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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 27, 2008

OR

For the transition period from                  to                 

Commission File Number 000-17157

NOVELLUS SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code; (408) 943-9700

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  þ

As of October 31, 2008, 97,664,418 shares of the Registrant’s common stock, no par value, were issued and outstanding.

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NOVELLUS SYSTEMS, INC.

FORM 10-Q

QUARTER ENDED September 27, 2008

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PART I: FINANCIAL INFORMATION

NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to Condensed Consolidated Financial Statements.

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NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to Condensed Consolidated Financial Statements.

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NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to Condensed Consolidated Financial Statements.

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NOVELLUS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. The interim financial information is unaudited and does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 27, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008 or any future period. The interim financial statements should be read in conjunction with the Consolidated Financial Statements and footnotes thereto included in Novellus’ Annual Report on Form 10-K for the year ended December 31, 2007.

The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures of contingent assets and liabilities. We evaluate estimates on an ongoing basis, including those related to recognition of revenue, valuation of investments, adequacy of the allowance for doubtful accounts, valuation of inventory, valuation of deferred tax assets, valuation of goodwill and other intangible assets, adequacy of warranty obligations, measurement of restructuring and impairment charges, compliance with hedge accounting for derivatives, contingencies and litigation, and measurement of stock-based compensation. We base estimates on historical experience and on other market-based assumptions that are believed to be reasonable under current circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our intent is to accurately state assets and liabilities given facts known at the time of measurement. Actual results may differ from these estimates under different assumptions or conditions.

The accompanying Condensed Consolidated Financial Statements include our accounts and the accounts of our subsidiaries after the elimination of all significant intercompany account balances and transactions. Warranty obligations in the amount of $10.0 million have been reclassified from Accrued warranty to Other non-current liabilities in the December 31, 2007 Condensed Consolidated Balance Sheet to conform to the 2008 financial statement presentation. This reclassification did not affect any prior amounts of reported total assets, liabilities, stockholders’ equity, results of operations or cash flows.

Derivatives

Our policy is to enter into foreign currency forward exchange contracts with maturities of less than 12 months to mitigate the impact of currency exchange fluctuations on (a) probable anticipated system sales in Japanese yen, (b) our net investment in certain foreign subsidiaries, and (c) existing monetary asset and liability balances denominated in foreign currencies. We record all derivatives at fair value in either Prepaid and other current assets or Other accrued liabilities. We report cash flows from derivative instruments in cash flows from operating activities. We used the income approach to value our derivative instruments using observable inputs other than quoted prices, including interest rates and credit risk.

Cash Flow Hedges

We designate and document as cash flow hedges foreign currency forward exchange contracts on sales transactions in which costs are denominated in U.S. dollars and the related revenues are generated in Japanese yen. We evaluate and calculate each hedge’s effectiveness at least quarterly, using the dollar offset method, comparing the change in the forward contract’s fair value on a spot-to-spot basis to the spot-to-spot change in the anticipated transaction. The effective change is recorded in Other comprehensive income (OCI) until the sale is recognized. Ineffectiveness, along with the excluded time value of the forward contracts, is recorded in Net sales as designated at the inception of the forward contract. During the three months ended September 27, 2008 and September 29, 2007, gains of $0.1 million and $0.8 million, respectively, were recorded in Net sales due to hedge ineffectiveness. During the nine months ended September 27, 2008 and September 29, 2007, gains of $0.5 million and $2.7 million, respectively, were recorded in Net sales due to hedge ineffectiveness. In the event it becomes probable that an anticipated hedged transaction will not occur as a result of the associated shipment date pushing outside of the forecasted range, the gains or losses on the related cash flow hedges are reclassified from Accumulated other comprehensive income (loss) to Net sales in the Condensed Consolidated Statement of Operations. No such events occurred during the three months ended September 27, 2008 and September 29, 2007. During both of the nine months ended September 27, 2008 and September 29, 2007, we reclassified losses of $0.7 million into Net sales as a result of the discontinuance of hedged anticipated transactions.

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The following table summarizes the pre-tax impact of cash flow hedges on OCI during the three and nine months ended September 27, 2008 and September 29, 2007.

We anticipate reclassifying the net gains recorded as of September 27, 2008 from OCI to Net sales within 12 months.

Net Investment Hedges

We hedge our net investment in certain foreign subsidiaries to reduce economic currency risk. The foreign currency forward exchange contracts used to hedge this exposure are designated and documented as net investment hedges. Effectiveness is evaluated at least quarterly, excluding time value, and hedges are highly effective when currency pairs and notional amounts on the forward exchange contracts are properly aligned with the net investment in subsidiaries. Changes in the spot-to-spot value are recorded as foreign currency translation adjustments within OCI. A gain of $1.2 million and a loss of $0.1 million were recorded in OCI for net investment hedges during the three months ended September 27, 2008 and September 29, 2007, respectively, and losses of $0.5 million and $0.4 million were recorded in OCI during the nine months ended September 27, 2008 and September 29, 2007, respectively. Ineffectiveness, if any, along with the excluded time value of the forward contracts, is recorded as foreign currency gain or loss in Other income, net. We recorded gains due to ineffectiveness of $0.1 million during both of the three months ended September 27, 2008 and September 29, 2007 and gains of $0.5 million during both of the nine months ended September 27, 2008 and September 29, 2007.

Other Foreign Currency Hedges

We enter into foreign currency forward exchange contracts (a) to hedge intercompany balances denominated in non-functional currencies, (b) to hedge certain third-party receivables denominated in Japanese yen and (c) to hedge anticipated sales denominated in foreign currency that do not qualify for special hedge accounting treatment under SFAS 133 due to uncertainty surrounding the timing of shipment. The maturities of these contracts are generally less than 12 months. Gains or losses arising from the remeasurement of these contracts to fair value each period are recorded in Other income, net. During the three months ended September 27, 2008 and September 29, 2007, we recorded derivative losses on these hedges of $2.5 million and $3.5 million, respectively, and during the nine months ended September 27, 2008 and September 29, 2007, we recorded derivative losses on these hedges of $6.7 million and $0.9 million, respectively.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (SFAS 157), which establishes specific criteria for the fair value measurements of financial and nonfinancial assets and liabilities that are already subject to fair value under current accounting rules. SFAS 157 also requires expanded disclosures related to fair value measurements. See Note 3 for information about fair value measurements.

In February 2008, the FASB issued FASB Staff Position (FSP) of Financial Accounting Standards (FAS) 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2), which allows companies to elect a one-year delay in applying SFAS 157 to certain fair value measurements of non-financial instruments, except for those recognized or disclosed at fair value on at least an annual basis. We elected the delayed adoption date for the portions of SFAS 157 impacted by FSP 157-2 and, as a result, we partially adopted SFAS 157 on January 1, 2008. The partial adoption of SFAS 157 was prospective and did not have a significant effect on our Condensed Consolidated Financial Statements. We are currently evaluating the impact of applying the deferred portion of SFAS 157 to the nonrecurring fair value measurements of our nonfinancial assets and nonfinancial liabilities. In accordance with FSP 157-2, the fair value measurements for these items will be adopted effective January 1, 2009.

In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP 157-3), which clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The adoption of this standard as of September 27, 2008 did not have a significant impact on our Condensed Consolidated Financial Statements.

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In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of SFAS 115” (SFAS 159). SFAS 159 permits a company to voluntarily elect to use fair value, instead of historic or original cost, to account for certain financial assets and liabilities. The fair value option is designated on an item-by-item basis, is irrevocable and requires that changes in fair value in subsequent periods be recognized in earnings in the period of change. We adopted SFAS 159 on January 1, 2008. The adoption had no impact on our Condensed Consolidated Financial Statements as we did not make a fair value election for any of our existing financial assets and liabilities. Any election to use the fair value method for future eligible transactions will be made on a case-by-case and instrument-by-instrument basis.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS 141R). Under SFAS 141R, an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life. The adoption of SFAS 141R will change our accounting treatment for business combinations on a prospective basis beginning in the first quarter of fiscal year 2009.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (SFAS 160), which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We do not expect that the adoption of SFAS 160 will have a significant impact on our Condensed Consolidated Financial Statements as all of our subsidiaries are currently wholly owned.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (SFAS 161), which requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improves the transparency of financial reporting. SFAS 161 is effective for fiscal years beginning after November 15, 2008. We are currently evaluating the impact of SFAS 161 on our Condensed Consolidated Financial Statements.

In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets” (FSP 142-3). FSP 142-3 provides guidance with respect to estimating the useful lives of recognized intangible assets acquired on or after the effective date and requires additional disclosure related to the renewal or extension of the terms of recognized intangible assets. FSP 142-3 is effective for fiscal years and interim periods beginning after December 15, 2008. We are currently evaluating the impact of FSP 142-3 on our Condensed Consolidated Financial Statements.

Note 2. Net Income Per Share

Basic net income per share is computed by dividing Net income by the weighted-average number of common shares outstanding during the period. For purposes of computing basic net income per share, the weighted-average number of outstanding shares of common stock excludes unvested restricted stock awards, consisting of restricted stock and restricted stock units that may be settled in our common shares.

Diluted net income per share is computed by dividing Net income by the weighted-average number of common and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist primarily of stock options and restricted stock awards.

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The following table provides a reconciliation of the numerators and denominators of the basic and diluted per share computations:

For the three months ended September 27, 2008 and September 29, 2007, 19.5 million and 15.4 million shares, respectively, and for the nine months ended September 27, 2008 and September 29, 2007, 20.1 million and 11.0 million shares, respectively, attributable to outstanding stock options were excluded from the calculation of diluted net income per share because their inclusion would have been anti-dilutive. Generally, options are considered anti-dilutive when their exercise prices are greater than or equal to the average market value of our common shares during the period of measurement. Restricted stock awards representing 0.8 million shares for both of the three and nine months ended September 27, 2008 and September 29, 2007 were excluded from the computation of diluted shares outstanding as the shares underlying these awards were subject to performance conditions that had not been met.

Note 3. Financial Instruments

Assets and liabilities measured at fair value on a recurring basis are as follows at September 27, 2008:

Money Market Funds

Money market funds include $116.2 million classified as Cash and cash equivalents and $143.3 million classified as Restricted cash and cash equivalents, current, on our Condensed Consolidated Balance Sheet.

Municipal Bonds

Municipal bonds are bonds issued by state and local governments and other governmental entities such as authorities or special districts. These are classified as available-for-sale within Short-term investments on our Condensed Consolidated Balance Sheet. We used the market approach to value municipal bonds. We classified these securities as Level 2 instruments due to either our use of observable market prices in less active markets or, when observable market prices were not available, our use of non-binding market prices that are corroborated by observable market data or quoted market prices for similar instruments.

Variable-Rate Demand Notes

Variable-rate demand notes are long-term, floating-rate obligations that are payable on demand. These are classified as available-for-sale within Short-term investments on our Condensed Consolidated Balance Sheet. We used the market approach to value variable-rate demand notes. We classified these securities as Level 2 instruments due to either our usage of observable market prices in less active markets or, when observable market prices were not available, our use of non-binding market prices that are corroborated by observable market data or quoted market prices for similar instruments.

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Auction-Rate Securities

Auction-rate securities include auction-rate notes and auction-rate preferred shares of tax-exempt closed-end municipal funds. Our auction-rate notes consist of student loans that are substantially backed by the federal government. Beginning in February 2008, our auction-rate securities became illiquid as their scheduled auctions failed to settle. An auction failure occurs when the parties wishing to sell securities cannot. As a result, the affected securities begin to pay interest under their default interest rate features. We will not have access to these funds unless (a) future auctions are successful, (b) the securities are called by the issuer, (c) we sell the securities in a secondary market, or (d) the underlying notes mature. Currently, there are no active secondary markets. As of September 27, 2008 we have recorded a temporary impairment charge of $10.7 million within OCI based upon our assessment of the fair value of our auction-rate securities. The impairment of these securities is temporary as we have both the ability and intent to hold these securities to recovery. Our valuation of these securities incorporates our assumptions about the anticipated term and the yield that a market participant would require to purchase such a security in the marketplace. We have included auction-rate securities, of which $1.9 million are classified as Short-term investments and $100.5 million are classified as non-current assets on our Condensed Consolidated Balance Sheet, in the Level 3 fair value category, as there are significant unobservable inputs to our cash-flow-based valuation model.

The table below presents a reconciliation of all financial instruments measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 27, 2008. We classify financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs. All Level 3 financial instrument activities for the three and nine months ended September 27, 2008 are related to auction-rate securities.

Note 4. Inventories

Inventories are stated at the lower of cost, on a first-in, first-out basis, or market. As of the balance sheet date, inventories consisted of the following:

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Note 5. Goodwill and Intangible Assets

Goodwill

A summary of changes in goodwill during the nine months ended September 27, 2008 is as follows:

There have been no significant events or circumstances affecting the valuation of goodwill since our annual impairment test was performed in the fourth quarter of 2007 when we concluded no impairment existed.

Intangible Assets

The following tables provide details of our acquired intangible assets:

Our estimated amortization expense for currently recognized identifiable intangible assets is approximately $1.6 million in the fourth quarter of 2008, and $4.3 million, $3.2 million, $2.1 million, $2.1 million and $2.1 million for the years ending December 31, 2009, 2010, 2011, 2012 and 2013, respectively. As of September 27, 2008, we had no identifiable intangible assets with indefinite lives.

Note 6. Product Warranty

We record the estimated cost of warranty coverage to Cost of sales when revenue is recognized. The estimated cost of warranty is determined by the warranty term as well as the average historical labor and material costs for a specific product. We review the actual product failure rates and material usage rates on a quarterly basis and adjust our warranty liability as necessary. Product warranty obligations that extend for more than twelve months from our balance sheet date are included in Other non-current liabilities. Changes in the accrued warranty liability were as follows:

Note 7. Restructuring and Other Charges

As of September 27, 2008, substantially all actions under our restructuring plans were completed, except for payments of future rent obligations. The remaining excess facility costs are stated at estimated net present value, net of estimated sublease income. We expect to pay remaining obligations in connection with vacated facilities no later than the expiration dates of the lease terms, which expire on various dates through 2017. An adjustment of prior restructuring costs was made due to changes in estimated sublease income over the remaining lease term. This adjustment is included within Selling, general and administrative expenses. All remaining restructuring activity relates to the Semiconductor Group (see Note 12. Operating Segments).

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The following table summarizes our facilities restructuring activity for the three and nine months ended September 27, 2008 and September 29, 2007:

In addition to the restructuring activity above, results of operations for the nine months ended September 27, 2008 include $13.6 million of charges recorded in the second quarter of 2008 as a result of strategic decisions to focus on our core products and reduce our cost structure going forward. These charges include: (a) impairments of inventory and evaluation systems of $6.4 million, (b) write-downs of certain research and development assets of $3.8 million and (c) reductions in workforce of $3.4 million. Of these charges, $6.5 million are in Cost of sales, $4.3 million are in Research and development expenses and $2.8 million are in Selling, general and administrative expenses.

Note 8. Debt Obligations

As of September 27, 2008, we had borrowings of $130.8 million denominated in Euros and Swiss francs. The weighted-average interest rate on these borrowings was 4.5% as of September 27, 2008. Substantially all of these borrowings are secured by cash and cash equivalents and are due and payable on or before June 25, 2009. Amounts to secure these borrowings are included within Restricted cash and cash equivalents, current on our Condensed Consolidated Balance Sheet.

Note 9. Other Income, Net

The components of other income, net are as follows:

Note 10. Shareholders’ Equity

Other Comprehensive Income (Loss)

The components of other comprehensive income (loss) are as follows:

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The components of accumulated other comprehensive income (loss) are as follows:

Common Stock Repurchase Program

The Board of Directors has authorized the repurchase of outstanding common stock, including approvals of $1.0 billion on September 14, 2004 and another $1.0 billion on October 26, 2007. As of September 27, 2008, we had $845.9 million available for stock repurchases under these authorizations. For the nine months ended September 27, 2008 and September 29, 2007, 7.6 million and 8.0 million shares, respectively, were repurchased under this plan for $173.8 million and $226.9 million, respectively, at a weighted average purchase price of $22.74 and $28.39, respectively.

Note 11. Litigation

Linear Technology Corporation

In March 2002, Linear Technology Corporation (Linear) filed a complaint against Novellus, among other parties, in the Superior Court of the State of California for the County of Santa Clara. The complaint seeks damages (including punitive damages), declaratory relief and injunctions for causes of action involving alleged breach of contract, fraud, unfair competition and breach of warranty. The Superior Court dismissed Linear’s claims for fraud and unfair competition on October 5, 2004. The Court of Appeal affirmed this dismissal on June 18, 2007. Trial on the remaining claims is currently set for May 26, 2009. At this time, we cannot predict the ultimate outcome of this case, nor can we estimate a range of potential loss, if any. However, we believe that the ultimate disposition of these matters will not have a material adverse effect on our business, financial condition or operating results.

Other Litigation

We are a defendant or plaintiff in various actions that have arisen in the normal course of business. We believe that the ultimate disposition of these matters will not have a material adverse effect on our business, financial condition or results of operations. However, due to the uncertainty surrounding litigation, we are unable at this time to estimate a range of loss, if any, that may result from any of these pending proceedings.

Note 12. Income Taxes

Our effective tax rates were 84.6% and 33.2% for the three months ended September 27, 2008 and September 29, 2007, respectively, and 53.1% and 33.1% for the nine months ended September 27, 2008 and September 29, 2007, respectively. The higher effective tax rates for 2008 are principally the result of decreased profits before taxes and an unfavorable mix of our anticipated annual operating results, particularly in certain foreign jurisdictions. This increased our effective tax rate for the nine months ended September 27, 2008 to 53.1% from 40.0% for the six months ended June 28, 2008 resulting in an 84.6% effective tax rate for the three months ended September 27, 2008.

Note 13. Stock-Based Compensation

The following table summarizes the stock-based compensation expense for stock options, restricted stock and employee stock purchase plan (ESPP) included in our Condensed Consolidated Statements of Operations:

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Stock Options

The exercise price of each stock option equals the market price of our common stock on the date of grant. Stock options generally vest ratably over a four-year period on the anniversary date of the grant and expire ten years after the grant date. The fair values of stock options were estimated using the Black-Scholes valuation model with the following weighted-average assumptions:

Our computation of volatility is based on a combination of historical and market-based implied volatility. Our computation of expected term is based on historical exercise patterns. We base the risk-free interest rate on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term of the option.

A summary of stock option activity during the nine months ended September 27, 2008 is as follows:

The aggregate intrinsic value of options outstanding is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 0.3 million and 7.2 million shares that had exercise prices lower than the market price of our common stock as of September 27, 2008 and December 31, 2007, respectively. The aggregate intrinsic value of options exercised, determined as of the date of exercise, was $0.2 million and $1.1 million during the three months ended September 27, 2008 and September 29, 2007, respectively, and $0.9 million and $7.9 million during the nine months ended September 27, 2008 and September 29, 2007, respectively. The weighted-average grant date fair value of options granted during the three months ended September 27, 2008 and September 29, 2007 was $9.40 and $13.39, respectively, and during the nine months ended September 27, 2008 and September 29, 2007 was $9.80 and $13.76, respectively. The total cash received from employees as a result of stock option exercises was $0.7 million and $3.7 million during the three months ended September 27, 2008 and September 29, 2007, respectively, and $1.6 million and $29.1 million during the nine months ended September 27, 2008 and September 29, 2007, respectively. In connection with these exercises and the disqualification of incentive stock options, we realized a tax benefit of $0.1 million and $0.4 million for the three months ended September 27, 2008 and September 29, 2007, respectively, and $0.2 million and $2.4 million for the nine months ended September 27, 2008 and September 29, 2007, respectively. We settle employee stock option exercises with newly issued common shares.

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As of September 27, 2008 there was $29.1 million of unrecognized compensation cost related to unvested stock options, of which $4.4 million is expected to be recognized in the fourth quarter of 2008, and $12.8 million, $9.1 million, $2.7 million and $0.1 million is expected to be recognized in 2009, 2010, 2011 and 2012, respectively.

Restricted Stock

Restricted stock awards include restricted stock and restricted stock units that are settled in common stock. Restricted stock awards generally vest over three, four, or five-year periods, excluding certain awards that vest upon the achievement of specific performance targets. A summary of restricted stock award activity during the nine months ended September 27, 2008 is as follows:

The unvested restricted stock awards at September 27, 2008 include 1.2 million of restricted stock units.

The total fair value of restricted stock awards that vested was $0.1 million and $0.3 million during the three months ended September 27, 2008 and September 29, 2007, respectively, and $1.7 million and $1.8 million during the nine months ended September 27, 2008 and September 29, 2007, respectively. In connection with the vesting of these awards, we realized tax benefits of $0.1 million for the three months ended September 27, 2008 and $0.6 million for both of the nine months ended September 27, 2008 and September 29, 2007. No tax benefit was realized for the three months ended September 29, 2007. As of September 27, 2008, there was a total of 0.8 million shares of restricted stock awards subject to performance conditions that will result in forfeiture if the conditions are not met.

As of September 27, 2008 there was $24.9 million of unrecognized compensation cost related to restricted stock awards, of which $3.5 million is expected to be recognized in the fourth quarter of 2008, and $10.3 million, $6.3 million, $4.6 million and $0.2 million, is expected to be recognized in 2009, 2010, 2011 and 2012, respectively.

Employee Stock Purchase Plan

We have an ESPP that allows qualified employees to purchase shares of common stock at 85 percent of the fair market value on specified dates. There were no ESPP shares issued during the third quarter of 2008 and 2007. The weighted-average grant date fair value of shares for the three months ended September 27, 2008 and September 28, 2007 was $6.11 and $7.98, respectively, and for the nine months ended September 27, 2008 and September 29, 2007 was $6.64 and $7.51, respectively. The fair values of ESPP were estimated using the Black-Scholes valuation model with the following weighted-average assumptions:

Note 14. Operating Segments

Our operations are organized into two segments, the Semiconductor Group and the Industrial Applications Group. The Semiconductor Group develops, manufactures, sells and supports equipment used in the fabrication of integrated circuits, commonly called chips or semiconductors. The Industrial Applications Group is a supplier of lapping, grinding, polishing and deburring products for fine-surface optimization. The accounting policies of these segments are the same as those described in Note 2 of our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2007.

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Segment information for the periods presented is as follows: