise of our
purchase option on properties previously leased under synthetic leases in
September 2003. The synthetic lease change reduced our interest income by
approximately $3.0 million and $6.0 million for the three and six months ended
June 26, 2004, respectively, as compared to the prior-year periods. Income Taxes Our effective tax rates were 32% and 25% for the three months ended June 26,
2004 and June 28, 2003. Tax expense for the second quarter of 2004 was $17.9
million, consisting of a 29% effective rate on income before deducting the $6.1
million in-process R&D charge taken in the second quarter. This charge is not
deductible for income tax purposes and has no tax benefit. The resulting
effective tax rate is 32%. Our effective tax rates for the six months ended
June 26, 2004 and June 28, 2003 were 29% and 25%, respectively. The increase in
2004 is due to the in-process R&D charge mentioned above, reduced benefits of
R&D tax credits due to current law which allows only one half year of credit in
2004, and increased pre-tax income. Our future effective income tax rate
depends on various factors, such as the Companys profits (losses) before
taxes, tax legislation, the geographic composition of pre-tax income and
non-deductible expenses incurred in connection with acquisitions. Critical Accounting Policies The preparation of financial statements in conformity with 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. 18




---



##### Table of Contents



Revenue related to sales
 of spare parts is recognized upon shipment. Revenue related to maintenance and service contracts is recognized
 ratably over the duration of the contracts. Unearned maintenance and service contract revenue is included in
 other accrued liabilities. Inventory Valuation We periodically assess the recoverability of all inventories, including raw
materials, work-in-process, finished goods, and spare parts, to determine
whether adjustments for impairment are required. Inventory that is obsolete or
in excess of our forecasted usage is written down to its estimated realizable
value based on assumptions about future demand and market conditions. If actual
demand is lower than our forecast, additional inventory write-downs may be
required. Goodwill and Other Intangible Assets We account for goodwill and other intangible assets in accordance with
Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets, or SFAS No. 142. SFAS No. 142 requires that goodwill and
identifiable intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually. SFAS No. 142
also requires that intangible assets with estimable useful lives be amortized
over their respective estimated useful lives to their estimated residual
values, and reviewed for impairment in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. We review our long-lived assets, including goodwill and other intangible
assets, for impairment at least annually or whenever events or changes in
circumstances indicate that the carrying amount of these assets may not be
recoverable. According to our policy, we completed goodwill impairment tests in
the third and fourth quarters of 2003. The test performed in the third quarter
was completed in connection with our restructuring plan implemented in that
quarter. Our annual goodwill impairment test was completed in the fourth
quarter. The first step of the test identifies when impairment may have
occurred, while the second step of the test measures the amount of the
impairment, if any. The results of our impairment tests did not indicate
impairment. Deferred Tax Assets We record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. As of June 26, 2004, we had
approximately $185.7 million of deferred tax assets, net of a valuation
allowance of $75.1 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 19




---



##### Table of Contents



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 generally short-term in nature. The effect of exchange
rate changes on forward foreign exchange contracts is expected to offset the
effect of exchange rate changes on the underlying hedged items. We believe
these financial instruments do not subject us to speculative risk that would
otherwise result from changes in currency exchange rates. Net foreign currency
gains and losses for effective and ineffective hedges have not been material to
our results of operations. Liquidity and Capital Resources We have historically financed our operating and capital resource requirements
through cash flows from operations, sales of equity securities and borrowings.
Our primary source of funds at June 26, 2004 consisted of $878.4 million of
cash, cash equivalents and short-term investments. This amount represents a
decrease of $123.7 million from $1,002.1 million at December 31, 2003. The
decrease was due primarily to the repurchase of common stock for $182.4
million, offset by net cash provided by operating activities of $60.4 million. Net cash provided by operating activities during the six months ended June 26,
2004 was $60.4 million. This amount consisted primarily of $54.5 million
provided by net income, adjusted for non-cash items. The net changes in working
capital accounts used $18.8 million. Net cash used in investing activities for the six months ended June 26, 2004
was $73.8 million, which consisted primarily the purchases of short-term
investments of $656.2 million, offset by proceeds from short-term investment
sales and maturities of $597.5 million. As of June 26, 2004, we did not have
any significant commitments to purchase property and equipment, except for
additional capital expenditures to enhance the functionality of our Enterprise Resource Management system. Net cash used in financing activities for the six months ended June 26, 2004
was $169.4 million, which is primarily due to the repurchase of common stock of
$182.4 million and net payments on the lines of credit of $5.0 million, offset
by the proceeds from employee stock compensation plans. Our subsidiaries in Asia and Europe have available lines of credit with various
banks with total borrowing capacity of $26.5 million. The lines of credit bear
interest at various rates, expire on various dates through March 2005 and can
be used for general operating purposes. Borrowings of $8.1 million were
outstanding under these credit facilities as of June 26, 2004. As of June 25, 2004, two of our European subsidiaries, entered into a credit
arrangement that allows for borrowing up to 127.5 million Euro. Future
borrowings are required to be secured by cash or marketable securities on
deposit. As of June 26, 2004, no amounts were outstanding under the credit
arrangement. On June 28, 2004, we borrowed the entire amount available to fund
the acquisition of Peter Wolters AG and for general corporate purposes. We believe that our current cash position, cash generated through operations
and equity offerings, and available borrowing capacity 20




---



##### Table of Contents



will be sufficient to meet our needs at least through the next twelve months. Related Party Transactions In the second quarter of 2002, we began leasing an aircraft from NVLS I, LLC, a
third-party entity wholly owned by Richard S. Hill, our Chairman and Chief
Executive Officer. Under the leasing agreement, we incurred rental expense of
approximately $198,000 and $430,000 for the three and six months ended June 26,
2004, respectively, and approximately $240,000 and $379,000 for the three and
six months ended June 28, 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 June 26, 2004 and June 28, 2003 and approximately $701,000 for the
six months 21




---



##### Table of Contents



ended June 26, 2004 and June 28, 2003. During the quarter ended June 26, 2004, 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 9.2% and 8.6% of our net sales for the three and six months ended
June 26, 2004 and 14.0% for the three and six months ended June 28, 2003. Intel
also accounted for 7.0% and 6.0% of our accounts receivable as of June 26, 2004
and December 31, 2003, respectively. From time to time, we have made secured relocation loans to our executive
officers, vice presidents and key personnel. As of June 26, 2004, we did not
have any outstanding loans to our executive officers as defined by the
Securities and Exchange Commission. However, we did have outstanding loans to
non-executive officers and key personnel. As of June 26, 2004 and December 31,
2003, the total outstanding balances of loans to non-executive officers and key
personnel were approximately $5.2 million and $5.7 million, respectively. Of
the total amount outstanding at June 26, 2004, $4.1 million was secured by
collateral. Risk Factors Set forth below and elsewhere in this Quarterly Report on Form 10-Q, including
in Item 2. Managements Discussion and Analysis, and in other documents we file
with the Securities and Exchange Commission, are risks and uncertainties that
could cause actual results to differ materially from the results contemplated
by the forward-looking statements contained in this 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 22




---



##### Table of Contents



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 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; 23




---



##### Table of Contents




    
    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.  AcquisitionsWe 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 24




---



##### Table of Contents



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 reduce our dependence
on this limited group of suppliers. However, disruption or termination of
certain of these suppliers may occur. Such disruptions could have an adverse
effect on our operations. A prolonged inability to obtain certain parts could
have a material adverse effect on our business, financial condition or results
of operations, and could result in our inability to meet customer demands on
time. Third-Party Indemnification From time to time, in the normal course of business, we indemnify third parties
with whom we enter into contractual relationships, including customers,
lessors, and parties to other transactions with us, with respect to certain
matters. We have agreed, under certain conditions, to hold these third parties
harmless against specified losses, such as those arising from a breach of
representations or covenants, other third party claims that our products when
used for their intended purposes infringe the intellectual property rights of
such other third parties or other claims made against certain parties. It is
not possible to determine the maximum potential amount of liability under these
indemnification obligations due to our limited history of prior indemnification
claims and the unique facts and circumstances that are likely to be involved in
each particular claim. Historically, payments made by us under these
obligations have not been material. Changes in Accounting Standards For Stock Option Plans 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. The financial impact of expensing stock options, had we been
required to do so, is disclosed in Note 2, Significant Accounting Policies of
our form 10-K for the year ended December 31, 2003 and Note 1 Basis of
Presentation and Stock-Based Compensation in this Form 10-Q. 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.
The impact to employee recruitment and retention, and the related impact to
profitability resulting from increased hiring and training expense, loss of
intellectual capital, potential damage to customer relationships, and the
numerous other facets of the Companys operations impacted by employee
recruitment and retention, cannot be quantified; however, could be material to
the financial statements. 
 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. 
 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 25




---



##### Table of Contents



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
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 26




---



##### Table of Contents



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 June 26, 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 Report on Form
10-Q for the quarter ended March 27, 2004. Semitool, Inc. The United States District Court for the District of Oregon has issued claim
construction orders regarding all of the patents-in-suit, and discovery has
closed. The Court denied the motion of Semitool, Inc. for summary judgment of
invalidity against U.S. Patent No. 6,074,544 and granted Semitools motion for
summary judgment of invalidity against U.S. Patent No. 6,110,346. The Court
granted Semitools motion for partial summary judgment of no direct
infringement of U.S. Patent No. 6,074,544, granted in part and denied in part
Semitools motion for partial summary judgment of no direct infringement of
U.S. Patent No. 6,162,344, and has not yet ruled on Semitools motion for
partial summary judgment of no indirect infringement of U.S. Patents 6,074,544,
6,110,346, and 6,162,344. The case is presently scheduled to proceed to trial
in November of 2004. We believe that we have meritorious claims against
Semitool and meritorious defenses to Semitools claims against us, and that
this litigation will not have a material adverse impact on our business,
financial condition, or results of operations. However, the outcome of patent
disputes is often affected by uncertainty in the resolution of complex issues
of fact and law. If Semitool were to prevail against us, the adverse effect on
our business, financial condition, or results of operations could be material. Linear Technology Corporation On March 12, 2002, Linear Technology Corporation filed a complaint against
Novellus, among other parties, in the Superior Court of the State of California
for the County of Santa Clara. The complaint sought damages (including punitive
damages) and injunctions for causes of actions involving alleged breach of
contract, fraud, unfair competition, breach of warranty, and declaratory
relief. We filed a demurrer to Linears complaint, which the court granted on
April 11, 2003, with leave to amend. On May 2, 2003, Linear filed a second
amended complaint. We filed a demurrer to Linears second amended complaint,
which the court granted on August 14, 2003, with leave to amend. On September
15, 2003, Linear filed a third amended complaint. We filed a demurrer to
Linears third amended complaint, which the court granted on January 15, 2004,
with leave to amend. 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 have not yet
filed a response to this complaint. This litigation is in its early stages and is therefore inherently difficult to
assess. We believe that this litigation will not have a material adverse impact
on our business, financial condition, or results of operations. However, the
outcome of patent disputes is often affected 27




---



##### Table of Contents



by uncertainty in the resolution of complex issues of fact and law. If Linear
were to prevail against us, the adverse effect on our business, financial
condition, or results of operations could be material. Employment Litigation On April 4, 2003, Thomas Graziani, et al. filed a class action lawsuit against
Novellus in the United States District Court for the District of Oregon. On
August 1, 2003, David Robinson, et al. filed a class action lawsuit against
Novellus in the United States District Court for the Northern District of
California, San Jose Division. Both lawsuits 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. 
 ITEM 2: CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES 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
    millionTotal
    
    
    6,000,000
    
    
    $
    30.39
    
    
    
    6,000,000
    
    
    $317.6
    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. 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 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At Novellus Annual Meeting of Shareholders, held on April 16, 2004, the
following proposals were voted on by the Shareholders as noted below: 1. Election of Directors. Name of Nominee
    
    In Favor
    
    WithheldRichard S. Hill
    
    
    134,693,008
    
    
    
    2,442,569Neil R. Bonke
    
    
    135,192,169
    
    
    
    1,943,408Youssef A. El-Mansy
    
    
    135,198,815
    
    
    
    1,936,762J. David Litster
    
    
    135,204,303
    
    
    
    1,931,274Yoshio Nishi
    
    
    135,188,622
    
    
    
    1,946,955
 28




---



##### Table of Contents



Name of Nominee
    
    In Favor
    
    WithheldGlen G. Possley
    
    
    128,860,486
    
    
    
    8,275,091Ann D. Rhoads
    
    
    129,204,440
    
    
    
    7,931,137William R. Spivey
    
    
    134,755,287
    
    
    
    2,380,290Delbert A. Whitaker
    
    
    135,190,366
    
    
    
    1,945,211
 2. Ratification and Approval of Ernst & Young LLP as independent auditors of
Novellus for the fiscal year ending December 31, 2004. In Favor
    
    Opposed
    
    Abstained126,152,326
    
    9,310,541
    
    1,672,708
 3. Shareholder proposal regarding provision of non-audit services by
independent auditors. In Favor
    
    Opposed
    
    Abstained12,449,395
    
    93,238,529
    
    3,408,555
 4. Shareholder proposal regarding executive compensation. In Favor
    
    Opposed
    
    Abstained6,855,107
    
    99,698,802
    
    2,542,571
 
 ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits  31.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated August
5, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated August 5, 2004 in accordance
with 18 U.S.C. 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated August
5, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated August 5, 2004 in accordance
with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K On April 12, 2004, we furnished a report on Form 8-K under items 7 and 12
announcing our results of operations for the quarter ended March 27, 2004. 29




---



##### 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 Chief
Accounting Officer)August 5, 2004
 30




---



##### 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 August
5, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated August 5, 2004 in accordance
with 18 U.S.C. 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Richard S. Hill, Chairman of the Board of Directors
and Chief Executive Officer of Novellus Systems, Inc. dated August
5, 2004 in accordance with 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Kevin S. Royal, Vice President and Chief Financial
Officer of Novellus Systems, Inc. dated August 5, 2004 in accordance
with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. 31