##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

(X Box) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 29, 2002

OR

(Box) 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

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 Box) NO (Box)

As of July 31, 2002, 145,070,611 shares of the Registrants common stock, no
par value, were issued and outstanding.





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TABLE OF CONTENTS



|                              |                                                                                               |                                                                  |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------------------- |  |  |  |  |  | 
|PART I: FINANCIAL INFORMATION
|                              | ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                          
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS                           
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                 
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
|                              | ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                              | ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK                            
|PART II: OTHER INFORMATION   
|                              | ITEM 1: LEGAL PROCEEDINGS                                                                    
|                              | ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|                              | ITEM 5: OTHER INFORMATION                                                                    
|                              | ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                   
|Exhibit Index                
|EXHIBIT 10.1                 



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##### Table of Contents



NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED JUNE 29, 2002

TABLE OF CONTENTS

|                              |  |  |    |         |  |                                                                                       |  |                                                                                                                    |    |      |   | 
|----------------------------- |  |  | -- | ------- |  | ------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------ | -- | ---- | - | 
|                              |  |  |    |         |  |                                                                                       |  |                                                                                                                    |    | Page
|Part I: Financial Information |  |  |    |        
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 1: |  | Condensed Consolidated Financial Statements                                           |  |                                                                                                                    |    |     
|                             
|                             
|                             
|                             
|                              |  |  |    |         |  |                                                                                       |  | Condensed Consolidated Statements of Operations for the three and six months ended
June 29, 2002 and June 30, 2001 |    |      | 3 | 
|                             
|                             
|                             
|                             
|                              |  |  |    |         |  |                                                                                       |  | Condensed Consolidated Balance Sheets at June 29, 2002 and December 31, 2001                                       |    |      | 4 | 
|                             
|                             
|                             
|                             
|                              |  |  |    |         |  |                                                                                       |  | Condensed Consolidated Statements of Cash Flows for the six months ended June 29,
2002 and June 30, 2001           |    |      | 5 | 
|                             
|                             
|                             
|                             
|                              |  |  |    |         |  |                                                                                       |  | Notes to Condensed Consolidated Financial Statements                                                               |    |      | 6 | 
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 2: |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  |                                                                                                                    | 13 |     
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 3: |  | Quantitative and Qualitative Disclosure About Market Risk                             |  |                                                                                                                    | 23 |     
|                             
|                             
|                             
|                             
|Part II: Other Information    |  |  |    |        
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 1: |  | Legal Proceedings                                                                     |  |                                                                                                                    | 24 |     
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 4: |  | Submission of Matters to a Vote of Security Holders                                   |  |                                                                                                                    | 27 |     
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 5: |  | Other Information                                                                     |  |                                                                                                                    | 27 |     
|                             
|                             
|                             
|                             
|                              |  |  |    | Item 6: |  | Exhibits and Reports on Form 8-K                                                      |  |                                                                                                                    | 28 |     
|                             
|                             
|                             
|                             
|Signatures                    |  |  | 28 |        

2



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##### Table of Contents






PART I: FINANCIAL INFORMATION




ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




NOVELLUS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

|                                         |                                      |                              |         |                    |      |                  |         |          |      |   |         |         |      |   |         |         |      | 
|---------------------------------------- | ------------------------------------ | ---------------------------- | ------- | ------------------ | ---- | ---------------- | ------- | -------- | ---- | - | ------- | ------- | ---- | - | ------- | ------- | ---- | 
|                                         |                                      |                              |         | Three months ended |      | Six months ended
|(in thousands, except per share amounts) |                                      | June 29,                     |         | June 30,           |      | June 29,         |         | June 30,
|(unaudited)                              |                                      | 2002                         |         | 2001               |      | 2002             |         | 2001    
|                                        
|Net sales                                |                                      | $                            | 222,147 |                    |      | $                | 376,899 |          |      | $ | 391,826 |         |      | $ | 835,604 |        
|                                        
|                                        
|                                        
|                                        
|Cost of sales                            |                                      |                              | 120,583 |                    |      |                  | 177,275 |          |      |   | 218,732 |         |      |   | 380,995 |        
|                                         |                                      |                             
|Gross profit                             |                                      |                              | 101,564 |                    |      |                  | 199,624 |          |      |   | 173,094 |         |      |   | 454,609 |        
|                                        
|                                        
|                                        
|                                        
|Operating expenses:                      |                                      |                              |         |                    |      |                  |         |          |      |   |         |         |      |   |         |        
|                                        
|                                        
|                                        
|                                        
|                                         | Selling, general, and administrative |                              |         | 39,478             |      |                  |         | 54,468   |      |   |         | 74,164  |      |   |         | 123,374 |     
|                                        
|                                        
|                                        
|                                        
|                                         | Research and development             |                              |         | 58,727             |      |                  |         | 72,707   |      |   |         | 112,773 |      |   |         | 143,198 |     
|                                        
|                                        
|                                        
|                                        
|                                         | Special charges                      |                              |         |                   |      |                  |         |         |      |   |         | 3,273   |      |   |         | 13,160  |     
|                                        
|                                        
|                                        
|                                        
|                                         | Bad
debt write-off (recovery)        |                              |         |                   |      |                  |         |         |      |   |         | (7,662  | )    |   |         |        |     
|                                         |                                      |                             
|Total operating expenses                 |                                      |                              | 98,205  |                    |      |                  | 127,175 |          |      |   | 182,548 |         |      |   | 279,732 |        
|                                         |                                      |                             
|Operating income (loss)                  |                                      |                              | 3,359   |                    |      |                  | 72,449  |          |      |   | (9,454  | )       |      |   | 174,877 |        
|                                        
|                                        
|                                        
|                                        
|Interest and other income, net           |                                      |                              | 11,847  |                    |      |                  | 13,379  |          |      |   | 29,516  |         |      |   | 29,939  |        
|                                         |                                      |                             
|Income before income taxes               |                                      |                              | 15,206  |                    |      |                  | 85,828  |          |      |   | 20,062  |         |      |   | 204,816 |        
|                                        
|                                        
|                                        
|                                        
|Provision for income taxes               |                                      |                              | 3,193   |                    |      |                  | 26,607  |          |      |   | 4,213   |         |      |   | 63,493  |        
|                                         |                                      |                             
|Net income                               |                                      | $                            | 12,013  |                    |      | $                | 59,221  |          |      | $ | 15,849  |         |      | $ | 141,323 |        
|                                         |                                      |                             
|Net income per share:                    |                                      |                              |         |                    |      |                  |         |          |      |   |         |         |      |   |         |        
|                                        
|                                        
|                                        
|                                        
|                                         |                                      | Basic net income per share   |         | $                  | 0.08 |                  |         | $        | 0.42 |   |         | $       | 0.11 |   |         | $       | 1.00 | 
|                                         |                                      |                             
|                                         |                                      | Diluted net income per share |         | $                  | 0.08 |                  |         | $        | 0.40 |   |         | $       | 0.11 |   |         | $       | 0.95 | 
|                                         |                                      |                             
|Shares used in basic calculation         |                                      |                              | 145,120 |                    |      |                  | 142,267 |          |      |   | 144,687 |         |      |   | 141,638 |        
|                                         |                                      |                             
|Shares used in diluted calculation       |                                      |                              | 151,053 |                    |      |                  | 149,643 |          |      |   | 150,838 |         |      |   | 148,876 |        
|                                         |                                      |                             

See accompanying notes.

3



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##### Table of Contents






NOVELLUS SYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS

|                                               |                                               |                                            |         |           |           |              |         |           |           | 
|---------------------------------------------- | --------------------------------------------- | ------------------------------------------ | ------- | --------- | --------- | ------------ | ------- | --------- | --------- | 
|                                               |                                               |                                            |         | June 29,  |           | December 31,
|(in thousands)                                 |                                               | 2002                                       |         | 2001 *   
|                                              
|Assets                                         |                                               | (unaudited)                                |         |           |           |             
|                                              
|                                              
|                                              
|                                              
|Current assets:                                |                                               |                                            |         |           |           |              |         |          
|                                              
|                                              
|                                              
|                                              
|                                               | Cash and cash equivalents                     |                                            | $       | 524,897   |           |              | $       | 550,640   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Short-term investments                        |                                            |         | 416,997   |           |              |         | 371,182   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Restricted short-term investments             |                                            |         | 872,299   |           |              |         | 961,643   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Accounts receivable, net                      |                                            |         | 221,244   |           |              |         | 225,916   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Inventories                                   |                                            |         | 251,362   |           |              |         | 244,712   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Deferred tax assets, net                      |                                            |         | 83,415    |           |              |         | 82,069    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Prepaid and other current assets              |                                            |         | 59,158    |           |              |         | 81,049    |          
|                                               |                                               |                                           
|                                               |                                               | Total current assets                       |         |           | 2,429,372 |              |         |           | 2,517,211 | 
|                                              
|                                              
|                                              
|                                              
|Property and equipment:                        |                                               |                                            |         |           |           |              |         |          
|                                              
|                                              
|                                              
|                                              
|                                               | Machinery and equipment                       |                                            |         | 251,577   |           |              |         | 243,677   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Furniture and fixtures                        |                                            |         | 15,297    |           |              |         | 15,256    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Leasehold improvements                        |                                            |         | 79,882    |           |              |         | 79,264    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Land                                          |                                            |         | 8,782     |           |              |         | 8,782     |          
|                                               |                                               |                                           
|                                               |                                               |                                            | 355,538 |           |           |              | 346,979 |          
|                                              
|                                              
|                                              
|                                              
|Less accumulated depreciation and amortization |                                               |                                            | 187,795 |           |           |              | 169,378 |          
|                                               |                                               |                                           
|                                               |                                               |                                            | 167,743 |           |           |              | 177,601 |          
|                                              
|                                              
|                                              
|                                              
|Other assets                                   |                                               |                                            | 91,773  |           |           |              | 70,177  |          
|                                              
|                                              
|                                              
|                                              
|Note receivable                                |                                               |                                            | 397,429 |           |           |              | 244,673 |          
|                                               |                                               |                                           
|                                               |                                               | Total assets                               |         | $         | 3,086,317 |              |         | $         | 3,009,662 | 
|                                               |                                               |                                           
|Liabilities and shareholders equity           |                                               |                                            |         |           |           |              |         |          
|                                              
|                                              
|                                              
|                                              
|Current liabilities:                           |                                               |                                            |         |           |           |              |         |          
|                                              
|                                              
|                                              
|                                              
|                                               | Accounts payable                              |                                            | $       | 95,520    |           |              | $       | 67,317    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Accrued payroll and related expenses          |                                            |         | 25,057    |           |              |         | 34,211    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Accrued warranty                              |                                            |         | 35,796    |           |              |         | 43,337    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Other accrued liabilities                     |                                            |         | 33,066    |           |              |         | 30,411    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Restructuring accrual                         |                                            |         | 22,871    |           |              |         | 26,849    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Income taxes payable                          |                                            |         | 9,504     |           |              |         | 5,870     |          
|                                              
|                                              
|                                              
|                                              
|                                               | Deferred profit                               |                                            |         | 51,528    |           |              |         | 40,835    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Current obligations under lines of credit     |                                            |         | 17,927    |           |              |         | 26,179    |          
|                                              
|                                              
|                                              
|                                              
|                                               | Convertible subordinated debentures           |                                            |         | 862,953   |           |              |         | 862,659   |          
|                                               |                                               |                                           
|                                               |                                               | Total current liabilities                  |         |           | 1,154,222 |              |         |           | 1,137,668 | 
|                                              
|                                              
|                                              
|                                              
|Shareholders equity:                          |                                               |                                            |         |           |           |              |         |          
|                                              
|                                              
|                                              
|                                              
|                                               | Common stock                                  |                                            |         | 1,329,303 |           |              |         | 1,273,201 |          
|                                              
|                                              
|                                              
|                                              
|                                               | Retained earnings                             |                                            |         | 603,935   |           |              |         | 597,267   |          
|                                              
|                                              
|                                              
|                                              
|                                               | Accumulated other comprehensive income (loss) |                                            |         | (1,143    | )         |              |         | 1,526     |          
|                                               |                                               |                                           
|                                               |                                               | Total shareholders equity                 |         |           | 1,932,095 |              |         |           | 1,871,994 | 
|                                               |                                               |                                           
|                                               |                                               | Total liabilities and shareholders equity |         | $         | 3,086,317 |              |         | $         | 3,009,662 | 
|                                               |                                               |                                           

*Amounts as of December 31, 2001 are
derived from the December 31, 2001 audited financial statements.

See accompanying notes.

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NOVELLUS SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                         |                                                                                   |                                                     |                   |            |                  |        |         |           |         |          |  
|-------------------------------------------------------- | --------------------------------------------------------------------------------- | --------------------------------------------------- | ----------------- | ---------- | ---------------- | ------ | ------- | --------- | ------- | -------- | -
|                                                         |                                                                                   |                                                     |                   |            | Six months ended
|(in thousands)                                           |                                                                                   | June 29,                                            |                   | June 30,  
|(unaudited)                                              |                                                                                   | 2002                                                |                   | 2001      
|                                                        
|Cash flows from operating activities:                    |                                                                                   |                                                     |                   |            |                  |        |         |          
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Net income                                                                        |                                                     | $                 | 15,849     |                  |        | $       | 141,323   |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Adjustments to reconcile net income to net cash
provided by operating activities: |                                                     |                   |            |                  |        |         |           |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Gain on sale of an investment                                                     |                                                     |                   | (4,602     | )                |        |         |          |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Depreciation and amortization                                                     |                                                     |                   | 24,919     |                  |        |         | 22,809    |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Deferred income taxes                                                             |                                                     |                   | (1,346     | )                |        |         | 43,358    |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Deferred compensation                                                             |                                                     |                   | 873        |                  |        |         | 725       |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Adjustment to conform fiscal year end of GaSonics                                 |                                                     |                   |           |                  |        |         | 1,714     |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Income
tax benefits from employee stock option plans                              |                                                     |                   | 16,942     |                  |        |         | 24,311    |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Changes in operating assets and liabilities:                                      |                                                     |                   |            |                  |        |         |           |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Accounts receivable                                 |                   |            | 4,672            |        |         |           | 102,006 |         
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Inventories                                         |                   |            | (6,313           | )      |         |           | (73,184 | )       
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Prepaid and other current assets                    |                   |            | 21,891           |        |         |           | (32,553 | )       
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Accounts payable                                    |                   |            | 28,203           |        |         |           | (30,608 | )       
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Accrued payroll and related expenses                |                   |            | (9,154           | )      |         |           | (14,001 | )       
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Accrued warranty                                    |                   |            | (7,541           | )      |         |           | 1,529   |         
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Deferred profit                                     |                   |            | 10,693           |        |         |           | (95,295 | )       
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Other accrued liabilities                           |                   |            | (1,323           | )      |         |           | (6,178  | )       
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         |                                                                                   | Income taxes payable                                |                   |            | 5,176            |        |         |           | (49,920 | )       
|                                                         |                                                                                   |                                                    
|                                                         |                                                                                   |                                                     | Total adjustments |            |                  | 83,090 |         |           |         | (105,287 | )
|                                                         |                                                                                   |                                                    
|                                                         |                                                                                   | Net cash provided by operating activities           |                   |            | 98,939           |        |         |           | 36,036  |         
|                                                         |                                                                                   |                                                    
|                                                        
|                                                        
|                                                        
|                                                        
|Cash flows from investing activities:                    |                                                                                   |                                                     |                   |            |                  |        |         |          
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Proceeds from the sale and maturity of short-term investments                     |                                                     |                   | 380,313    |                  |        |         | 1,073,177 |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Purchases of short-term investments                                               |                                                     |                   | (425,289   | )                |        |         | (980,500  | )      
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Proceeds from the sale and maturity of restricted short-term
investments          |                                                     |                   | 1,274,583  |                  |        |         |          |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Purchases of restricted short-term investments                                    |                                                     |                   | (1,186,362 | )                |        |         |          |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Capital expenditures                                                              |                                                     |                   | (12,376    | )                |        |         | (49,355   | )      
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Decrease in other assets                                                          |                                                     |                   | 1,052      |                  |        |         | 555       |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Participation in synthetic leases                                                 |                                                     |                   | (177,457   | )                |        |         |          |        
|                                                         |                                                                                   |                                                    
|                                                         |                                                                                   | Net cash provided by (used in) investing activities |                   |            | (145,536         | )      |         |           | 43,877  |         
|                                                         |                                                                                   |                                                    
|                                                        
|                                                        
|                                                        
|                                                        
|Cash flows from financing activities:                    |                                                                                   |                                                     |                   |            |                  |        |         |          
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Proceeds from employee
stock option plans                                         |                                                     |                   | 41,750     |                  |        |         | 33,155    |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Proceeds from (payments on) lines of credit, net                                  |                                                     |                   | (8,252     | )                |        |         | 5,945     |        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                         | Repurchase of common stock                                                        |                                                     |                   | (12,644    | )                |        |         |          |        
|                                                         |                                                                                   |                                                    
|                                                         |                                                                                   | Net cash provided by financing activities           |                   |            | 20,854           |        |         |           | 39,100  |         
|                                                         |                                                                                   |                                                    
|                                                        
|                                                        
|                                                        
|                                                        
|Net increase (decrease) in cash and cash equivalents     |                                                                                   |                                                     | (25,743           | )          |                  |        | 119,013 |          
|                                                        
|                                                        
|                                                        
|                                                        
|Cash and cash equivalents at the beginning of the period |                                                                                   |                                                     | 550,640           |            |                  |        | 589,415 |          
|                                                         |                                                                                   |                                                    
|Cash and cash equivalents at the end of the period       |                                                                                   | $                                                   | 524,897           |            |                  | $      | 708,428 |          
|                                                         |                                                                                   |                                                    

See accompanying notes.

5



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##### Table of Contents






NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with accounting principles generally accepted in
the United States of America for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by 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 29, 2002 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2002. For further information, refer to the consolidated
financial statements and footnotes thereto included in Novellus Annual Report
on Form 10-K for the year ended December 31, 2001.

On January 10, 2001, Novellus merged with GaSonics International Corporation
(GaSonics). The merger was accounted for as a pooling-of-interests
transaction in accordance with generally accepted accounting principles. In
the transaction, Novellus acquired all outstanding shares of GaSonics in a
stock-for-stock merger, with all outstanding shares of GaSonics capital stock
converted into approximately 9,240,000 shares of Novellus common stock. In
addition, all outstanding options to purchase shares of GaSonics capital stock
were automatically converted into options to purchase approximately 1,400,000
shares of Novellus common stock. Merger related expenses of approximately
$13.2 million were recorded in the first quarter of 2001 and were included in
special charges within the statement of operations.

Novellus adopted Statement of Financial Accounting Standards No. 142, (SFAS
142) Goodwill and Other Intangible Assets in the first quarter of 2002.
SFAS 142 discontinues amortization of goodwill and intangible assets deemed to
have indefinite lives and requires such assets to be reviewed at least annually
for impairment. SFAS 142 also includes provisions on the identification of
intangible assets, reclassification of certain intangibles from previously
reported goodwill, and reassessment of the useful lives of existing
intangibles. As of January 1, 2002, Novellus had a goodwill balance of
approximately $20.1 million. Consequently upon adoption, the application of
the non-amortization provisions of SFAS 142 resulted in an increase in pre-tax
operating income of $0.9 million and $1.8 million, in the three and six months
ended June 29, 2002, respectively. If Novellus had adopted the provisions of
SFAS 142 in the first quarter of 2001, the increase in pre-tax operating income
would have been $0.9 million and $1.8 million, in the three
and six months ended June 30, 2001, respectively. Novellus would have recorded
earnings per share, on a diluted basis, $0.40 and $0.96 for the three and six
months ended June 30, 2001, respectively. In the first quarter of 2002,
Novellus conducted a test for impairment of its goodwill using the two-step
process prescribed in SFAS 142. The first step identifies when impairment may
have occurred, while the second step measures the amount of the impairment, if
any. The conclusion of the test was that the Companys goodwill assets were
not impaired.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires Novellus
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and the related disclosure of contingent
assets and liabilities. On an ongoing basis, Novellus evaluates its estimates,
including those related to allowance for doubtful accounts, inventories,
investments, deferred tax assets, income taxes, warranty
obligations, restructuring, and contingencies and litigation. Novellus bases
its estimates on historical experience and on various other assumptions that
are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions.

Novellus believes the following critical accounting policies affect its more
significant judgments and estimates used in the preparation of its condensed
consolidated financial statements.

Revenue Recognition

Novellus recognizes revenue in accordance with SEC Staff Accounting Bulletin
No. 101 (SAB 101), Revenue Recognition in Financial Statements and SAB
101: Revenue Recognition in Financial Statements-Frequently Asked Questions and
Answers (SAB 101 FAQ). Novellus recognizes revenue when persuasive evidence
of an arrangement exists, delivery has

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

occurred or services have been rendered, the sellers price is fixed or
determinable, and collectibility is reasonably assured. Certain of Novellus
product sales are accounted for as multiple-element arrangements. If Novellus
has met defined customer acceptance experience levels with both the customer
and the specific type of equipment, then Novellus recognizes equipment revenue
upon shipment and transfer of title, with the remainder when it becomes due
(generally upon acceptance). All other equipment sales are recognized upon
customer acceptance. Revenue related to spare part sales is recognized on
shipment. Revenue related to maintenance and service contracts is recognized
ratably over the duration of the contracts. Unearned maintenance and service
contract revenue is not significant and is included in other accrued
liabilities.

Allowance for Doubtful Accounts

Novellus evaluates its allowance for doubtful accounts based on a combination
of factors. In circumstances where Novellus is aware of a specific customers
inability to meet its financial obligations to us, Novellus records a specific
allowance for bad debts against amounts due to reduce the net recognized
receivable to the amount Novellus reasonably believes will be collected. For
all other customers, Novellus recognizes a reserve for bad debts based on a
certain percentage of total revenues, which is based on Novellus historical
experience over five years. If circumstances change (e.g. higher than expected
defaults or an unexpected material adverse change in a major customers ability
to meet its financial obligations to us), Novellus may amend its estimates of
the recoverability of amounts due to Novellus.

Inventory Reserves

Novellus assesses the recoverability of all inventory, including
work-in-process, finished goods, and spare parts to determine whether
adjustments for impairment are required. Inventory which is obsolete or in
excess of Novellus forecasted usage is written down to its estimated market
value based on assumptions about future demand and market conditions. If
actual demand is lower than the Companys forecast, additional inventory
write-downs may be required.

Warranty and Installation

Novellus warranty and installation policy generally states that Novellus will
provide installation services as well as warranty coverage, for a predetermined
amount of time, on systems and modules for material and labor to repair and
service the equipment. Novellus records the estimated cost of warranty
coverage and installation upon system shipment. The estimated cost of warranty
and installation coverage is determined by the warranty term as well as the
average historical warranty and installation expense for a specific tool.
Should actual product failure rates, material usage, or installation costs
differ from Novellus estimates, revisions to the estimated warranty and
installation liability may be required.

Investments

Novellus classifies its marketable securities as available-for-sale in
accordance with the provisions of the Statement of Financial Accounting
Standard (SFAS) No. 115, Accounting for Certain Investments in Debt and
Equity Securities. Securities classified as available-for-sale are reported at
fair market value with the related unrealized gains and losses included, net of
tax, in accumulated other comprehensive income (loss). Realized gains and
losses and declines in value of securities judged to be other than temporary
are included in other income. Interest on all securities is included in
interest income. Future adverse changes in market conditions or poor operating
results of underlying investments could result in losses or an inability to
recover the carrying value of the investments that may not be reflected in an
investments current carrying value, thereby possibly requiring impairment
charges in the future. The fair values of investments are determined using
quoted market prices if available. If quoted market prices are not
available, investments are estimated using discounted cash flows and
market interest rates.

Deferred Tax Assets

Novellus records a valuation allowance to reduce its deferred tax assets to the
amount that is more likely than not to be realized. While Novellus has
considered future taxable income and ongoing prudent and feasible tax planning
strategies in

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

assessing the need for the valuation allowance, in the event
Novellus determined that it would be able to realize its deferred tax assets in excess of
its net recorded amount, an adjustment to the deferred tax
assets would increase income in the period such determination was made.
Likewise, should Novellus determine that it would not be able to realize
all or part of its net deferred tax assets in the future, an adjustment to the
deferred tax assets would decrease income in the period such determination
was made.

Restructuring

Novellus accounts for the need to record restructuring charges in accordance with
Emerging Issues Task Force (EITF) 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), EITF 95-3, Recognition
of Liabilities in Connection with a Purchase Business Combination and Staff
Accounting Bulletin No. 100, Restructuring and Impairment Charges. In
accordance with this guidance, management must execute an exit plan that will
result in the incurrence of costs that have no future economic benefit. Also
under the terms of EITF 94-3, a liability for the restructuring charges is
recognized in the period management approves the restructuring plan. In the
third quarter of 2001, Novellus established restructuring reserves for its
operations. In the first quarter of 2002, Novellus had a reduction in force,
which required reserves for severance benefits. These
reserves required the use of estimates. Though Novellus believes that these
estimates accurately reflect the costs of these plans, actual results may be
different. See Note 8 to Condensed Consolidated Financial Statements.

Contingencies and Litigation

Novellus makes an assessment of the probability of an adverse judgment
resulting from current and threatened litigation. Novellus would accrue the
cost of an adverse judgment if, in Novellus estimation, the adverse settlement
is probable and Novellus can reasonably estimate the ultimate cost to Novellus.
Novellus has made no such accruals at June 29, 2002.

2. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No.
143, Accounting for Asset Retirement Obligations, which addresses accounting
and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. SFAS 143 is
effective for fiscal years beginning after June 15, 2002. Novellus does not
expect the adoption of SFAS 143 to be material to its financial condition or
results of operations.

In August 2001, the FASB issued SFAS No. 144, Impairment or Disposal of
Long-Lived Assets, which is effective for fiscal years beginning after
December 15, 2001. SFAS 144 supersedes SFAS 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,
and provides a single accounting model for impairment of long-lived assets.
Novellus does not expect the adoption of SFAS 144 to have a material effect on
Novellus financial condition or results of operations.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. For most companies, SFAS 145 will require gains and losses

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

on extinguishments of debt to be classified as income or loss from continuing
operations rather than as extraordinary items as previously required under SFAS
4. Extraordinary treatment will be required for certain extinguishments as
provided in APB Opinion No. 30. The statement also amended SFAS 13 for certain
sales-leaseback transactions and sublease accounting. Novellus is
required to adopt the provisions of SFAS 145 effective January 1, 2003.
Novellus does not expect the adoption of SFAS 145 to have a material effect on
the Companys financial condition or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities. SFAS 146 addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies
EITF 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 must be applied beginning January 1, 2003. SFAS 146
requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred rather than when the exit
or disposal plan is approved. Novellus is currently evaluating the impact of
this adoption.

3. INVENTORIES

Inventories are stated at the lower of cost (first-in, first-out) or market.
Inventories consisted of the following (in thousands):

|                          |                 |   |          |         |              |   |         |         | 
|------------------------- | --------------- | - | -------- | ------- | ------------ | - | ------- | ------- | 
|                          |                 |   | June 29, |         | December 31,
|                          |                 |   | 2002     |         | 2001        
|                          |                 |  
|Purchased and spare parts |                 | $ | 198,290  |         |              | $ | 199,702 |        
|                         
|                         
|                         
|                         
|Work-in-process           |                 |   | 46,169   |         |              |   | 42,717  |        
|                         
|                         
|                         
|                         
|Finished goods            |                 |   | 6,903    |         |              |   | 2,293   |        
|                          |                 |  
|                          | Total inventory |   | $        | 251,362 |              |   | $       | 244,712 | 
|                          |                 |  

4. LINES OF CREDIT

As of June 29, 2002, Novellus has lines of credit with four Japanese banks,
which expire at various dates through October 2002, under which Novellus can
borrow up to $30.2 million at the banks prime rates (ranging from 0.46% to
0.50%) as of June 29, 2002. These facilities are available to Novellus
Japanese subsidiary, Novellus Systems, Japan. At June 29, 2002 and December 31,
2001, amounts outstanding were $17.9 million and
$26.2 million, respectively, at annual
weighted-average interest rates of 0.48% and 0.62%, respectively. All
borrowings under the lines of credit were by Novellus Systems, Japan.

5. NET INCOME PER SHARE

Net income per share is calculated in accordance with SFAS No. 128. Basic net
income per share excludes the dilutive effect of employee stock options.
Diluted net income per share includes the dilutive effect of employee stock
options. The following table sets forth the computation of basic and diluted
net income per share (in thousands, except per share amounts):

|                             |                                           |                                             |      |                    |         |                  |      |          |         |          |      |         |         |   |      |         |         | 
|---------------------------- | ----------------------------------------- | ------------------------------------------- | ---- | ------------------ | ------- | ---------------- | ---- | -------- | ------- | -------- | ---- | ------- | ------- | - | ---- | ------- | ------- | 
|                             |                                           |                                             |      | Three months ended |         | Six months ended
|                             |                                           |                                             |      | June 29,           |         | June 30,         |      | June 29, |         | June 30,
|                             |                                           |                                             |      | 2002               |         | 2001             |      | 2002     |         | 2001    
|                             |                                           |                                            
|Numerator:                   |                                           |                                             |      |                    |         |                  |      |          |         |          |      |         |         |   |      |        
|                            
|                            
|                            
|                            
|                             | Net income                                |                                             | $    | 12,013             |         |                  | $    | 59,221   |         |          | $    | 15,849  |         |   | $    | 141,323 |        
|                             |                                           |                                            
|Denominator:                 |                                           |                                             |      |                    |         |                  |      |          |         |          |      |         |         |   |      |        
|                            
|                            
|                            
|                            
|                             | Basic weighted-average shares outstanding |                                             |      | 145,120            |         |                  |      | 142,267  |         |          |      | 144,687 |         |   |      | 141,638 |        
|                            
|                            
|                            
|                            
|                             | Employee stock options                    |                                             |      | 5,933              |         |                  |      | 7,376    |         |          |      | 6,151   |         |   |      | 7,238   |        
|                             |                                           |                                            
|                             |                                           | Diluted weighted-average shares outstanding |      |                    | 151,053 |                  |      |          | 149,643 |          |      |         | 150,838 |   |      |         | 148,876 | 
|                             |                                           |                                            
|Basic net income per share   |                                           | $                                           | 0.08 |                    |         | $                | 0.42 |          |         | $        | 0.11 |         |         | $ | 1.00 |        
|                             |                                           |                                            
|Diluted net income per share |                                           | $                                           | 0.08 |                    |         | $                | 0.40 |          |         | $        | 0.11 |         |         | $ | 0.95 |        
|                             |                                           |                                            

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6. COMMITMENTS

Novellus leases nearly all of its facilities under operating leases, including
synthetic leases, which expire at various dates through 2010. A synthetic
lease is a form of operating lease whereby a third party lessor funds 100% of
the acquisition and construction costs relating to one or more properties to be
leased to a lessee. The lessor is the owner of the leased property and must
provide at least 3% of the required funds in the form of at-risk equity. The
lessor generally borrows the balance of the funds necessary to fund the
acquisition and construction. Under certain of Novellus synthetic lease
agreements, Novellus is obligated to lend approximately 87% of the cost of the
leased asset to the lessor upon completion of construction. The leases with
this requirement are known as defeased or self-funded transactions.
Additionally, Novellus synthetic leases require the Company to maintain
collateral for the benefit of the lessor.

Novellus holds synthetic lease agreements on
properties in San Jose, California and Tualatin, Oregon. During the six months ended June 29, 2002, Novellus drew
an additional $87.5 million against its available lease financing line for the
Tualatin property for which construction was completed in May 2002.There are
no additional amounts available under the Tualatin lease facility. The total
financing under the San Jose synthetic lease has not changed significantly
since December 31, 2001.

Summary information regarding Novellus synthetic lease arrangements is as follows
as of June 29, 2002 (currency amounts in thousands):

|             |  |            |    |             |  |               |         |           |  |            |         |                |  |   |        |  |  |   |        |  |  |   |         | 
|------------ |  | ---------- | -- | ----------- |  | ------------- | ------- | --------- |  | ---------- | ------- | -------------- |  | - | ------ |  |  | - | ------ |  |  | - | ------- | 
|Property     |  | Number of  |    | Total Lease |  | Novellus'     |         | Net Lease |  | Collateral |         | Residual Value
|Location     |  | Properties |    | Financing   |  | Participation |         | Financing |  | Value      |         | Guarantee     
|             |  |            |    |             |  |              
|             |  |            |    |             |  |               |         |           |  |           
|San Jose, CA |  |            | 13 |             |  | $             | 293,183 |           |  | $          | 257,042 |                |  | $ | 36,141 |  |  | $ | 36,141 |  |  | $ | 258,220 | 
|            
|            
|            
|            
|Tualatin, OR |  |            | 1  |             |  |               | 163,241 |           |  |            | 140,387 |                |  |   | 22,854 |  |  |   | 22,854 |  |  |   | 140,387 | 
|             |  |            |    |             |  |               |         |          
|             |  |            | 14 |             |  | $             | 456,424 |           |  | $          | 397,429 |                |  | $ | 58,995 |  |  | $ | 58,995 |  |  | $ | 398,607 | 
|             |  |            |    |             |  |               |         |          

7. CONVERTIBLE SUBORDINATED DEBENTURES

On July 26, 2001, Novellus issued $880.0 million of Liquid Yield Option Notes
(LYONs) due July 26, 2031. The net proceeds after issuance costs (which will
be amortized over 30 years) from the LYONs offering were $862.4 million. The
LYONs are zero coupon, zero-yield subordinated debentures that may be converted
into shares of Novellus common stock, subject to specified conditions as set
forth in the indenture. The LYONs are convertible into 13.09504 shares of
Novellus common stock per $1,000 LYON, or 11.5 million shares and 7.9% of all
outstanding shares as of June 29, 2002, if (1) the sales price of Novellus
common stock reaches a specified threshold, (2) the LYONs are called for
redemption, or (3) specified corporate transactions have occurred, subject to
antidilutive adjustments.

On July 26, 2002, the security holders had the option to deliver the LYONs to
Novellus and to require Novellus to repurchase the LYONs for $1,000 in cash
each, up to a maximum of $880.0 million for all outstanding LYONs.
Additionally, security holders also have the option to require Novellus to
repurchase the LYONs on July 26, 2006, 2011, 2016, 2021, and 2026. On those
repurchase dates in 2006 and thereafter, Novellus has the ability to determine
whether the repurchase of the LYONs will be for cash or common stock or a
combination of cash and common stock.

Novellus deposited U.S. treasury securities into a pledge account to secure
Novellus obligations under the LYONs until July 26, 2002. These securities
are reflected on Novellus balance sheet as restricted short-term investments.

On July 26, 2002, the security holders exercised their option to deliver the
LYONs to Novellus and required Novellus to repurchase the LYONs for $1,000 in
cash each on such date, representing $880.0 million for substantially all
outstanding LYONs. Novellus used the restricted short-term investments
discussed above, which had matured to $880.0 million, to
repurchase the LYONs. Novellus will record a charge in July 2002 of
approximately $17.0 million to other expense for the remaining unamortized
issuance costs related to the LYONs.

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

8. SPECIAL CHARGES

Reduction in Force

In the first quarter of 2002, Novellus reduced its workforce in response to
market conditions. Novellus recorded a special charge of $3.3 million,
primarily for the cost of severance compensation. As of June 29, 2002, all
severance benefits related to the reduction in workforce had been paid.

Merger-Related Expense

During the first quarter of 2001, Novellus incurred merger costs related to the
acquisition of GaSonics of $13.2 million. These costs included professional
fees, financial printing, and other related costs. Additionally, these costs
included charges related to the cancellation of various contracts and the
write-off of certain redundant assets. As of June 29, 2002, all expenses related
to these accruals had been paid.

Restructuring

In September 2001, Novellus announced its intention to restructure its
operations, which was driven by the decline in Novellus orders due to the
contraction of the semiconductor capital equipment market from calendar year
2000 levels. During the third quarter of 2001, the restructuring plan was
approved by the appropriate level of management necessary to commit Novellus to
its specific actions. Novellus began implementing the plan during the third
quarter of 2001 and recorded restructuring and asset impairment charges
totaling $55.0 million, of which $47.9 million was included in operating
expenses and $7.1 million was included in cost of sales. The restructuring
charges included $33.8 million related to vacated facilities, $9.5 million
related to abandoned assets associated with the discontinuation of certain
projects, and $4.6 million related to the write-off of purchased technology.
Additionally, the discontinuation of certain projects resulted in $7.1 million
of inventory write-downs, which were included in cost of sales.

Below is a table summarizing activity relating to the September 2001 Plan (in
thousands):

|                             |               |   |            |        |           |   |            |   |          |   |              |   |                   |   |        |        |   |   |   |   |  |   |        |        |  
|---------------------------- | ------------- | - | ---------- | ------ | --------- | - | ---------- | - | -------- | - | ------------ | - | ----------------- | - | ------ | ------ | - | - | - | - |  | - | ------ | ------ | -
|                             |               |   |            |        |           |   |            |   |          |   | Write-off of |   |                   |   |        |        |   |   |   |   |  |   |       
|                             |               |   | Vacated    |        | Abandoned |   | Purchased  |   |          |   |              |   | Discontinued      |   |        |        |  
|                             |               |   | Facilities |        | Assets    |   | Technology |   | Subtotal |   | Inventory    |   | Total Restructure
|                             |               |  
|Balance at December 31, 2001 |               | $ | 26,849     |        |           | $ |           |   |          | $ |             |   |                   | $ | 26,849 |        |   | $ |  |   |  | $ | 26,849 |       
|                            
|                            
|                            
|                            
|                             | Cash payments |   |            | (3,978 | )         |   |            |  |          |   |              |  |                   |   |        | (3,978 | ) |   |   |  |  |   |        | (3,978 | )
|                             |               |  
|Balance at June 29, 2002     |               | $ | 22,871     |        |           | $ |           |   |          | $ |             |   |                   | $ | 22,871 |        |   | $ |  |   |  | $ | 22,871 |       
|                             |               |  

The charge for vacated facilities was related to rent obligations after the
abandonment of certain facilities currently under long-term operating lease
agreements. When applicable, anticipated future sublease income relating to
vacated buildings was offset against the charge for the remaining lease
payments. All leasehold improvements relating to the vacated buildings with no
future economic benefit were abandoned. Additionally, certain fixed assets
associated with these facilities had no future economic benefit and were
written off.

The charge for abandoned assets and discontinued inventory were associated with
programs exited by Novellus. The write-off of purchased technology was related
to technology that was abandoned by Novellus.

As of June 29, 2002, significantly all actions under the restructuring plan
have been achieved except for future rent obligations related to vacated
facilities. The remaining $22.9 million balance of the restructuring accrual
is for future rent obligations which are to be paid in cash over the next five
years.

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

9. BAD DEBT WRITE-OFF (RECOVERY)

In September 2001, Novellus determined that due to the financial difficulties
facing one of its customers, an outstanding accounts receivable balance was at
risk for collection. Accordingly, Novellus recorded a write-off of $7.7
million. In the first quarter of 2002, all amounts under this accounts
receivable balance were paid, resulting in a recovery of $7.7 million.

10. COMPREHENSIVE INCOME (LOSS)

The following are the components of comprehensive
income (loss) (in thousands):

|                                                                                                                       |                            |   |                    |        |                  |   |          |        |          |   |        |        |  |   |         |         | 
|---------------------------------------------------------------------------------------------------------------------- | -------------------------- | - | ------------------ | ------ | ---------------- | - | -------- | ------ | -------- | - | ------ | ------ |  | - | ------- | ------- | 
|                                                                                                                       |                            |   | Three months ended |        | Six months ended
|                                                                                                                       |                            |   | June 29,           |        | June 30,         |   | June 29, |        | June 30,
|                                                                                                                       |                            |   | 2002               |        | 2001             |   | 2002     |        | 2001    
|                                                                                                                       |                            |  
|Net income                                                                                                             |                            | $ | 12,013             |        |                  | $ | 59,221   |        |          | $ | 15,849 |        |  | $ | 141,323 |        
|                                                                                                                      
|                                                                                                                      
|                                                                                                                      
|                                                                                                                      
|Foreign currency translation adjustment                                                                                |                            |   | 2,475              |        |                  |   | (1,391   | )      |          |   | 675    |        |  |   | 820     |        
|                                                                                                                      
|                                                                                                                      
|                                                                                                                      
|                                                                                                                      
|Unrealized gain on available-for-sale securities                                                                       |                            |   | 579                |        |                  |   | 2,991    |        |          |   | 292    |        |  |   | 8,317   |        
|                                                                                                                      
|                                                                                                                      
|                                                                                                                      
|                                                                                                                      
|Reclassification adjustment for a realized gain on
an available-for-sale investment included in net income, net of tax |                            |   |                   |        |                  |   |         |        |          |   | (3,636 | )      |  |   |        |        
|                                                                                                                       |                            |  
|                                                                                                                       | Other comprehensive income |   | $                  | 15,067 |                  |   | $        | 60,821 |          |   | $      | 13,180 |  |   | $       | 150,460 | 
|                                                                                                                       |                            |  

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

|                                                 |                                               |   |          |        |              |   |        |       | 
|------------------------------------------------ | --------------------------------------------- | - | -------- | ------ | ------------ | - | ------ | ----- | 
|                                                 |                                               |   | June 29, |        | December 31,
|                                                 |                                               |   | 2002     |        | 2001        
|                                                 |                                               |  
|Foreign currency translation adjustment          |                                               | $ | (1,500   | )      |              | $ | (2,175 | )    
|                                                
|                                                
|                                                
|                                                
|Unrealized gain on available-for-sale securities |                                               |   | 357      |        |              |   | 3,701  |      
|                                                 |                                               |  
|                                                 | Accumulated other comprehensive income (loss) |   | $        | (1,143 | )            |   | $      | 1,526 | 
|                                                 |                                               |  

11. RELATED PARTY TRANSACTIONS

During the second quarter of 2002, Novellus leased
an aircraft from a third-party entity wholly owned by Richard S.
Hill, Novellus Chairman and Chief Executive Officer. Under the
aircraft lease agreement with the third-party entity wholly owned by
Mr. Hill, Novellus incurred lease expense of approximately $58,000
through June 29, 2002. Novellus believes that the amount billed for
use of the aircraft is within the range charged by third-party
commercial charter companies for a similar type of aircraft.

A member of Novellus board of directors also
serves on the board of directors of one of Novellus customers
and therefore, this customer is considered a related party. This
related-party customer represented 12% and 16% of net sales for the
three and six months ended June 29, 2002, respectively. This
related-party customer represented 20% and 17% of net sales during
the three and six months ended June 30, 2001, respectively.

12. SUBSEQUENT EVENT

On August 12, 2002, Novellus entered into a definitive agreement to acquire
 SpeedFam-IPEC, Inc., a global supplier of
chemical mechanical planarization (CMP) systems used in the fabrication of
advanced copper interconnects.  Novellus will acquire all outstanding shares of
SpeedFam-IPEC in a stock-for-stock merger and will assume all of
SpeedFam-IPEC's 6 1/4 percent Convertible Subordinated Notes due 2004, totaling $115 million.
Together with the purchase of stock and the assumption of net debt, the transaction is valued
at approximately $220 million. If the merger is completed, SpeedFam-IPEC will
become a wholly-owned subsidiary of Novellus, and each outstanding share of SpeedFam-IPEC
common stock will be converted into the right to receive 0.1818 of a share of Novellus
common stock on a fixed-exchange ratio basis. The merger will be accounted for as
a purchase transaction and is intended to qualify as a tax-free reorganization under IRS
regulations. The transaction has been approved by the board of directors of both companies
and is expected to formally close in the fourth calendar quarter of
2002, subject to certain closing conditions, including SpeedFam-IPEC shareholder approval.  Novellus shareholder approval is
not required.

13. LITIGATION

For a discussion of legal matters, see Part II: Other Information, Item 1:
Legal Proceedings.

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ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains forward-looking statements within
the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. All statements included in this Quarterly Report, other than statements
that are purely historical, are forward-looking statements. Words such as
anticipates, expects, intends, plans, believes, seeks, estimates,
and similar expressions also identify forward-looking statements.
Forward-looking statements in this Quarterly Report include, without
limitation: Novellus continued belief that significant investment in R&D is
required to remain competitive and its plans to continue to invest in new
products; Novellus
expectations regarding the effect of the adoption of SFAS 143, 144,
145 and 146 on its financial
condition or results of operations; Novellus expectations
regarding its acquisition of SpeedFam-IPEC, Inc., including the
transactions anticipated closing date and that the acquisition will be
accretive to the Companys earnings on a per-share basis by the
third calendar quarter of 2003; Novellus belief that it would exercise its
purchase option under the terms of the synthetic leases if the final Statement
regarding the treatment of the assets associated with Novellus synthetic
leases by FASB is consistent with Novellus interpretation of the Exposure Draft
(ED), Consolidation of Certain Special-Purpose
Entities, an Interpretation of ARB No. 51, and the Companys expectation that the adoption of the ED would not have
an impact on its liquidity; Novellus expectations regarding investments in
property and equipment in fiscal 2002; Novellus belief that its current cash
position, cash generated through operations and equity offerings, and
available borrowings will be
sufficient to meet Novellus needs through the next twelve months;
Novellus beliefs that the ultimate outcome of the Applied Materials, Semitool,
Plasma Physics, and Linear Technology litigation matters will not have a
material adverse effect on Novellus financial condition or results of
operations; and Novellus beliefs and expectations with respect to the outcomes
of the Applied Materials, Semitool, Plasma Physics, and Linear Technology
litigation matters and current patent infringement inquiries.

Novellus expectations, beliefs, objectives, anticipations, intentions and
strategies regarding the future, expected operating results, revenues and
earnings and current and potential litigation, or set forth in the other
forward-looking statements found herein, are not guarantees of future
performance and are subject to risks and uncertainties that could cause actual
results to differ materially from the results contemplated by the
forward-looking statements including, but not limited to, the current downturn
in the U.S. economy, continued customer capital spending reductions in the
semiconductor industry; further periodic downturns in the semiconductor
industry which could have a material adverse effect on the semiconductor
industrys demand for semiconductor processing equipment, the greater
financial, marketing, technical or other resources, broader product lines, and
more established customer bases that some of Novellus competitors possess,
future competition from new market entrants, improvement of the design and
performance of Novellus competitors products, Novellus success in selecting,
developing, and marketing new products, or enhancing existing products, its
ability to enforce its patents and the inherent uncertainty in the outcome of
litigation matters, the availability of raw materials and critical
manufacturing equipment, and risks associated with regulatory and trade
environments.

All forward-looking statements included in this Quarterly Report are based on
information available to Novellus on the date hereof, and Novellus assumes no
obligation to update any such forward-looking statements. You are cautioned
not to place undue reliance on such statements, which speak only as of the date
of this Quarterly Report. You should also consult the cautionary statements
and risk factors listed in Trends, Risks and Uncertainties beginning on page 19
of this Report as the cautionary statements and risk factors listed from time
to time in this Report as well as Novellus Reports on Forms 10-Q, 8-K, 10-K,
and its Annual Reports to Shareholders, including Novellus most recent Annual
Report on Form 10-K for the year ended December 31, 2001.

CRITICAL ACCOUNTING POLICIES

Novellus discussion and analysis of its financial condition and results of
operations are based upon Novellus condensed consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial
statements requires Novellus to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. On an ongoing basis, Novellus
evaluates its estimates, including those related to allowance for doubtful
accounts, inventories, investments, deferred tax assets, income taxes, warranty obligations, restructuring, and contingencies and
litigation. Novellus bases its estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent
from other sources. Actual results may differ from these estimates under
different assumptions or conditions.

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Novellus believes the following critical accounting policies affect its more
significant judgments and estimates used in the preparation of its condensed
consolidated financial statements.

Revenue Recognition

Novellus recognizes revenue in accordance with SEC Staff Accounting Bulletin
No. 101 (SAB 101), Revenue Recognition in Financial Statements and SAB
101: Revenue Recognition in Financial Statements-Frequently Asked Questions and
Answers (SAB 101 FAQ). Novellus recognizes 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 Novellus product sales are accounted for as
multiple-element arrangements. If Novellus has met defined customer acceptance
experience levels with both the customer and the specific type of equipment,
then Novellus recognizes equipment revenue upon shipment and transfer of title,
with the remainder when it becomes due (generally upon acceptance). All other
equipment sales are recognized upon customer acceptance. Revenue related to
spare part sales is recognized on shipment. Revenue related to maintenance and
service contracts is recognized ratably over the duration of the contracts.
Unearned maintenance and service contract revenue is not significant and is
included in other accrued liabilities.

Allowance for Doubtful Accounts

Novellus evaluates its allowance for doubtful accounts based on a combination
of factors. In circumstances where Novellus is aware of a specific customers
inability to meet its financial obligations to us, Novellus records a specific
allowance for bad debts against amounts due to reduce the net recognized
receivable to the amount Novellus reasonably believes will be collected. For
all other customers, Novellus recognizes a reserve for bad debts based on a
certain percentage of total revenues, which is based on Novellus historical
experience over five years. If circumstances change (e.g. higher than expected
defaults or an unexpected material adverse change in a major customers ability
to meet its financial obligations to us), Novellus may amend its estimates of
the recoverability of amounts due to Novellus.

Inventory Reserves

Novellus assesses the recoverability of all inventory, including
work-in-process, finished goods, and spare parts to determine whether
adjustments for impairment are required. Inventory which is obsolete or in
excess of Novellus forecasted usage is written down to its estimated market
value based on assumptions about future demand and market conditions. If
actual demand is lower than the Companys forecast, additional inventory
write-downs may be required.

Warranty and Installation

Novellus warranty and installation policy generally states that Novellus will
provide installation services as well as warranty coverage, for a predetermined
amount of time, on systems and modules for material and labor to repair and
service the equipment. Novellus records the estimated cost of warranty
coverage and installation upon system shipment. The estimated cost of warranty
and installation coverage is determined by the warranty term as well as the
average historical warranty and installation expense for a specific tool.
Should actual product failure rates, material usage, or installation costs
differ from Novellus estimates, revisions to the estimated warranty and
installation liability may be required.

Investments

Novellus classifies its marketable securities as available-for-sale in
accordance with the provisions of the Statement of Financial Accounting
Standard (SFAS) No. 115, Accounting for Certain Investments in Debt and
Equity Securities. Securities classified as available-for-sale are reported at
fair market value with the related unrealized gains and losses included, net of
tax, in accumulated other comprehensive income (loss). Realized gains and
losses and declines in value of securities judged to be other than temporary
are included in other income. Interest on all securities is included in
interest income. Future adverse changes in market conditions or poor operating
results of underlying investments could result in losses or an inability to
recover the carrying value of the investments that may not be reflected in an
investments current carrying value, thereby possibly requiring impairment
charges in the future. The fair values of investments are determined using
quoted market prices if available. If quoted market prices are not
available, investments are estimated using discounted cash flows and
market interest rates.

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Deferred Tax Assets

Novellus records a valuation allowance to reduce its deferred tax assets to the
amount that is more likely than not to be realized. While Novellus has
considered future taxable income and ongoing prudent and feasible tax planning
strategies in assessing the need for the valuation allowance, in the event
Novellus determined that it would be able to realize its deferred tax
assets in excess of its net recorded amount, an adjustment to the
deferred tax assets would increase income in the period such determination was
made. Likewise, should Novellus determine that it would not be able to realize
all or part of its net deferred tax assets in the future, an adjustment to the
deferred tax assets would decrease income in the period such determination
was made.

Restructuring

Novellus accounts for the need to record restructuring charges in accordance with
Emerging Issues Task Force (EITF) 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), EITF 95-3, Recognition
of Liabilities in Connection with a Purchase Business Combination and Staff
Accounting Bulletin No. 100, Restructuring and Impairment Charges. In
accordance with this guidance, management must execute an exit plan that will
result in the incurrence of costs that have no future economic benefit. Also
under the terms of EITF 94-3, a liability for the restructuring charges is
recognized in the period management approves the restructuring plan. In the
third quarter of 2001, Novellus established restructuring reserves for its
operations. In the first quarter of 2002, Novellus had a reduction in force,
which required reserves for severance benefits. These
reserves required the use of estimates. Though Novellus believes that these
estimates accurately reflect the costs of these plans, actual results may be
different. See Note 8 to Condensed Consolidated Financial Statements.

Contingencies and Litigation

Novellus makes an assessment of the probability of an adverse judgment
resulting from current and threatened litigation. Novellus would accrue the
cost of an adverse judgment if, in Novellus estimation, the adverse
settlement is probable and Novellus can reasonably estimate the ultimate cost
to Novellus. Novellus has made no such accruals at June 29, 2002.

Novellus critical accounting policies are also discussed in the Novellus
Annual Report on Form 10-K for the year ended December 31, 2001, in the section
Managements Discussion and Analysis of Financial Condition and Results of
Operations and in Note 1 to the Novellus Consolidated Financial Statements for
the year ended December 31, 2001.

RESULTS OF OPERATIONS

Net sales for the three and six months ended June 29, 2002 were $222.1 million
and $391.8 million, respectively. Net sales for the three and six months ended
June 30, 2001 were $376.9 million and $835.6 million, respectively. Net sales
were $169.7 million in the quarter ended March 30, 2002. The decrease in net
sales over the comparable year-ago periods is primarily due to customer capital
spending reductions in response to slowing worldwide demand for semiconductors.
The increase in net sales over the immediately preceding quarter is primarily
due to improving market conditions and higher revenue associated with
sales of Novellus dielectric high-density plasma (HDP) and
dielectric plasma enhanced chemical vapor deposition (PECVD) tools.

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International net sales (including export sales) for both the three and six
months ended June 29, 2002 were 76% and 66% of total net sales, as compared to
56% for both the three and six months ended June 30, 2001, and 54% in the
immediately preceding quarter. The increase from the comparable year-ago
periods is primarily a result of a higher proportional decrease in net sales in
North America. The increase from the immediately preceding quarter is
primarily due to higher sales in the Pacific Rim.

Gross profit as a percentage of net sales for the three and six months ended
June 29, 2002 was 46% and 44%, compared with 53% and 54%, respectively, for the
comparable year-ago periods. Gross profit as a percentage of sales increased
from 42% in the immediately preceding quarter. The decrease in gross profit as
a percentage of net sales from the comparable year-ago periods is due
to reduced absorption of fixed overhead costs resulting from lower
shipments and from lower gross margins on Novellus 300mm
systems, which have higher costs as they are not yet in high volume production. The increase in gross
profit as a percentage of sales from the immediately preceding quarter is
primarily due to improving margins on the 300mm systems and improved
absorption of fixed overhead costs due to increased shipments.

Selling, general, and administrative (SG&A) expense for the three and six
months ended June 29, 2002 was $39.5 million and $74.2 million compared with
$54.5 million and $123.4 million in the comparable year-ago periods and $34.7
million in the immediately preceding quarter. SG&A expense as a percentage of
net sales for the three and six months ended June 29, 2002 was 18% and 19%
compared with 14% and 15% for the comparable year-ago periods and 20% for the
immediately preceding quarter. The increase in SG&A expense as a percentage of
net sales versus the comparable year-ago periods is primarily due to a
substantial reduction in net sales associated with the decline in customer
capital spending. The decrease in SG&A expense in absolute dollars from the
comparable year-ago periods is primarily due to the impact of cost reduction
measures implemented in the second half of 2001, including travel, workforce
reductions, executive and employee pay reductions and facilities consolidation.
The increase in SG&A expense in absolute dollars from the immediately
preceding quarter was primarily due to the reinstatement of salaries from the
previous years wage reductions, higher selling costs due to increased shipments,
and an increase in travel due to the improved market conditions from the
immediately preceding quarter.

Research and development (R&D) expense for the three and six months ended June
29, 2002 was $58.7 million and $112.8 million compared with $72.7 million and
$143.2 million for the comparable year-ago periods and $54.0 million in the
immediately preceding quarter. R&D expense as a percentage of net sales for
the three and six months ended June 29, 2002 was 26% and 29% compared with 19%
and 17% for the comparable year-ago periods and 32% for the immediately
preceding quarter. The increase in R&D expense as a percentage of net sales
versus the comparable year-ago periods is primarily due to a substantial
reduction in net sales associated with the decline in customer capital
spending. The decrease in R&D expense in absolute dollars over the comparable
year-ago periods is primarily due to workforce reductions, pay reductions, and
facilities consolidations and other cost containment efforts aimed at focusing
Novellus R&D efforts on key products necessary for long-term growth. The
increase in R&D expense from the immediately preceding quarter is due to the
reinstatement of salaries from the previous years wage reductions and
increased infrastructure costs. Novellus continues to believe that significant
investment in R&D is required to remain competitive and plans to continue to
invest in new products.

In the first quarter of 2002, Novellus reduced its workforce in response to
market conditions. Novellus recorded a special charge of $3.3 million,
primarily for the cost of severance compensation. As of June 29, 2002, all
severance benefits related to the reduction in workforce had been paid.

During the first quarter of 2001, Novellus incurred merger costs related to the
acquisition of GaSonics of $13.2 million. These costs included professional
fees, financial printing, and other related costs. Additionally, these costs
included charges related to the cancellation of various contracts and the
write-off of certain redundant assets. As of June 29, 2002, all expenses
related to these accruals had been paid.

In September 2001, Novellus determined that due to the financial difficulties
facing one of its customers, an outstanding accounts receivable balance was at
risk for collection. Accordingly, Novellus recorded a write-off of $7.7
million. In the first quarter of 2002, all amounts under this accounts
receivable balance were paid resulting in a benefit to operations of $7.7
million.

Other income, including interest income, for the three and six months ended
June 29, 2002 was $11.8 million and $29.5 million compared with $13.4 million
and $29.9 million for the comparable year-ago periods and $17.7 million in the
immediately preceding quarter. The decrease in other income from the year-ago
three month period is due to lower interest

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rates. The decrease in other income from the year-ago six month period and the
immediately preceding quarter is due to lower interest rates offset by a $4.6
million gain on the sale of an investment recorded in the first quarter of
2002.

Novellus effective tax rate for the three and six months ended June 29, 2002
was 21% compared to 31% for the comparable year-ago periods. The decrease
in the tax rate results from the tax benefit of the R&D credit
and a reduction in
the valuation allowance being proportionately greater in 2002 due to
lower pretax income.

Net income for the three and six months ended June 29, 2002 was $12.0 million
and $15.8 million or $0.08 and $0.11 per diluted share, compared with $59.2
million and $141.3 million or $0.40 and $0.95 per diluted share for the
comparable year-ago periods and $3.8 million or $0.03 per diluted share for the
immediately preceding quarter.

Excluding the $4.6 million gain on the sale of an investment, the $7.7 million
benefit for the recovery of an account receivable which had been previously
reserved, and a $3.3 million charge associated with a reduction in workforce
recorded in the first quarter of 2002, Novellus recorded net income of $8.7
million for the six months ended June 29, 2002, or $0.06 per diluted share.
Excluding merger costs related to the acquisition of GaSonics of $13.2 million
recorded in the first quarter of 2001, Novellus recorded net income of $150.4
million for the six months ended June 30, 2001, or $1.01 per diluted share.

The number of shares used in the per fully diluted share calculations for the
three and six months ended June 29, 2002 was 151.1 million and 150.8 million,
respectively, compared with 149.6 million and 148.9 million for the comparable
year-ago periods and 150.6 million in the immediately preceding quarter. The
increase in shares used for the three and six months ended June 29, 2002
compared to the comparable year-ago periods and to the immediately preceding
quarter is primarily due to shares issued under Novellus
employee stock option plans.

During the second quarter of 2002, Novellus leased an aircraft from a
third-party entity wholly owned by Richard S. Hill, Novellus Chairman and
Chief Executive Officer. Under the aircraft lease agreement with the
third-party entity wholly owned by Mr. Hill, Novellus incurred lease expense of
approximately $58,000 through June 29, 2002. Novellus believes that the amount
billed for use of the aircraft is within the range charged by third-party
commercial charter companies for a similar type of aircraft.

A member of Novellus board of directors also serves on the board of directors
of one of Novellus customers and therefore, this customer is considered a
related party. This related-party customer represented 12% and 16% of net
sales for the three and six months ended June 29, 2002, respectively. This
related-party customer represented 20% and 17% of net sales during the three
and six months ended June 30, 2001, respectively.

On August 12, 2002, Novellus entered into a definitive agreement to acquire SpeedFam-IPEC,
Inc., a global supplier of chemical mechanical planarization (CMP) systems used in the
fabrication of advanced copper interconnects.  Novellus will acquire all outstanding shares of
SpeedFam-IPEC in a stock-for-stock merger and will assume all of SpeedFam-IPEC's
6 1/4 percent Convertible Subordinated Notes due 2004, totaling $115 million.
Together with the purchase of stock and the assumption of net debt, the transaction is
valued at approximately $220 million. If the merger is completed, SpeedFam-IPEC will become a
wholly-owned subsidiary of Novellus, and each outstanding share of SpeedFam-IPEC
common stock will be converted into the right to receive 0.1818 of a share of
Novellus common stock on a fixed-exchange ratio basis. The merger will be accounted for as a
purchase transaction and is intended to qualify as a tax-free reorganization under IRS
regulations. The transaction has been approved by the board of directors of both companies
and is expected to formally close in the fourth calendar quarter of
2002, subject to certain closing conditions, including SpeedFam-IPEC shareholder approval.  Novellus shareholder approval is not required.
The transaction is expected to be accretive to Novellus' earnings on
a per-share basis by the third calendar quarter of 2003.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No.
143, Accounting for Asset Retirement Obligations, which addresses accounting
and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. SFAS 143 is
effective for fiscal years beginning after June 15, 2002. Novellus does not
expect the adoption of SFAS 143 to be material to its financial condition or
results of operations.

In August 2001, the FASB issued SFAS No. 144, Impairment or Disposal of
Long-Lived Assets, which is effective for fiscal years beginning after
December 15, 2001. SFAS 144 supersedes SFAS 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,
and provides a single accounting model for impairment of long-lived assets.
Novellus does not expect the adoption of SFAS 144 to have a material effect on
Novellus financial condition or results of operations.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. For most companies, SFAS 145 will require gains and losses on
extinguishments of debt to be classified as income or loss from continuing
operations rather than as extraordinary items as previously required under SFAS
4. Extraordinary treatment will be required for certain extinguishments as
provided in APB Opinion No. 30. The statement also amended SFAS 13 for certain
sales-leaseback transactions and sublease accounting. Novellus is required to adopt the
provisions of SFAS 145 effective January 1, 2003. Novellus does not expect the
adoption of SFAS 145 to have a material effect on the Companys financial condition
or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities. SFAS 146 addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies
EITF Issue

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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 must be applied beginning January 1, 2003. SFAS 146
requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred rather than when the exit
or disposal plan is approved. Novellus is currently evaluating the impact of
this adoption.

In connection with their ongoing consolidations project, the FASB issued an
exposure draft (ED), Consolidation of Certain Special-Purpose Entities, an
Interpretation of ARB No. 51, in June 2002 for public comment. The ED could
substantially change the accounting for synthetic leases. The comment period
on the ED will end on August 30, 2002, and the final guidance will become
effective for Novellus in its second fiscal quarter of 2003. If the final
Statement is consistent with the ED, and Novellus were required to consolidate
its special purpose entity, Novellus believes that it would exercise its
purchase option under the terms of the synthetic leases and purchase the leased
assets thereunder. This treatment would result in Novellus recording the
property and equipment purchase under the leases of approximately $456.4
million. Novellus lease receivable and cash collateral under the synthetic
leases would be returned to Novellus as cash or used to offset the purchase
price of the properties. As a result of the purchase, depreciation expense
would increase by approximately $30.0 million to $35.0 million per year, and
rent expense and interest income would each decrease by approximately $15.0
million per year based on current interest rates. Because this treatment would
result in the lease receivable and cash collateral being returned to Novellus,
the Company does not expect the adoption of the ED to have an impact on its
liquidity.

LIQUIDITY AND CAPITAL RESOURCES

Novellus has historically financed its operating and capital resource
requirements through cash flows from operations, sales of equity securities,
and borrowings. Novellus primary source of funds at June 29, 2002 consisted
of $941.9 million of cash, cash equivalents, and short-term investments. This
amount represents an increase of $20.1 million from the December 31, 2001
balance of $921.8 million. Net cash provided by operating activities during the six months ended
June 29, 2002 was $98.9 million. This amount consisted primarily of an
increase in accounts payable of $28.2 million, a decrease in prepaids and other
current assets of $21.9 million, and an income tax benefit from employee
stock option plans of $16.9 million.

Net cash used in investing activities was $145.5 million during the six months
ended June 29, 2002. During this period, Novellus cash outflows consisted
primarily of $43.2 million in net proceeds of both restricted short-term
investments and short-term investments offset by Novellus participation in its
synthetic leases of $177.5 million.

As of June 29, 2002, Novellus does not have
any significant commitments to purchase property and equipment.

During the six months ended June 29, 2002, net cash provided by financing
activities was $20.9 million due to $41.8 million from
employee stock option plans, offset by $12.6 million of common stock repurchases and net payments of
$8.3 million on its bank lines of credit.

Novellus leases nearly all of its facilities under operating leases, including
synthetic leases, which expire at various dates through 2010. A synthetic
lease is a form of operating lease whereby a third party lessor funds 100% of
the acquisition and construction costs relating to one or more properties to be
leased to a lessee. The lessor is the owner of the leased property and must
provide at least 3% of the required funds in the form of at-risk equity. The
lessor generally borrows the balance of the funds necessary to fund the
acquisition and construction. Under certain of Novellus synthetic lease
agreements, Novellus is obligated to lend approximately 87% of the cost of the
leased asset to the lessor upon completion of construction. The leases with
this requirement are known as defeased or self-funded transactions.
Additionally, Novellus synthetic leases require the Company to maintain
collateral for the benefit of the lessor. Novellus synthetic lease
arrangements are discussed in greater detail in the Novellus Annual Report on
Form 10-K for the year ended December 31, 2001, in the section Managements
Discussion and Analysis of Financial Condition and Results of Operations and
in Note 7 to the Novellus Consolidated Financial Statements for the year ended
December 31, 2001, provided that such discussion speaks only as of the date
such Form 10-K was filed.

Novellus holds synthetic lease agreements on
properties in San Jose, California and Tualatin, Oregon. During the six months ended June 29, 2002, Novellus drew
an additional $87.5 million against its available lease financing line for the
Tualatin

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property for which construction was completed in May 2002. There are no
additional amounts available under the Tualatin lease facility. The total
financing under the San Jose synthetic lease has not changed significantly
since December 31, 2001.

As of June 29, 2002, Novellus has lines of credit with four Japanese banks,
which expire at various dates through October 2002, under which Novellus can
borrow up to $30.2 million at the banks prime rates (ranging from 0.46% to
0.50%) as of June 29, 2002. These facilities are available to Novellus
Japanese subsidiary, Novellus Systems, Japan. At June 29, 2002 and December 31,
2001, amounts outstanding were $17.9 million and
$26.2 million, respectively, at annual
weighted-average interest rates of 0.48% and 0.62%, respectively. All
borrowings under the lines of credit were by Novellus Systems, Japan.

On July 26, 2001, Novellus issued $880.0 million of Liquid Yield Option Notes
(LYONs) due July 26, 2031. The net proceeds after issuance costs (which will
be amortized over 30 years) from the LYONs offering were $862.4 million. The
LYONs are zero coupon, zero-yield subordinated debentures that may be converted
into shares of Novellus common stock, subject to specified conditions as set
forth in the indenture. The LYONs are convertible into 13.09504 shares of
Novellus common stock per $1,000 LYON, or 11.5 million shares and 7.9% of all
outstanding shares as of June 29, 2002, if (1) the sales price of Novellus
common stock reaches a specified threshold, (2) the LYONs are called for
redemption, or (3) specified corporate transactions have occurred, subject to
antidilutive adjustments.

On July 26, 2002, the security holders exercised their option to deliver the
LYONs to Novellus and required Novellus to repurchase the LYONs for $1,000 in
cash each on such date, representing $880.0 million for substantially all outstanding LYONs.
Novellus used the restricted short-term investments, which had matured to
$880.0 million, to repurchase the LYONs. Novellus will record a charge in July
2002 of approximately $17.0 million to other expense for the remaining
unamortized issuance costs related to the LYONs. For further discussion, see
Note 7 to Condensed Consolidated Financial Statements included in this Report,
Convertible Subordinated Debentures.

Related-party transaction disclosures are made by
the Company when and if it issues loans to its executive officers and members of its
board of directors.  As of June 29, 2002, Novellus does not have any
outstanding loans with these individuals.  Novellus does, from time
to time, issue secured, short-term relocation loans to the Company's
management and key personnel, the issuance of which requires management's approval.
As of June 29, 2002, these loans were approximately $5.3 million.

On August 12, 2002, Novellus entered into a
definitive agreement to acquire SpeedFam-IPEC, Inc., a global
supplier of chemical mechanical planarization (CMP) systems used in
the fabrication of advanced mechanical copper interconnects. If the
transaction closes, Novellus will assume all of SpeedFam-IPECs
6 1/4 percent Convertible Subordinated Notes due 2004, totaling
$115 million.

Novellus believes that its current cash position, cash generated through
operations and equity offerings, and available borrowings will be sufficient to
meet Novellus needs through the next twelve months.

TRENDS, RISKS, AND UNCERTAINTIES

Set forth below and elsewhere in this Form 10-Q, including in Item 2,
Managements Discussion and Analysis beginning on page 13 of this Report, and
in other documents Novellus files with the Securities and Exchange Commission
are trends, risks and uncertainties that could cause Novellus actual results
to differ materially from the results contemplated by the forward-looking
statements contained in this Form 10-Q. As noted, these trends,
risks, and uncertainties are discussed below.

Market Risk and Cyclical Downturns in the Semiconductor Industry

Novellus business depends predominantly on capital expenditures of
semiconductor manufacturers, which in turn depends on the current and
anticipated market demand for integrated circuits and products utilizing
integrated circuits. The semiconductor industry has historically been very
cyclical and has experienced periodic downturns, which have had a material
adverse effect on the semiconductor industrys demand for semiconductor
processing equipment, including equipment manufactured and marketed by
Novellus. During periods of reduced and declining demand, Novellus must be
able to quickly and effectively align its cost structure with prevailing market
conditions, and motivate and retain key employees. In particular, during a
period of reduced demand, Novellus inventory levels have in the past reached
and currently are at higher than necessary levels for the current levels of
production demand. No assurance can be given that Novellus may not be required
to make inventory valuation adjustments in future periods. During periods of
rapid growth, Novellus 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. No assurance can be given that
Novellus net sales and operating results will not be adversely affected if
this current downturn in the semiconductor industry continues or other
downturns or slowdowns in the rate of capital investment in the semiconductor
industry occur in the future.

Demand Shifts in the PC Industry

In the PC market, a shift in demand from more expensive, high-performance
products to lower-priced products (sub-$1,000 PCs) has resulted in reduced
profitability for semiconductor manufacturers. Strengthening demand for
sub-$1,000 PCs could cause further delays or decreased demand for Novellus
products.

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Intense Competition in the Semiconductor Equipment Industry

The semiconductor equipment industry is highly competitive. Novellus faces
substantial competition in the markets in which it competes from both
established competitors and potential new entrants. Certain of Novellus
competitors have greater financial, marketing, technical or other resources,
broader product lines, greater customer service capabilities, and larger and
more established sales organizations and customer bases than Novellus.
Novellus may also face future competition from new market entrants from
overseas and domestic sources. Novellus expects its competitors to continue to
improve the design and performance of their products. There can be no
assurance that Novellus competitors will not develop enhancements to or future
generations of competitive products that will offer superior price or
performance features over Novellus products, and there can be no assurance
that Novellus will be successful, or as successful as its competitors, in
selecting, developing, manufacturing, and marketing its new products, or
enhancing its existing products. Failure to successfully develop new products
could materially adversely affect Novellus revenues, financial condition, and
results of operations. In addition, a substantial investment is required by
Novellus customers to install and integrate capital equipment into a
semiconductor production line. As a result, once a semiconductor manufacturer
has selected another vendors capital equipment, Novellus believes that the
manufacturer will be generally reliant upon that equipment vendor for the
specific production line application. Accordingly, Novellus may experience
difficulty in selling a product to a particular customer for a significant
period of time if that customer first selects a competitors product.
Increased competitive pressure could lead to lower prices for Novellus
products, thereby adversely affecting Novellus revenue and operating results.
There can be no assurance that Novellus will be able to compete successfully
against established competitors and new entrants in the future.

International Operations

Novellus anticipates that export sales will account for a significant portion
of net sales in the foreseeable future. As a result, a significant portion of
Novellus sales will be subject to certain risks, including tariffs and other
barriers, difficulties in staffing and managing foreign subsidiary operations,
difficulties in managing distributors, potentially adverse tax consequences and
the possibility of difficulty in accounts receivable collection. Novellus is
also subject to the risks associated with the imposition of legislation and
regulations relating to the import or export of semiconductor products.
Novellus cannot predict whether quotas, duties, taxes, or other charges or
restrictions will be implemented by the United States or any other country upon
the importation or exportation of Novellus products in the future. There can
be no assurance that any of these factors or the adoption of restrictive
policies will not have a material adverse effect on Novellus business,
financial condition, or results of operations. Moreover, each region in the
global semiconductor equipment market exhibits unique characteristics that can
cause capital equipment investment patterns to vary significantly from period
to period. Although international markets provide Novellus with significant
growth opportunities, periodic economic downturns, trade balance issues,
political instability and fluctuations in interest and foreign currency
exchange rates are all risks that could materially and adversely affect global
products and service demand, and, therefore, Novellus business operations and
financial condition. Asian countries, particularly Japan and Korea, are
affected by banking, currency and other difficulties that contribute to the
economic developments in those countries. Novellus derives a substantial
portion of its revenues from customers in Asian countries. Any negative
economic developments of Asian countries could result in the cancellation or
delay of orders for Novellus products from Asian customers, thus materially
adversely affecting Novellus business, financial condition or results of
operations. In addition to the concerns described above, sales of systems
shipped by Novellus Japanese subsidiary are denominated in Japanese Yen.
Novellus sells the systems to its Japanese subsidiary in U.S. Dollars.
Novellus then enters into forward foreign exchange contracts to hedge against
the short-term impact of foreign currency fluctuations of intercompany accounts
payable denominated in U.S. Dollars recorded by the Japanese subsidiary in
order to manage this exposure. However, there can be no assurance that future
changes in the Japanese Yen will not have a material effect on Novellus
business, financial condition, or results of operations.

Possible Volatility of Stock Price

The price of Novellus common stock may be subject to wide fluctuations and
possible rapid increases or declines in a short time period. These
fluctuations may be due to factors specific to Novellus such as variations in
quarterly operating results or changes in analysts earnings estimates, or to
factors relating to the semiconductor industry or to the securities markets in
general, which, in recent years, have experienced significant price
fluctuations. These fluctuations often have been unrelated to the operating
performance of the specific companies whose stocks are traded. Shareholders
should be willing to incur the risk of such fluctuations. Sales of substantial
amounts of common stock in the public market after any offering of Novellus
securities could adversely affect the market price of the outstanding common
stock.

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Variability of Quarterly Operating Results

If Novellus operating results are below the expectations of public market
analysts or investors, then the market price of its common stock could decline.
Novellus has experienced and expects to continue to experience significant
fluctuations in its quarterly operating results. During each quarter, Novellus
customarily sells a relatively small number of systems that typically sell for
prices in excess of $1 million. Novellus backlog at the beginning of each
quarter does not necessarily include all system sales needed to achieve
expected net sales for that quarter. Consequently, Novellus is often dependent
on obtaining orders for shipment in the same quarter that the order is
received. Because Novellus builds its systems according to forecast, the
absence of significant backlog for an extended period of time could hinder
Novellus ability to plan production and inventory levels, which could
adversely affect operating results. Novellus net sales and operating results
could also be adversely affected for a particular quarter if an anticipated
order for even a few systems is not received in time to permit shipment during
that quarter. Moreover, customers may reschedule or cancel shipments, with, in
the case of cancellations, little or no penalties, and production difficulties
could delay shipments. A delay in a shipment in any quarter, due, for example,
to an unanticipated shipment rescheduling, to cancellations by customers, or to
unexpected manufacturing difficulties experienced by Novellus, may cause net
sales in such quarter to fall significantly below expectations and may
materially adversely affect Novellus operating results for such quarter. The
timing of new product announcements and releases by Novellus may also
contribute to fluctuations in quarterly operating results, particularly in
cases where new product offerings cause customers to defer ordering products
from Novellus existing product lines. Novellus results of operations also
could be affected by new product announcements and releases by Novellus
competitors, the volume, mix and timing of orders received during a period,
availability and pricing of key components, fluctuations in foreign exchange
rates, and conditions in the semiconductor equipment industry. Novellus
operating results also fluctuate based on gross profit realized on system
sales. Gross profit as a percentage of net sales may vary based on a variety
of factors, including the mix and average selling prices of products sold and
costs to manufacture upgrades and customize systems. Because Novellus
operating expenses are based on anticipated net sales levels, and a high
percentage of those expenses are relatively fixed, a variation in the timing of
recognition of net sales and the level of gross profit from a single
transaction can cause material variations in operating results from quarter to
quarter.

Benefits of Novellus Acquisition of GaSonics May Not Be Realized

The integration of Novellus and GaSonics is not fully complete and continues to
be a complex, time consuming, and expensive process. The challenges involved
in this integration include the following: satisfying the needs of the combined
companys customers in a timely and efficient manner and maintaining GaSonics
and Novellus key customer relationships; persuading employees that Novellus
and GaSonics business cultures are compatible and retaining the combined
companys key management, marketing, customer support, and technical personnel;
maintaining managements ability to focus on anticipating, responding to or
utilizing changing technologies in the semiconductor industry; combining
GaSonics product offerings and technologies with Novellus product offerings
and technologies effectively and quickly and coordinating research and
development activities to enhance introduction of new products and
technologies; maintaining GaSonics key supplier relationships; and the
introduction of new technologies by competitors to the marketplace which reduce
GaSonics market share prior to the successful integration of the two
companies. It is not certain that Novellus and GaSonics can be successfully
integrated in a timely manner or at all or that any of the anticipated benefits
will be realized. Failure to do so could materially harm the business and
operating results of the combined company. Also, neither Novellus nor GaSonics
can assure that the growth rate of the combined company will equal the
historical growth rates experienced by Novellus and GaSonics.

A Large Portion of Novellus Net Sales Is Derived from Sales to a Few Customers

Historically, Novellus has sold a significant proportion of its systems in any
particular period to a limited number of customers. Sales to Novellus ten
largest customers in the six months ended June 29, 2002 and in fiscal year 2001
accounted for 84% and 71% of net sales, respectively. Novellus expects that
sales of its products to relatively few customers will continue to account for
a high percentage of its net sales in the foreseeable future. None of
Novellus customers have entered into a long-term agreement requiring them to
purchase Novellus products. Novellus believes that sales to certain of its
customers will decrease in the near future as those customers complete current
purchasing requirements for new or expanded fabrication facilities. Although
the composition of the group comprising Novellus largest customers has varied
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, market, economic or competitive
conditions in the semiconductor industry or in the industries that manufacture
products utilizing integrated circuits, could adversely affect Novellus
business, financial condition and results of operations. In addition, sales of
Novellus systems depend in significant part upon the decision of a

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prospective customer to increase manufacturing capacity or to expand current
manufacturing capacity, both of which typically involve a significant capital
commitment. Novellus has from time to time experienced delays in finalizing
system sales following initial system qualification. Due to these and other
factors, Novellus systems typically have a lengthy sales cycle during which
Novellus may expend substantial funds and management effort with no guarantee
that Novellus will sell a particular system.

Novellus Industry Is Characterized by Rapidly Changing Technology

The semiconductor manufacturing industry is subject to rapid technological
change and new product introductions and enhancements. Novellus ability to
remain competitive in this market depends in part upon Novellus ability to
develop new and enhanced systems and to introduce these systems at competitive
prices and on a timely and cost-effective basis. Accordingly, Novellus devotes
a significant portion of its personnel and financial resources to research and
development programs and seeks to maintain close relationships with its
customers to remain responsive to their product needs. Novellus current
research and development efforts are directed at the development of new systems
and processes and improving existing system capabilities. Novellus is focusing
its research and development efforts on additional Concept Two modules,
advanced PVD systems, advanced gap fill technology, primary conductor metals,
low-K dielectric materials and additional advanced technologies for the next
generation of smaller geometry fabrication lines, as well as equipment to
process 300mm wafers. There is no assurance that Novellus research and
development programs will allow Novellus to remain responsive to its customers
product needs or that Novellus current or new customers will buy its new
products.

Research and Development Expenditures Represent a Substantial Portion of
Novellus Net Sales

Novellus expenditures for research and development during the six months ended
June 29, 2002 and June 30, 2001, were $74.2 million
and $123.4 million, respectively, or approximately 19% and 15% of net sales. Novellus 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, timely and efficient
implementation of manufacturing and assembly processes, product performance in
the field and effective sales and marketing. There can be no assurance that
Novellus will be successful in selecting, developing, manufacturing and
marketing new products or in enhancing its existing products. As is typical in
the semiconductor capital equipment market, Novellus has experienced delays
from time to time in the introduction of, and certain technical and
manufacturing difficulties with, certain of its systems and enhancements and
may experience delays and technical and manufacturing difficulties in future
introductions or volume production of new systems or enhancements. Novellus
inability to complete the development or meet the technical specifications of
any of its new systems or enhancements or to manufacture and ship these systems
or enhancements in volume in a timely manner would materially adversely affect
Novellus business, financial condition and results of operations. In
addition, Novellus may incur substantial unanticipated costs to ensure the
functionality and reliability of its future product introductions early in the
products life cycle. If new products have reliability or quality problems,
reduced orders or higher manufacturing costs, delays in collecting accounts
receivable and additional service and warranty expense may result. Any of
these events could materially adversely affect Novellus business, financial
condition, and results of operations.

Novellus Intellectual Property Is Critical to the Success of Its Business

Novellus intends to continue to pursue the legal protection of its technology
primarily through patent and trade secret protection. Novellus currently holds
over 100 patents and intends to file additional patent applications as
appropriate. There can be no assurance that patents will be issued from any of
these pending applications or that any claims allowed from existing or pending
patents will be sufficiently broad to protect Novellus technology. While
Novellus intends to protect its intellectual property rights vigorously, there
can be no assurance that any patents held by Novellus will not be challenged,
invalidated or circumvented, or that the rights granted thereunder will provide
competitive advantages to Novellus. Novellus also relies on trade secrets and
proprietary technology that it seeks to protect, in part, through Novellus
confidentiality agreements with employees, consultants and other parties.
There can be no assurance that these agreements will not be breached, that
Novellus will have adequate remedies for any breach, or that Novellus trade
secrets will not otherwise become known to or independently developed by
others. There has also been substantial litigation regarding patent and other
intellectual property rights in semiconductor related industries. Novellus is
currently involved in such litigation (see Part II, Other Information, Item 1.
Legal Proceedings). Except as set forth in Part II, Other Information, Item
1. Legal Proceedings, Novellus is not aware of any significant claim of
infringement by Novellus products of any patent or proprietary rights of
others, however, Novellus could become involved in additional litigation in the
future. Although Novellus does not believe the outcome of the current
litigation will have a material impact on its business, financial condition, or
results of operations, no assurances can be given that this litigation or
future litigation will not have such an impact. In addition to the current

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litigation, Novellus operations, including the further commercialization of
Novellus products, could provoke additional claims of infringement from third
parties. In the future, litigation may be necessary to enforce patents issued
to Novellus, to protect trade secrets or know-how owned by Novellus or to
defend Novellus against claimed infringement of the rights of others and to
determine the scope and validity of the proprietary rights of others. Any such
litigation could result in substantial cost and diversion of effort by
Novellus, which by itself could have a material adverse effect on Novellus
financial condition and operating results. Further, adverse determinations in
such litigation could result in Novellus loss of proprietary rights, subject
Novellus to significant liabilities to third parties, require Novellus to seek
licenses from third parties or prevent Novellus from manufacturing or selling
its products, any of which could have a material adverse effect on Novellus
business, financial condition, and results of operations.

Novellus Is Susceptible to Supply Shortages

Novellus uses numerous suppliers to supply parts, components, and
sub-assemblies for the manufacture and support of its products. Although
Novellus makes reasonable efforts to ensure that such parts are available from
multiple suppliers, this is not always possible. Accordingly, Novellus obtains
certain key parts from a single supplier or a limited group of suppliers.
These suppliers are, in some cases, thinly capitalized, independent companies
that generate significant portions of their business from Novellus and/or a
small group of other companies in the semiconductor industry. Although
Novellus seeks to reduce its dependence on these limited source suppliers,
disruption or termination of certain of these sources could occur and such
disruptions could have at least a temporary adverse effect on Novellus
operations. Moreover, a prolonged inability to obtain certain components could
have a material adverse effect on Novellus business, financial condition, and
results of operations and could result in damage to its customer relationships.

Concentration of Credit Risk

Novellus uses financial instruments that potentially subject it to
concentrations of credit risk. Such instruments include cash equivalents,
short-term investments, accounts receivable, and financial instruments used in
hedging activities. Novellus invests its cash in cash deposits, money market
funds, commercial paper, certificates of deposit, readily marketable debt
securities, or medium-term notes. Novellus places its investments with
high-credit-quality financial institutions and limits the credit exposure from
any one financial institution or instrument. Novellus performs ongoing credit
evaluations of its customers financial condition and generally requires no
collateral. Novellus has an exposure to nonperformance by counterparties on
the foreign exchange contracts used in hedging activities. These
counterparties are large international financial institutions and to date, no
such counterparty has failed to meet its financial obligations to Novellus.
Novellus does not believe there is a significant risk of nonperformance by
these counterparties because Novellus continuously monitors its positions and
the credit ratings of such counterparties and the amount of contracts it enters
into with any one party. However, there can be no assurance that there will be
no significant nonperformance by these counterparties and that this would not
materially adversely affect Novellus business, financial condition, and
results of operations.

Recent Accounting Pronouncements May Impact Novellus Financial Position and
Results of Operations

The FASB has issued an Exposure Draft related to their consolidations project
that could substantially change the accounting for synthetic leases. If the
Exposure Draft is enacted in its current form, Novellus may be required to
treat the assets subject to the synthetic leases as purchased assets. Additionally, in June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, Accounting for Asset Retirement Obligations. SFAS 143 is effective for fiscal
years beginning after June 15, 2002. Novellus does not expect the adoption of SFAS 143 to
be material to its financial condition or results of operations. In August 2001, the FASB
issued SFAS No. 144, Impairment or Disposal of Long-Lived Assets, which is effective for
fiscal years beginning after December 15, 2001. SFAS 144 supersedes SFAS 121, Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and
provides a single accounting model for impairment of long-lived assets. Novellus does not
expect the adoption of SFAS 144 to have a material effect on Novellus financial condition
or results of operations. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement
No. 13, and Technical Corrections. Novellus is required to adopt the provisions of SFAS 145 effective January 1,
2003. Novellus does not expect the adoption of SFAS 145 to have a material effect on
Novellus financial condition or results of operations. In June 2002, the FASB issued SFAS
No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Novellus is
currently evaluating the impact of this adoption. Although Novellus does not expect the
adoption of these standards to have a material effect on its financial condition or results
of operations, there can be no assurances that there will not be a material adverse affect
on the Companys business, financial condition, and results of
operations in future periods. For a further discussion of how these recent accounting
pronouncements may affect Novellus, please see Item 2, Managements Discussion
and Analysis and Note 2 to Condensed Consolidated Financial Statements. There
also can be no assurances that the issuance by FASB of additional statements of
financial accounting standards in the future would not materially adversely affect Novellus
business, financial condition, and results of operations if such were required
to be adopted by Novellus.




ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Not Applicable.

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PART II: OTHER INFORMATION




ITEM 1: LEGAL PROCEEDINGS

Applied Litigation

On July 7, 1997, prior to the consummation of the purchase of the TFS business
unit from Varian Associates Inc. (Varian), Applied Materials, Inc.
(Applied) filed a complaint (the Applied Complaint) against Varian in the
United States District Court for the Northern District of California, San Jose
Division, Civil Action No. C-97-20523 RMW, alleging, among other things,
infringement by Varian (including the making, using, selling and/or offering
for sale of certain products and systems made by TFS) of United States Patent
Nos. 5,171,412, 5,186,718, 5,496,455 and 5,540,821 (the Applied Patents),
which patents are owned by Applied.

Immediately after consummation of the TFS purchase, Novellus filed a complaint
(the Novellus Complaint) against Applied in the same Court, Civil Action No.
C-97-20551 RMW, alleging infringement by Applied (including the making, using,
selling and/or offering for sale of certain products and systems) of United
States Patent Nos. 5,314,597 (the 597 patent), 5,330,628, and 5,635,036 (the
Novellus Patents) (the 036 patent) which patents Novellus acquired from
Varian in the TFS purchase. In the Novellus Complaint, Novellus also alleged
that it is entitled to declarations from Applied that Novellus does not
infringe the Applied Patents and/or that the Applied Patents are invalid and/or
unenforceable. Applied has filed counterclaims alleging that Novellus
infringes the Applied Patents.

Also after consummation of the TFS purchase, but some time after Novellus filed
the Novellus Complaint, Applied amended the Applied Complaint to add Novellus
as a defendant. Novellus has requested that the Court dismiss Novellus as a
defendant in Applieds lawsuit against Varian. The Court has not yet required
Novellus to file an answer to the Applied Complaint.

In addition to a request for a permanent injunction against further
infringement, the Applied Complaint and Applieds counterclaims to the Novellus
Complaint include requests for damages for alleged prior infringement and
treble damages for alleged willful infringement. In connection with the
consummation of the TFS purchase, Varian agreed, under certain circumstances,
to reimburse Novellus for certain of its legal and other expenses in connection
with the defense and prosecution of this litigation, and to indemnify Novellus
for a portion of any losses incurred by Novellus arising from this litigation
(including losses resulting from a permanent injunction). Novellus and Varian
believe that there are meritorious defenses to Applieds allegations, including
among other things, that Novellus operations (including TFS products and
systems) do not infringe the Applied Patents and/or that the Applied Patents
are invalid and/or unenforceable. However, the resolution of intellectual
property disputes is often fact intensive and, therefore, inherently uncertain.
Although Novellus believes that the ultimate outcome of the dispute with
Applied will not have a material adverse effect on Novellus business,
financial condition, or results of operations (taking into account both the
defenses available to Novellus and Varians reimbursement and indemnity
obligations), there can be no assurances that Applied will not ultimately
prevail in this dispute and that, in such an event, Varians reimbursement and
indemnity obligations will not be sufficient to fully reimburse Novellus for
its losses. If Applied were to prevail in this dispute, it could have a
material adverse effect on Novellus business, financial condition, or results
of operations.

On March 25, 2002, the Court issued an order: (1) denying Applieds motion for
summary judgment of no literal infringement and no infringement under the
doctrine of equivalents of claims 1 and 8 of Novellus 597 patent with respect
to Applieds 300mm Al WP series magnet arrays; (2) granting summary judgment of
no literal infringement of claims 1 and 8 of Novellus 597 patent to Applied
with respect to its 200mm RH and 300mm IMP series arrays, but denying summary
judgment with respect to infringement under the doctrine of equivalents for
these products and claims; (3) denying Novellus cross-motion for summary
judgment of infringement of claims 1 and 8 of Novellus 597 patent; and (4)
granting summary judgment of non-infringement to Applied with respect to claims
27 and 28 of Novellus 597 patent and Applieds 300mm Al WP series magnet
arrays.

On May 13, 2002, the Court issued an order: (1) denying Applieds motion for
summary judgment of no literal infringement of the 036 patent; and (2)
granting Applieds motion to bar Novellus from proving infringement of the 036
patent under the doctrine of equivalents.

The Novellus Complaint against Applied also includes requests for damages for
prior infringement and treble damages for willful infringement, in addition to
a request for a permanent injunction for further infringement. Novellus
believes that this litigation will not have a material adverse impact on
Novellus financial condition or results of operations. However, there

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can be no assurances that Novellus will prevail against Applied. If Applied
were to prevail against Novellus, it could have a material adverse impact on
Novellus business, financial condition, or results of operations.

Semitool Litigation I

On August 10, 1998, Semitool sued Novellus for patent infringement in the
United States District Court for the Northern District of California (the
District Court). Semitool alleges that Novellus SABRE and SABRE xT copper
deposition systems infringe two Semitool patents, U.S. Patent No. 5,222,310
(the 310 patent), issued June 29, 1993, entitled Single Wafer Processor
with a Frame, and U.S. Patent No. 5,377,708 (the 708 patent), issued
January 3, 1995, entitled Multi-Station Semiconductor Processor with
Volatilization. Semitool seeks an injunction against Novellus manufacture
and sale of the SABRE and SABRE xT systems, and seeks damages for past
infringement. Semitool also seeks treble damages for alleged willful
infringement. Semitool further seeks its attorneys fees and costs, and
interest on any judgment.

On September 24, 1999, the District Court ruled on the interpretation of the
claims of the 310 and 708 patents. On December 18, 1999, Novellus filed a
motion for summary judgment of non-infringement.

On March 17, 2000, the District Court granted Novellus motion for summary
judgment of non-infringement. The District Court ruled that Novellus SABRE
and SABRE xT systems do not infringe the 310 and 708 patents.

On May 15, 2000, Semitool filed a notice of appeal, appealing the District
Courts judgment to the United States Court of Appeals for the Federal Circuit
(the Federal Circuit). On June 8, 2001, the Federal Circuit affirmed the
District Courts judgment that Novellus SABRE and SABRE xT systems do not
infringe the 310 and 708 patents.

On September 6, 2001, Semitool filed a petition for writ of certiorari with the
United States Supreme Court to review the judgment of the Federal Circuit. The
Supreme Court granted this writ, vacated the Federal Circuits opinion, and
remanded the case to the Federal Circuit for further consideration in light of
the Supreme Courts decision in Festo Corp. v. Shoketsu Kinzoku Kogyo
Kabushiki, Co., 122 S. Ct. 1831 (2002). On July 23, 2002, the Federal Circuit
again affirmed the District Courts judgment of non-infringement.

Semitool Litigation II

On June 11, 2001, Semitool sued Novellus for patent infringement in the United
States District Court for the District of Oregon. Semitool alleges that
Novellus infringes Semitools U.S. Patent No. 6,197,181, issued March 6, 2001,
entitled Apparatus and Method for Electrolytically Depositing a Metal on a
Microelectronic Workpiece. Semitool seeks an injunction against Novellus and
damages for past infringement. Semitool also seeks treble damages for alleged
willful infringement. Semitool further seeks its attorneys fees and costs,
and interest on any judgment.

On November 13, 2001, Novellus countersued Semitool for patent infringement in
the United States District Court for the District of Oregon. Novellus alleges
that Semitool infringes Novellus U.S. Patent Nos. 6,179,983 (the 983
patent), issued January 30, 2001 and entitled Method and Apparatus for
Treating Surface Including Virtual Anode; 6,162,344, issued December 19, 2000
and entitled Method of Electroplating Semiconductor Wafer Using Variable
Currents and Mass Transfer to Obtain Uniform Plated Layer; 6,110,346, issued
August 29, 2000 and also entitled Method of Electroplating Semiconductor Wafer
Using Variable Currents and Mass Transfer to Obtain Uniform Plated Layer; and
6,074,544, issued June 13, 2000 and also entitled Method of Electroplating
Semiconductor Wafer Using Variable Currents and Mass Transfer to Obtain Uniform
Plated Layer. Novellus seeks an injunction against Semitool and damages for
past infringement. Novellus also seeks treble damages for willful infringement
by Semitool. Novellus further seeks its attorneys fees and costs, and
interest on any judgment.

On July 19, 2002, Novellus and Semitool entered into and filed a stipulation
dismissing with prejudice both parties claims relating to the 983 patent.

Although it is inherently difficult to assess the outcome of litigation matters
when the litigation is in such an early stage, Novellus believes that this
litigation will not have a material adverse impact on Novellus financial
condition or results of

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operations. However, there can be no assurances that Novellus will prevail
against Semitool. If Semitool were to prevail against Novellus, it could have
a material adverse impact on Novellus business, financial condition, or
results of operations.

Plasma Physics Litigation

On December 28, 1999, Plasma Physics Corporation and Solar Physics Corporation
(collectively, Plasma Physics) filed a patent infringement lawsuit against
many of Novellus Japanese and Korean customers. The suit was entitled Plasma
Physics and Solar Physics v. Fujitsu et al., Civil Action No. 99-8593, and was
pending in the United States District Court for the Eastern District of New
York. On July 24, 2000, the Court ordered Plasma Physics to re-file separate
complaints against the Japanese and Korean defendants, whereupon, Civil Action
No. 99-8593 would be dismissed without prejudice. In accordance with the
Courts order, Plasma Physics re-filed separate complaints against the Japanese
and Korean defendants in the United States District Court for the Eastern
District of New York. Many of the defendants notified Novellus that they
believed that Novellus had indemnification obligations and liability for the
lawsuits.

Plasma Physics asserted U.S. Patent Nos. 4,226,897, 5,470,784, and/or 5,543,634
(the 897, 784, and 634 patents, respectively) against the defendants.
Plasma Physics sought an injunction against the defendants alleged
infringement of the 784 and 634 patents (the 897 patent had expired).
Plasma Physics also sought treble damages for alleged willful infringement.
Plasma Physics further sought its attorneys fees and costs, and interest on
any judgment. All of the Japanese and Korean defendants who are or were
customers of Novellus have since settled with Plasma Physics.

On June 1, 2000, Novellus filed a declaratory relief action against Plasma
Physics and Solar Physics requesting a judgment of non-infringement,
invalidity, and unenforceability with respect to the 897 and 784 patents.
The suit was entitled Novellus v. Plasma Physics and Solar Physics, Civil
Action No. 00-3146, and was pending in the United States District Court for the
Eastern District of New York. On July 31, 2000, Plasma Physics filed an Answer
and Conditional Counterclaim. Plasma Physics denied that the 897 and 784
patents are invalid and unenforceable. Plasma Physics further denied that the
784 patent is not infringed by Novellus. Plasma Physics also asserted a
conditional counterclaim against Novellus, alleging that Novellus PECVD
processing systems infringe the 784 patent. On April 3, 2002, the suit was
dismissed pursuant to a stipulation of voluntary dismissal without prejudice.

On June 12, 2001, the United States Patent and Trademark Office issued to
Plasma Physics U.S. Patent No. 6,245,648, entitled Method of Forming
Semiconducting Materials and Barriers (the 648 Patent). On June 13, 2001,
Plasma Physics sent a letter to Novellus, indicating that it may sue Novellus
customers for their alleged infringement of the 648 Patent.

On June 14, 2002, certain of Novellus 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, and Analog Devices Inc., were sued by Plasma
Physics on certain U.S. Patents, including the 897, 784, 634, and 648
patents. Many of the defendants notified Novellus that they believed that
Novellus had indemnification obligations and liability for the lawsuits.

Novellus believes that this matter will not have a material adverse impact on
Novellus financial condition or results of operations. However, there can be
no assurances that Novellus and its customers will prevail against Plasma
Physics. If Plasma Physics were to prevail against Novellus or its customers,
it could have a material adverse impact on Novellus business, financial
condition, or results of operations.

Linear Technology Litigation

On March 12, 2002, Linear Technology Corporation (Linear) filed a complaint
against Novellus, among other parties, in the Superior Court of the State of
California for the County of Santa Clara, Case No. CV806004. The complaint
seeks damages (including punitive damages) and injunctions for causes of
actions involving, among other things, alleged breach of contract, fraud,
unfair competition, breach of warranty, and declaratory relief. Novellus filed
a demurrer to Linears complaint.

Although it is inherently difficult to assess the outcome of litigation matters
when the litigation is in such an early stage, Novellus believes that this
litigation will not have a material adverse impact on Novellus financial
condition or results of operations. However, there can be no assurances that
Novellus will prevail against Linear. If Linear were to prevail against
Novellus, it could have a material adverse impact on Novellus business,
financial condition, or results of operations.

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ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At Novellus Annual Meeting of Shareholders, held on May 17, 2002, the
following proposals were adopted by the margins indicated:

1.     Election of Directors.

|                    |  |          |             |          |  |  |            | 
|------------------- |  | -------- | ----------- | -------- |  |  | ---------- | 
|Nominee             |  | In Favor |             | Withheld
|Richard S. Hill     |  |          | 99,723,142  |          |  |  | 29,617,501 | 
|                   
|                   
|                   
|                   
|D. James Guzy       |  |          | 127,917,306 |          |  |  | 1,423,337  | 
|                   
|                   
|                   
|                   
|J. David Litster    |  |          | 128,337,030 |          |  |  | 1,003,613  | 
|                   
|                   
|                   
|                   
|Glen Possley        |  |          | 128,356,721 |          |  |  | 983,922    | 
|                   
|                   
|                   
|                   
|Robert H. Smith     |  |          | 99,668,658  |          |  |  | 29,671,985 | 
|                   
|                   
|                   
|                   
|William R. Spivey   |  |          | 127,958,144 |          |  |  | 1,382,499  | 
|                   
|                   
|                   
|                   
|Delbert A. Whitaker |  |          | 128,340,010 |          |  |  | 1,000,633  | 

As of August 7, 2002, Robert H. Smith retired as a member of the Board of
Directors.

2.     Approval of the amendment to Novellus 1992 Employee Stock Purchase Plan
(the  Purchase Plan), which reserved for the issuance of 4,900,000 shares
under the Purchase Plan.

|            |  |         |           |           |  |  |         | 
|----------- |  | ------- | --------- | --------- |  |  | ------- | 
|In Favor    |  | Opposed |           | Abstained
|125,861,620 |  |         | 2,919,829 |           |  |  | 559,194 | 

3.     Ratification of Appointment of Ernst & Young LLP as Certified Public
Accountants of Novellus for the next fiscal year ended December 31, 2002.

|            |  |         |           |           |  |  |         | 
|----------- |  | ------- | --------- | --------- |  |  | ------- | 
|In Favor    |  | Opposed |           | Abstained
|124,865,557 |  |         | 4,020,093 |           |  |  | 454,733 | 




ITEM 5: OTHER INFORMATION

The ratio of earnings to fixed charges for the six months ended June 29, 2002
and each of the five most recent fiscal years was as follows:

|                 |                         |      |       |      |  |      |       |      |  |      |      |  |  |  |      |  |  |  |   | 
|---------------- | ----------------------- | ---- | ----- | ---- |  | ---- | ----- | ---- |  | ---- | ---- |  |  |  | ---- |  |  |  | - | 
|Six months ended | Year ended December 31,
|June 29, 2002    |                         | 2001 |       | 2000 |  | 1999 |       | 1998 |  | 1997
|                
|4.48             |                         |      | 13.41 |      |  |      | 16.30 |      |  |      | 6.95 |  |  |  | 6.33 |  |  |  |  | 

The ratio of earnings to fixed charges is computed by dividing fixed charges
into earnings before income taxes and before the cumulative effect of a change
in accounting principle plus fixed charges. Fixed charges consist of interest
expense and that portion of net rental expense deemed representative of
interest. In the year ended December 31, 1997, Novellus incurred a loss of
$92.7 million, net of an income tax benefit of $23.8 million. Fixed charges
for this period were $5.0 million.

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ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits

10.1 Form of Directors and Officers Indemnification Agreement

(b)  Reports on Form 8-K

None




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.
| | ----------------------



| | /s/ Kevin S. Royal
Kevin S. Royal
Vice President and Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer)
| | ---------------------------------------------------------------------------------------------------------------------------------------



| | August 13, 2002
| | ---------------

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Exhibit Index

10.1 Form of Directors and Officers Indemnification Agreement