e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended September 29, 2007


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 000-17157

NOVELLUS SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)


California		77-0024666
(State or other jurisdiction of		(I.R.S. Employer Identification
incorporation or organization)		Number)

4000 North First Street, San Jose, California 95134
(Address of principal executive offices including zip code)

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

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

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

Large accelerated filer þ Accelerated filer o Non-accelerated filer o

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

As of November 2, 2007, 116,144,972 shares of the Registrant’s common stock, no par value, were issued and outstanding.

PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)


	Three Months Ended				Nine Months Ended
	September 29,		September 30,		September 29,		September 30,
	2007		2006		2007		2006
	(In thousands, except per share amounts)
Net sales	$	393,277	$	444,032	$	1,206,586	$	1,220,011
Cost of sales		198,970		217,507		609,260		621,182

Gross profit		194,307		226,525		597,326		598,829
Operating expenses:
Selling, general and administrative		67,420		67,664		206,531		192,457
Research and development		61,384		60,645		185,158		187,726
Restructuring and other charges		—		—		—		12,629
Legal settlement		—		—		—		3,250

Total operating expenses		128,804		128,309		391,689		396,062

Operating income		65,503		98,216		205,637		202,767
Interest income, net		8,617		6,044		25,005		16,244
Other income, net		316		3,530		9,632		7,020

Interest and other income, net		8,933		9,574		34,637		23,264

Income before provision for income taxes and cumulative effect of a change in accounting principle		74,436		107,790		240,274		226,031
Provision for income taxes		24,725		37,770		79,435		79,537

Income before cumulative effect of a change in accounting principle		49,711		70,020		160,839		146,494
Cumulative effect of a change in accounting principle, net of tax of $594		—		—		—		948

Net income	$	49,711	$	70,020	$	160,839	$	147,442

Net income per share:
Basic:
Income before cumulative effect of a change in accounting principle	$	0.41	$	0.57	$	1.31	$	1.16
Cumulative effect of a change in accounting principle		—		—		—		0.01

Basic net income per share	$	0.41	$	0.57	$	1.31	$	1.17

Diluted:
Income before cumulative effect of a change in accounting principle	$	0.41	$	0.57	$	1.28	$	1.15
Cumulative effect of a change in accounting principle		—		—		—		0.01

Diluted net income per share	$	0.41	$	0.57	$	1.28	$	1.16

Shares used in basic per share calculations		120,414		122,150		122,730		126,125

Shares used in diluted per share calculations		121,902		123,357		125,244		127,177

See accompanying notes to Condensed Consolidated Financial Statements.

NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS


	September 29,		December 31,
	2007		2006 *
	(unaudited)
	(In thousands)
ASSETS

Current assets:
Cash and cash equivalents	$	105,651	$	58,463
Short-term investments		751,811		794,865
Accounts receivable, net		362,259		310,888
Inventories		231,271		198,571
Deferred tax assets, net		69,702		102,266
Assets held for sale		34,043		21,966
Prepaid and other current assets		19,259		18,274

Total current assets		1,573,996		1,505,293
Property and equipment, net		333,733		364,599
Restricted cash and cash equivalents		151,003		143,769
Goodwill		235,753		225,431
Intangible and other assets		124,275		123,400

Total assets	$	2,418,760	$	2,362,492


LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	95,515	$	76,406
Accrued payroll and related expenses		69,638		81,836
Accrued warranty		59,337		55,349
Other accrued liabilities		62,335		40,534
Income taxes payable		27,714		38,879
Deferred profit		57,614		41,351
Current obligations under lines of credit		7,685		19,480

Total current liabilities		379,838		353,835
Long-term debt		137,662		127,862
Other non-current liabilities		68,411		46,090

Total liabilities		585,911		527,787
Commitments and contingencies
Shareholders’ equity:
Common stock		1,370,752		1,393,914
Retained earnings		459,471		438,196
Accumulated other comprehensive income		2,626		2,595

Total shareholders’ equity		1,832,849		1,834,705

Total liabilities and shareholders’ equity	$	2,418,760	$	2,362,492


*		Amounts are derived from the December 31, 2006 audited consolidated financial statements.

See accompanying notes to Condensed Consolidated Financial Statements.

NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	Nine Months Ended
	September 29,			September 30,
	2007			2006
	(In thousands)
Cash flows from operating activities:
Net income	$	160,839		$	147,442
Adjustments to reconcile net income to net cash provided by operating activities:
Loss on disposal of property and equipment		50			1,834
Non-cash portion of restructuring and other charges		—			10,199
Depreciation and amortization		50,709			53,754
Deferred income taxes		24,479			1,488
Stock-based compensation		28,227			26,257
Tax benefit from stock-based compensation		3,251			18,297
Excess tax benefit from stock-based compensation		(782	)		(11,067	)
Other-than-temporary impairment of short-term investment		1,763			—
Other non-cash charges, net		2,052			—
Cumulative effect of a change in accounting principle		—			(1,542	)
Changes in operating assets and liabilities:
Accounts receivable		(48,864	)		(11,484	)
Inventories		(28,183	)		(12,772	)
Prepaid and other assets		(2,885	)		14,575
Accounts payable		7,930			(2,009	)
Accrued payroll and related expenses		(8,828	)		18,137
Accrued warranty		3,781			2,764
Other liabilities		19,678			(2,197	)
Income taxes payable		6,859			4,422
Deferred profit		15,963			5,710

Net cash provided by operating activities		236,039			263,808

Cash flows from investing activities:
Proceeds from sales of short-term investments		669,945			384,113
Proceeds from maturities of short-term investments		176,380			154,711
Purchases of short-term investments		(807,424	)		(505,103	)
Capital expenditures		(26,949	)		(28,255	)
Proceeds from sale of property and equipment		275			626
Increase in restricted cash and cash equivalents		(7,234	)		(4,645	)
Other investing activities		(339	)		(353	)

Net cash provided by investing activities		4,654			1,094

Cash flows from financing activities:
Proceeds from employee stock compensation plans		33,777			11,747
Proceeds from (repayments of) lines of credit, net		(11,964	)		9,207
Payments on long-term debt		(21	)		(6,955	)
Repurchases of common stock		(216,893	)		(249,864	)
Excess tax benefit from stock-based compensation		782			11,067

Net cash used in financing activities		(194,319	)		(224,798	)

Effects of exchange rate changes on cash and cash equivalents		814			2,992

Net increase in cash and cash equivalents		47,188			43,096
Cash and cash equivalents at the beginning of the period		58,463			40,403

Cash and cash equivalents at the end of the period	$	105,651		$	83,499

See accompanying notes to Condensed Consolidated Financial Statements.

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 29, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007 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, 2006. A liability of $7.5 million related to employee termination benefits has been reclassified from other accrued liabilities to other non-current liabilities in the December 31, 2006 Condensed Consolidated Balance Sheet to conform to the current period presentation.

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, 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. Our assumptions may adjust over time as facts may change in the future. Actual results may differ from these estimates under different assumptions or conditions.

The accompanying Condensed Consolidated Financial Statements include our accounts and the accounts of our subsidiaries after the elimination of all significant intercompany account balances and transactions.

Derivatives

To address increasing international growth and related currency risks, we expanded our foreign currency exposure management policy in 2006. 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 (a) on probable anticipated system sales denominated in Japanese yen; (b) on our net investment in certain foreign subsidiaries; and (c) on existing monetary asset and liability balances denominated in foreign currencies. In accordance with Statement of Financial Accounting Standard (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), all derivatives are recorded at fair value in either other current assets or other current liabilities. Cash flows from derivative instruments are reported in cash flows from operating activities.

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 and nine months ended September 29, 2007, gains of $0.8 million and $2.7 million, respectively, were recorded in net sales due to hedge ineffectiveness. During the three and nine months ended September 30, 2006, gains of $0.6 million and $1.7 million, respectively, were recorded in cost of sales due to hedge ineffectiveness. (In 2006 ineffectiveness was recorded in cost of sales.) In the event it becomes probable that a hedged anticipated transaction will not occur, the gains or losses on the related cash flow hedges are immediately reclassified from accumulated OCI to net sales. During the three months ended June 30, 2007 we reclassified a loss of $0.7 million from OCI into net sales as a result of the discontinuance of hedged anticipated transactions.

The following table summarizes the pre-tax impact of cash flow hedges on OCI during the three and nine months ended September 29, 2007 and September 30, 2006.


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2007			2006			2007			2006
	(In thousands)
Balance, beginning of period – gains (losses)	$	1,805		$	1,820		$	(329	)	$	—
Effective change of cash flow hedges		(4,533	)		184			(3,641	)		1,955
Reclassification to cost of sales		—			(958	)		—			(909	)
Reclassification to net sales		(433	)		—			809			—

Balance, end of period – gains (losses)	$	(3,161	)	$	1,046		$	(3,161	)	$	1,046

We anticipate reclassifying the net losses recorded as of September 29, 2007 from OCI to earnings within 12 months.

Net Investment Hedges — During the second quarter of 2006, we began to 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. Ineffectiveness, if any, along with the excluded time value of the forward contracts, is recorded in other income, net, and resulted in gains of $0.1 million and $0.2 million in the three months ended September 29, 2007 and September 30, 2006, respectively, and gains of $0.5 million in each of the nine-month periods ended September 29, 2007 and September 30, 2006. Losses of $0.1 million and $0.4 million were recorded in OCI for net investment hedges during the three months ended September 29, 2007 and September 30, 2006, respectively, and losses of $0.4 million and $1.6 million were recorded in OCI during the nine months ended September 29, 2007 and September 30, 2006, respectively.

Fair Value Hedges — We enter into foreign currency forward exchange contracts to hedge intercompany balances that are denominated in currencies other than the U.S. dollar. The fair value of these contracts is remeasured each period and the corresponding gain or loss is recorded in other income, net. The maturities of these contracts are generally less than 12 months. We do not apply special hedge accounting treatment under SFAS 133 because the gains or losses are recorded in other income, net each period, where they are expected to substantially offset the remeasurement gain or loss on the corresponding intercompany balances. During the three months ended September 29, 2007 and September 30, 2006, gains of $0.3 million and $0.2 million, respectively, were recorded in other income, net, related to these contracts, and during the nine months ended September 29, 2007 and September 30, 2006, gains of $0.2 million and $2.0 million, respectively, were recorded in other income, net, related to these contracts.

Recent Accounting Pronouncements

In June 2006, the Emerging Issues Task Force (EITF) issued EITF No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43” (EITF 06-2), which clarifies the accounting for compensated absences known as a sabbatical leave whereby an employee is entitled to paid time off after working for a specified period of time. We adopted the interpretation effective January 1, 2007, resulting in an adjustment to beginning retained earnings of $3.8 million, net of tax of $2.2 million, and an increase to short-term and long-term sabbatical liability of $2.0 million and $4.0 million, respectively.

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainties in Income Taxes — An Interpretation of FASB Statement No. 109” (FIN 48), which we adopted effective January 1, 2007. FIN 48 requires that we recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. No cumulative adjustment to retained earnings was required upon our adoption of FIN 48. As of January 1, 2007, we had approximately $11.4 million of unrecognized tax benefits. During the three and nine months ended September 29, 2007 unrecognized tax benefits increased by $3.6 million and $10.7 million, respectively, due to tax positions taken in the respective periods. As of September 29, 2007 we had approximately $22.1 million of unrecognized tax benefits, substantially all of which would, if recognized, affect our tax expense. We have elected to include interest and penalties as a component of tax expense. Accrued interest and penalties as of January 1, 2007 was approximately $0.1 million. We do not anticipate that the amount of existing unrecognized tax benefits will significantly increase or decrease within the next 12 months. Generally, fiscal years from 2004 forward remain open to examination by federal tax authorities, although the utilization of tax loss and credit carryforwards from fiscal years 2001 through 2003 could also be subject to examination. Most state and foreign jurisdictions have three or four open tax years at any time.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which establishes a common definition for fair value to be applied to U.S. GAAP guidance requiring use of fair value. Also, SFAS 157 establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of SFAS 157 on our Consolidated Financial Statements.

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). The standard allows entities to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not otherwise required to be so measured. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of SFAS 159 on our 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, which include restricted stock and restricted stock units that are settled in our common shares.

Diluted net income per share is computed using 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.

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


	Three Months Ended				Nine Months Ended
	September 29,		September 30,		September 29,		September 30,
	2007		2006		2007		2006
	(In thousands, except per share amounts)
Numerator:
Net income	$	49,711	$	70,020	$	160,839	$	147,442

Denominator:
Basic weighted-average shares outstanding		120,414		122,150		122,730		126,125
Dilutive potential common shares		1,488		1,207		2,514		1,052

Diluted weighted-average shares outstanding		121,902		123,357		125,244		127,177

Basic net income per share	$	0.41	$	0.57	$	1.31	$	1.17
Diluted net income per share	$	0.41	$	0.57	$	1.28	$	1.16

For the three months ended September 29, 2007 and September 30, 2006, 15.4 million and 18.8 million shares, respectively, and for the nine months ended September 29, 2007 and September 30, 2006, 11.0 million and 21.7 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 0.7 million and 0.2 million shares for the nine months ended September 29, 2007 and September 30, 2006, respectively, 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. 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:


	September 29,		December 31,
	2007		2006
	(In thousands)
Purchased and spare parts	$	160,414	$	152,727
Work-in-process		52,534		30,524
Finished goods		18,323		15,320

Total inventories	$	231,271	$	198,571

Note 4. Goodwill and Intangible Assets

Goodwill

A summary of changes in goodwill during the three and nine months ended September 29, 2007 is as follows:


			Industrial
	Semiconductor		Applications
	Group		Group		Total
	(In thousands)
Balance as of December 31, 2006	$	109,059	$	116,372	$	225,431
Foreign currency translation and other adjustments		1,326		1,819		3,145

Balance as of March 31, 2007	$	110,385	$	118,191	$	228,576
Foreign currency translation		—		1,074		1,074

Balance as of June 30, 2007	$	110,385	$	119,265	$	229,650
Foreign currency translation		—		6,103		6,103

Balance as of September 29, 2007	$	110,385	$	125,368	$	235,753

There have been no significant events or circumstances affecting the valuation of goodwill since the fourth quarter of 2006 when we performed our annual impairment test and concluded no impairment existed.

Intangible Assets

The following tables provide details of our acquired intangible assets:


	Weighted
	Average
	Amortization				Accumulated
September 29, 2007	Period		Gross		Amortization			Net
	(Years)				(In thousands)
Patents and other intangibles		12	$	16,656	$	(1,318	)	$	15,338
Developed technology		6		29,806		(20,647	)		9,159
Tradename		10		7,178		(2,333	)		4,845

Total		8	$	53,640	$	(24,298	)	$	29,342


	Weighted
	Average
	Amortization				Accumulated
December 31, 2006	Period		Gross		Amortization			Net
	(Years)				(In thousands)
Patents and other intangibles		11	$	20,707	$	(2,164	)	$	18,543
Developed technology		6		28,995		(16,555	)		12,440
Tradename		10		6,663		(1,666	)		4,997

Total		8	$	56,365	$	(20,385	)	$	35,980

Our estimated amortization expense for currently recognized identifiable intangible assets is approximately $6.9 million, $4.3 million, $3.1 million, $2.1 million and $2.1 million for the years ending December 31, 2008, 2009, 2010, 2011 and 2012, respectively. As of September 29, 2007, we had no identifiable intangible assets with indefinite lives.

Note 5. Product Warranty

We record the estimated cost of warranty as a component of cost of sales upon system shipment. The estimated cost for a specific product is determined by the warranty term and the estimated labor and material costs for that product. Should actual labor costs, product failure rates or material usage differ from the estimate, revisions to the estimated warranty liability may be required. We review actual labor rates on an annual basis and product failure rates and material usage on a quarterly basis and adjust the warranty liability as necessary. Changes in the accrued warranty liability were as follows:


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2007			2006			2007			2006
	(In thousands)
Balance, beginning of period	$	58,650		$	60,083		$	55,349		$	54,553
Warranties issued		18,992			20,488			61,888			65,274
Settlements		(18,199	)		(20,731	)		(57,928	)		(61,726	)
Net changes in liability for pre-existing warranties, including expirations		(106	)		(2,320	)		28			(581	)

Balance, end of period	$	59,337		$	57,520		$	59,337		$	57,520

Note 6. Restructuring and Other Charges

In an effort to consolidate operations, streamline our product offerings and align manufacturing operations with current business conditions we implemented several restructuring plans starting in 2001.

During the first quarter of 2006, we implemented a restructuring plan to dispose of certain owned facilities in San Jose, California. However, because the anticipated period to close the sale of these assets was in excess of one year, they did not qualify as assets held for sale at that time. We considered the change in planned use of the facilities as an indicator of impairment and determined that two of the properties were impaired. We recorded impairment charges of $8.9 million in the three months ended April 1, 2006 to write these two facilities down to their estimated fair value. The other properties are not impaired. During the third quarter of 2006 and the first quarter of 2007, certain facilities were reclassified under this restructuring plan as assets held for sale. As of September 29, 2007 we have not sold any of the aforementioned facilities classified as held for sale because of unexpected delays in the sale process. We have addressed these issues and expect to sell these facilities in the near term, and therefore, we continue to present them as assets held for sale.

Net charges of $3.7 million were also recorded in the nine months ended September 30, 2006 related to our restructuring plan to relocate operations from Chandler, Arizona to San Jose, California and Tualatin, Oregon.

The charges discussed above are included in restructuring and other charges in the Condensed Consolidated Statements of Operations and are related to the Semiconductor Group (see Note 12. Operating Segments).

The following table summarizes our facilities restructuring activity for the three and nine months ended September 29, 2007 and September 30, 2006:


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2007			2006			2007			2006
	(In thousands)
Balance, beginning of period	$	15,700		$	25,880		$	17,503		$	27,239
Restructuring charges		—			—			—			6,235
Non-cash adjustment		—			—			—			1,161
Adjustment of prior restructuring costs		—			—			—			(3,856	)
Cash payments		(1,248	)		(2,687	)		(3,051	)		(7,586	)

Balance, end of period	$	14,452		$	23,193		$	14,452		$	23,193

As of September 29, 2007, substantially all actions under the 2001 through 2006 restructuring plans had been completed, except for payments of future rent obligations and the sale of assets classified as held for sale. The remaining excess facility costs are stated at estimated fair 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.

Note 7. Long-Term Obligations

As of September 29, 2007, we had long-term borrowings of $137.7 million, denominated in Euros and Swiss francs. The weighted-average interest rate on these borrowings was 4.9% as of September 29, 2007. Substantially all borrowings are secured by cash or

marketable securities on deposit and are due and payable on or before June 25, 2009. Amounts to secure these borrowings are included within restricted cash and cash equivalents on the Condensed Consolidated Balance Sheets.

Note 8. Other Income, Net

The components of other income, net within the Condensed Consolidated Statements of Operations are as follows:


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2007			2006			2007			2006
	(In thousands)
Other income	$	2,723		$	1,926		$	7,742		$	3,083
Other expense		(426	)		(292	)		(529	)		(563	)
Other-than-temporary impairment of short-term investment		(1,763	)		—			(1,763	)		—
Foreign currency gain, net		(218	)		1,896			4,182			4,500

Total other income, net	$	316		$	3,530		$	9,632		$	7,020

Note 9. Comprehensive Income

The components of comprehensive income are as follows:


	Three Months Ended					Nine Months Ended
	September 29,			September 30,		September 29,			September 30,
	2007			2006		2007			2006
				(In thousands)
Net income	$	49,711		$	70,020	$	160,839		$	147,442
Other comprehensive income:
Foreign currency translation adjustments		3,568			2,631		3,238			3,599
Unrealized gain (loss) on short-term investments		783			120		(338	)		2,152
Unrealized gain (loss) on derivative instruments		(4,966	)		769		(2,832	)		(1,046	)
Unrealized loss on minimum pension liability adjustment		(44	)		—		(37	)		—

Comprehensive income	$	49,052		$	73,540	$	160,870		$	152,147

The components of accumulated other comprehensive income are as follows:


	September 29,			December 31,
	2007			2006
	(In thousands)
Foreign currency translation adjustments	$	6,816		$	3,578
Unrealized gain (loss) on short-term investments		(114	)		224
Unrealized loss on derivative instruments		(3,161	)		(329	)
Unrealized loss on minimum pension liability adjustment		(915	)		(878	)

Accumulated other comprehensive income	$	2,626		$	2,595

Note 10. Litigation

Linear Technology Corporation

claims, finding that the Superior Court had erred in concluding that it lacked subject matter jurisdiction over these claims. On October 19, 2007 the California Supreme Court decided not to review the judgment of the Court of Appeal. As a result, Novellus expects to litigate these claims in the Superior Court. This ruling does not affect the substance of any non-jurisdictional defenses that Novellus may assert to Linear’s claims. 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 11. Stock-Based Compensation

Prior to 2007, we had several stock plans that provided for grants of equity instruments to our employees and non-employee directors. Effective February 2007 and May 2007, the Board of Directors and shareholders, respectively, approved the amended and restated 2001 Stock Incentive Plan (the “Plan”) to increase the number of shares available and to consolidate all stock plans into a single plan. Awards under the Plan include incentive stock options, non-statutory stock options and restricted stock awards. Restricted stock awards include restricted stock and restricted stock units that are settled in our common stock. 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. Restricted stock awards generally vest over three, four, or five-year periods, excluding certain awards that vest upon the achievement of specific revenue or shipment performance targets.

We also have an Employee Stock Purchase Plan (ESPP) that allows qualified employees to purchase shares of common stock at 85% of the fair market value on specified dates.

Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R) using the modified prospective transition method. Under that transition method, stock-based compensation expense includes: (a) compensation expense for all share-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted or modified on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after January 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2007			2006			2007			2006
	(In thousands)
	(1)			(2)			(1)			(2)
Cost of sales	$	543		$	400		$	1,619		$	1,246
Selling, general and administrative		6,674			5,516			17,619			16,545
Research and development		2,987			2,741			8,989			8,466

Stock-based compensation expense before income taxes		10,204			8,657			28,227			26,257
Income tax benefit		(3,449	)		(3,333	)		(7,805	)		(10,109	)

Total stock-based compensation expense after income taxes	$	6,755		$	5,324		$	20,422		$	16,148


(1)		Amounts include amortization expense related to stock options of $5.4 million and $15.3 million, employee stock purchase plan of $0.8 million and $2.2 million, and restricted stock awards of $4.0 million and $10.7 million for the three and nine months ended September 29, 2007, respectively.

(2)		Amounts include amortization expense related to stock options of $6.3 million and $19.2 million, employee stock purchase plan of $0.5 million and $1.7 million, and restricted stock awards of $1.7 million and $5.2 million for the three and nine months ended September 30, 2006, respectively.

The fair values of stock options and ESPP were estimated using the Black-Scholes valuation model with the following weighted-average assumptions:


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
Options	2007			2006			2007			2006
Risk-free interest rate		4.6	%		4.9	%		4.7	%		4.9	%
Volatility		48.6	%		49.9	%		47.6	%		49.5	%
Expected term	4.4 years			4.3 years			4.4 years			4.3 years
Dividends	None			None			None			None
Weighted-average fair value at grant date	$	13.39		$	11.30		$	13.76		$	11.20


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
ESPP	2007			2006			2007			2006
Risk-free interest rate		5.0	%		5.0	%		5.0	%		5.0	%
Volatility		31.6	%		32.0	%		32.6	%		32.0	%
Expected term	6 months			6 months			6 months			6 months
Dividends	None			None			None			None
Weighted-average fair value at grant date	$	7.98		$	6.07		$	7.51		$	6.07

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 29, 2007 is as follows:


						Weighted-Average
						Remaining
	Number of			Weighted-Average		Contractual		Aggregate
	Shares			Exercise Price		Term (in Years)		Intrinsic Value
	(In thousands)							(In thousands)
Outstanding as of December 31, 2006		22,899		$	32.16		6.23	$	102,527

Grants		449			30.85
Exercises		(1,081	)		25.31
Forfeitures or expirations		(1,106	)		34.51

Outstanding as of September 29, 2007		21,161		$	32.36		5.58	$	15,306

Vested and expected to vest as of September 29, 2007		20,465		$	32.45		5.47	$	14,719

Exercisable as of September 29, 2007		15,788		$	33.53		4.60	$	10,390

The aggregate intrinsic value of options outstanding as of September 29, 2007 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 4.9 million shares that had exercise prices that were lower than the market price of our common stock as of September 29, 2007. The total intrinsic value of options exercised, determined as of the date of exercise, was $1.1 million and $1.6 million during the three months ended September 29, 2007 and September 30, 2006, respectively, and $7.9 million and $4.9 million during the nine months ended September 29, 2007 and September 30, 2006, respectively. The total cash received from employees as a result of stock option exercises was $3.7 million and $2.2 million during the three months ended September 29, 2007 and September 30, 2006, respectively, and $29.1 million and $7.9 million during the nine months ended September 29, 2007 and September 30, 2006, respectively. In connection with these exercises and the disqualification of incentive stock options, we realized tax benefits of $0.4 million and $0.5 million for the three months ended September 29, 2007

and September 30, 2006, respectively, and $2.4 million and $1.7 million for the nine months ended September 29, 2007 and September 30, 2006, respectively. We settle employee stock option exercises with newly issued common shares.

As of September 29, 2007 there was $37.3 million of unrecognized compensation cost related to unvested stock options, of which $5.2 million, $15.4 million, $9.9 million, $6.5 million, and $0.3 million is expected to be recognized in 2007, 2008, 2009, 2010, and 2011, respectively.

A summary of restricted stock award activity during the nine months ended September 29, 2007 is as follows:


				Weighted-Average
	Number of			Grant Date
	Shares			Fair Value
	(In thousands)
Unvested restricted stock awards as of December 31, 2006		1,894		$	29.68
Granted		89			31.22
Vested		(57	)		25.60
Forfeited		(150	)		29.25

Unvested restricted stock awards as of September 29, 2007		1,776		$	29.94

As of September 29, 2007 there was $24.2 million of unrecognized compensation cost related to restricted stock awards, of which $3.8 million, $14.1 million, $5.3 million, $0.9 million, and $0.1 million is expected to be recognized in 2007, 2008, 2009, 2010, and 2011, respectively. The total fair value of restricted stock awards that vested in each of the three month periods ended September 29, 2007 and September 30, 2006 was $0.3 million and the fair value of restricted stock awards that vested in each of the nine month periods ended September 29, 2007 and September 30, 2006 was $1.8 million. In connection with the vesting of these awards, we realized tax benefits of $0.1 million for the three months ended September 30, 2006, and $0.6 million and $0.7 million for the nine months ended September 29, 2007 and September 30, 2006, respectively. No tax benefit was realized for the three months ended September 29, 2007. As of September 29, 2007, there were a total of 0.7 million restricted stock awards subject to performance conditions that will result in forfeiture if the conditions are not met.

Note 12. Operating Segments

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” established standards for reporting information about operating segments in annual and interim financial statements. It also established standards for related disclosures about products and services, major customers and geographic areas. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker (CODM), in deciding how to allocate resources and in assessing performance. Our CODM is the Chief Executive Officer.

Our organizational structure is based on a number of factors that the CODM uses to evaluate, view and run our business operations which include, but are not limited to, customer base, homogeneity of products and technology. Our operating segments are based on this organizational structure and information reviewed by our CODM to evaluate the operating segment results. Our operations are organized into two segments: 1) Semiconductor Group; and 2) 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, 2006.

Segment information for the periods presented is as follows:


	Three Months Ended September 29, 2007						Nine Months Ended September 29, 2007
	(In thousands)
			Industrial						Industrial
	Semiconductor		Applications				Semiconductor		Applications
	Group		Group		Consolidated		Group		Group		Consolidated
Sales to unaffiliated customers	$	348,625	$	44,652	$	393,277	$	1,093,027	$	113,559	$	1,206,586
Operating income	$	58,855	$	6,648	$	65,503	$	192,139	$	13,498	$	205,637


	Three Months Ended September 30, 2006						Nine Months Ended September 30, 2006
	(In thousands)
			Industrial						Industrial
	Semiconductor		Applications				Semiconductor		Applications
	Group		Group		Consolidated		Group		Group		Consolidated
Sales to unaffiliated customers	$	418,055	$	25,977	$	444,032	$	1,142,480	$	77,531	$	1,220,011
Operating income	$	96,549	$	1,667	$	98,216	$	197,362	$	5,405	$	202,767


	September 29, 2007						December 31, 2006
	(In thousands)
			Industrial						Industrial
	Semiconductor		Applications				Semiconductor		Applications
	Group		Group		Consolidated		Group		Group		Consolidated
Total assets	$	2,157,509	$	261,251	$	2,418,760	$	2,152,651	$	209,841	$	2,362,492

Note 13. Related Party Transactions

We lease an aircraft from a third-party entity wholly owned by Richard S. Hill, our Chairman and Chief Executive Officer. Under the aircraft lease agreement, we incurred lease expenses of $0.2 million in each of the three-month periods ended September 29, 2007 and September 30, 2006 and $0.5 million and $0.6 million in the nine months ended September 29, 2007 and September 30, 2006, respectively.

We recognized aggregate compensation expense of $0.1 million during each of the three months ended September 29, 2007 and September 30, 2006, and $0.4 million during each of the nine month periods ended September 29, 2007 and September 30, 2006 for certain immediate family members of our executive officers employed in non-executive positions.

Current regulations prohibit company loans to “executive officers,” as defined by the SEC. We have outstanding loans to non-executive vice presidents and other key personnel. As of September 29, 2007 and December 31, 2006, the total outstanding balance of such loans was $1.0 million and $1.5 million, respectively. As of September 29, 2007, nearly all of the outstanding balance was secured by collateral. Loans typically bear interest, except for those made for employee relocation purposes. Bad debt expense related to loans to personnel has not historically been significant.

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

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q and certain information incorporated herein by reference contain forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included or incorporated by reference in this Quarterly Report, other than statements that are purely historical, are forward-looking statements. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “estimate,” and similar expressions also identify forward-looking statements. The forward-looking statements include, without limitation: the cyclicality of the semiconductor industry; our anticipation to reclassify net losses recorded as of September 29, 2007 from OCI to earnings within the next twelve months; our anticipation that the amount of unrecognized tax benefits will not significantly increase or decrease within the next twelve months; the possibility that tax loss and credit carryforwards for fiscal years 2001 through 2003 could be subject to federal tax examination; our expectation that the foreign currency forward exchange contracts we enter into will substantially offset the remeasurement gain or loss on corresponding intercompany balances; our estimated amortization expense for currently recognized identifiable intangible assets for the years ending December 31, 2008, 2009, 2010, 2011 and 2012, respectively; our expectation that we will sell certain remaining facilities under the restructuring plan in the near term; our expectation that the remaining obligations in connection with vacated facilities will be satisfied no later than the lease terms, which expire on various dates through 2017; our expectation to litigate the Linear Technology claims in the California Superior Court; our efforts to continue to deliver innovative products; our expectation that net orders will continue to vary; our belief that there is strong underlying demand in the semiconductor industry over the long term; our belief that significant additional growth potential exists in the Asia region over the long term; our continued outsourcing of manufacturing functions; our belief that we must develop new and enhanced systems and introduce them at competitive prices on a timely basis, while managing our research and development and warranty costs is required to maintain or capture a position in the market; our belief that significant investment in research and development is required to remain competitive; our plan to continue to invest in new products and enhancement of our current product lines; our belief that most of our deferred tax assets will be realized due to anticipated future income; our expectation that $37.3 million of unrecognized compensation related to unvested stock options,

of which $5.2 million, $15.4 million, $9.9 million, $6.5 million and $0.3 million will be recognized in 2007, 2008, 2009, 2010 and 2011, respectively; our expectation that $24.2 million of unrecognized compensation cost related to restricted stock awards, of which $3.8 million, $14.1 million, $5.3 million, $0.9 million and $0.1 million will be recognized in 2007, 2008, 2009, 2010 and 2011, respectively; the possibility that 0.7 million shares of restricted stock awards subject to performance conditions will be forfeited if the performance conditions are not realized; our intention to continue to seek legal protection through patents and trade secrets for our proprietary technology; our belief that our current cash position, cash generated through operations and equity offerings, and available borrowing capacity will be sufficient to meet our needs through the next twelve months; our belief that the ultimate outcome of actions that have arisen in the normal course of business will not have a material adverse effect on our business, financial condition or results of operations; our expectation that sales of our products to relatively few customers will continue to account for a high percentage of our net sales in the foreseeable future; our expectation to use the proceeds from certain credit agreements for working capital and other general corporate purposes, including the repurchase of shares; our expectation to repurchase shares from time to time in the open market, through block shares or otherwise.

Our expectations, beliefs, objectives, intentions and strategies regarding the future, including, without limitation, those concerning expected operating results, revenues and earnings and current and potential litigation are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from results contemplated by the forward-looking statements. These risks and uncertainties include, but are not limited to: unanticipated trends with respect to the cyclicality of the semiconductor industry; inability to accurately assess demand in the semiconductor industry over the long term; inaccuracies regarding growth potential in the Asia region over the long term; unanticipated difficulties in implementing and inability to realize savings from our restructuring plans; sustained decrease in or leveling off of customer demand; inability to accurately assess any potential increase or decrease of unrecognized tax benefits during the next twelve months; inability to predict the forum where the Company will need to litigate the Linear Technology claims; inability to accurately predict the consequences of any federal tax examination of the Company’s tax loss and credit carryforwards; inability to accurately assess the ability of certain foreign currency forward exchange contracts to offset remeasurement gains and losses; inability to accurately assess the period in which the Company can recognize unrecognized compensation related to unvested stock options and restricted stock awards; inability of the Company to meet certain performance conditions that may result in forfeiture of certain restricted stock awards; inability to anticipate cyclical changes in customers’ capacity utilization and demand; the negative impact of higher cost of services on gross margins; inability to realize efficiencies from outsourcing; inability to invest in research and development of existing and new product lines; inability to introduce new and enhanced products in a timely way in order to remain competitive; inability to accurately assess the changing product needs of our customers; loss of a major customer; the need to seek new customers and diversify our customer base; unanticipated need for additional liquid assets in the next twelve months; our failure to accurately predict the effect of the ultimate outcome of current litigation on our business, financial condition, results of operations or material adjustment to our financial statements; inherent uncertainty in the outcome of litigation matters; and our potential inability to enforce our patents and protect our trade secrets; unanticipated limitations on the use of proceeds from certain credit agreements including limitations on the ability of the Company to repurchase shares in the open market.

The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties set forth under the heading “Risk Factors” in Item 1A of Part II, and are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of the filing of this Quarterly Report on Form 10-Q. Readers should also review carefully the cautionary statements and risk factors listed in our Annual Report on Form 10-K for the year ended December 31, 2006 and in our other filings with the SEC, including our Forms 10-Q and 8-K and our Annual Report to Shareholders.

Introduction

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide readers with an understanding of our business. The following are included in our MD&A:

	•		Overview of our Business and Industry;

	•		Financial Performance Overview;

	•		Results of Operations;

	•		Critical Accounting Policies; and

•

Liquidity and Capital Resources.

Overview of Our Business and Industry

Novellus Systems, Inc. is a California corporation organized in 1984 that develops, manufactures, sells and supports equipment used in the fabrication of integrated circuits, which are commonly called chips or semiconductors. The customers for our products manufacture chips for sale or for incorporation in their own products, or provide chip-manufacturing services to third parties.

Our business depends on capital expenditures made by integrated circuit manufacturers, who in turn are dependent on corporate and consumer demand for integrated circuits and the electronic products which use them. Since the industry in which we operate is driven by spending for electronic products, our business is directly affected by growth or contraction in the global economy as well as by the adoption of new technologies. Demand for personal computers, the expansion of the Internet and telecommunications industries, and the emergence of new applications in consumer electronics have a direct impact on our business. In addition, the industry is characterized by intense competition and rapidly changing technology. We continue to work closely with our customers and make substantial investments in research and development in order to continue delivering innovative products which enhance productivity for our customers and utilize the latest technology. We believe these investments have positioned us for future growth.

We focus on certain key quarterly financial data to manage our business. Net sales, gross profit, net income and net income per share are the primary measures we use to monitor performance, and we also use certain non-GAAP measures, such as shipment revenue, to assess business trends and performance. Net orders, which are also referred to as bookings, are also used to forecast and plan future operations. Net orders consist of current period orders less current period cancellations. We do not report orders for systems with delivery dates more than 12 months after receipt of the order.

The following table sets forth certain quarterly financial information for the periods indicated (in thousands, except per share data and percentages):


	Quarterly Financial Data
	2007									2006
	Third			Second			First			Fourth			Third			Second			First
	Quarter			Quarter			Quarter			Quarter			Quarter			Quarter			Quarter
Net sales	$	393,277		$	416,335		$	396,974		$	438,505		$	444,032		$	410,073		$	365,906
Gross profit	$	194,307		$	208,110		$	194,909		$	225,520		$	226,525		$	204,764		$	167,540
Income before cumulative effect of a change in accounting principle	$	49,711		$	57,345		$	53,783		$	42,574		$	70,020		$	52,705		$	23,769
Net income	$	49,711		$	57,345		$	53,783		$	42,574		$	70,020		$	52,705		$	24,717
Diluted net income per share before cumulative effect of a change in accounting principle	$	0.41		$	0.45		$	0.42		$	0.34		$	0.57		$	0.42		$	0.18
Diluted net income per share	$	0.41		$	0.45		$	0.42		$	0.34		$	0.57		$	0.42		$	0.19
Shipment revenue	$	387,817		$	436,382		$	389,052		$	390,151		$	414,213		$	457,320		$	354,160
Change in shipment revenue from prior quarter		(11	)%		12	%		(0	)%		(6	)%		(9	)%		29	%		12	%
Net orders	$	305,329		$	332,201		$	412,219		$	441,620		$	470,322		$	457,545		$	416,770
Change in net orders from prior quarter		(8	)%		(19	)%		(7	)%		(6	)%		3	%		10	%		19	%

Due to the cyclical nature of our industry, we expect that net orders will continue to fluctuate. The receipt of net orders in a particular quarter affects revenue in subsequent quarters. Net orders result in revenue either at shipment and transfer of title or upon customer acceptance of the equipment. Our revenue recognition policy addresses the distinction between the revenue recognized upon shipment and transfer of title and the revenue recognized upon customer acceptance. Equipment generally ships within two to six months of receiving the related order and if applicable, customer acceptance is typically received one to six months after shipment. These time lines are general estimates and actual times may vary depending on specific customer circumstances.

The decrease in net orders during the last four quarters is the result of weakening semiconductor industry demand caused primarily by overcapacity. We believe there is strong underlying demand in the industry over the long term. However, capacity may continue to outpace demand through 2007. We took preemptive actions to reduce expenses in the second half of 2007, including a reduction of executive salaries and planned shutdowns, which reduced operating expenses by approximately $3.3 million in the third quarter.

Financial Performance Overview

The following is an overview of our financial performance for the third quarter of 2007 compared to the third quarter of 2006:

	•		Net sales decreased 11.4% to $393.3 million from $444.0 million;

	•		Net income decreased 29.0% to $49.7 million from $70.0 million;

	•		Diluted net income per share decreased to $0.41 from $0.57;

	•		Bookings decreased 35.1% to $305.3 million from $470.3 million; and

	•		Shipments decreased 6.4% to $387.8 million from $414.2 million.

Results of Operations

Net Sales


							% Change From
	Q3 2007		Q2 2007		Q3 2006		Q2 2007			Q3 2006			YTD 2007		YTD 2006		% Change
	(In thousands)												(In thousands)
Semiconductor Group	$	348,625	$	380,207	$	418,055		(8	)%		(17	)%	$	1,093,027	$	1,142,480		(4	)%
Industrial Applications Group		44,652		36,128		25,977		24	%		72	%		113,559		77,531		46	%

Net sales	$	393,277	$	416,335	$	444,032		(6	)%		(11	)%	$	1,206,586	$	1,220,011		(1	)%

The net sales we report is correlated to shipments in the current period, previously reported shipments and timing of customer acceptance. Deferred revenue at the end of the third quarter 2007 was $108.9 million. Net sales recorded in the Semiconductor Group decreased compared to prior periods as a result of weakening semiconductor industry demand.

Industrial Applications Group (IAG) net sales are up sequentially and year over year due to improved performance in the business and favorable exchange rate fluctuations. The functional currency of IAG is primarily the Euro. Changes in the exchange rate increased net sales by 6% from the third quarter 2006 to the third quarter 2007 and 7% for the nine months ended September 29, 2007 over the same period in the prior year.

Geographical net sales as a percentage of total net sales were as follows (based upon the location of our customers’ facilities):


	Three Months Ended									Nine Months Ended
	Q3 2007			Q2 2007			Q3 2006			YTD 2007			YTD 2006
North America		25	%		29	%		24	%		26	%		28	%
Europe		9	%		6	%		9	%		7	%		8	%
Asia		66	%		65	%		67	%		67	%		64	%

A significant portion of our net sales is generated in Asia, primarily because a substantial portion of the world’s semiconductor manufacturing capacity is located there. We consider the Asia region to include Korea, Japan, Singapore, Malaysia, China and Taiwan. In the fourth quarter 2006, we established, in Singapore, our new international headquarters for sales, which more closely aligns our operational structure with our customer base. We plan to continue to focus on expanding our market presence in Asia, as we believe that significant additional growth potential exists in this region over the long term.

Gross Profit


										% Change From
	Q3 2007			Q2 2007			Q3 2006			Q2 2007			Q3 2006			YTD 2007			YTD 2006			% Change
	(Dollars In thousands)															(Dollars In thousands)
Gross profit	$	194,307		$	208,110		$	226,525			(7	)%		(14	)%	$	597,326		$	598,829			(0	)%
Gross margin		49	%		50	%		51	%								50	%		49	%

The decrease in gross profit in the third quarter 2007 compared to the second quarter 2007 and third quarter 2006 is primarily due to lower revenues. Gross margin decreased from the second quarter 2007 and from the third quarter 2006 primarily as a result of increased sales as a percentage of total sales in IAG, where margins are generally lower than in the Semiconductor Group. In order to conform classification practices of IAG with those of the Semiconductor Group, in the third quarter 2007 we reclassified certain costs from SG&A expense to cost of sales ($1.9 million of which relate to the first six months of 2007).

Selling, General and Administrative (SG&A)


										% Change From
	Q3 2007			Q2 2007			Q3 2006			Q2 2007			Q3 2006			YTD 2007			YTD 2006			% Change
	(Dollars In thousands)															(Dollars In thousands)
SG&A expense	$	67,420		$	72,011		$	67,664			(6	)%		(0	)%	$	206,531		$	192,457			7	%
% of net sales		17	%		17	%		15	%								17	%		16	%

SG&A expense includes compensation and benefits for corporate, financial, marketing, sales and administrative personnel as well as travel expenses and professional service fees. Also included are expenses for rents, utilities, and depreciation and amortization related to the assets utilized by these functions.

SG&A expense decreased in absolute dollars in the third quarter 2007 from the second quarter 2007 as a result of savings from decreases in executive salaries and our planned shutdowns. SG&A expense was also affected by the reclassification discussed above and the reclassification in the third quarter 2007 of certain costs from SG&A expense to R&D expense ($0.7 million of which relate to the first six months of 2007). SG&A expense increased as a percentage of net sales in the third quarter 2007 from the third quarter 2006 primarily due to the decrease in net sales. SG&A expense has increased in absolute dollars in the nine months ended September 29, 2007, compared to the same period in the prior year, primarily due to increases in employee compensation costs, including merit pay increases and profit sharing.

Research and Development (R&D)


										% Change From
	Q3 2007			Q2 2007			Q3 2006			Q2 2007			Q3 2006			YTD 2007			YTD 2006			% Change
	(Dollars In thousands)															(Dollars In thousands)
R&D expense	$	61,384		$	63,374		$	60,645			(3	)%		1	%	$	185,158		$	187,726			(1	)%
% of net sales		16	%		15	%		14	%								15	%		15	%

R&D expense includes compensation and benefits for our research and development personnel, project materials, chemicals and other direct expenses incurred in product and technology development. Also included are expenses for equipment repairs and maintenance, rents, utilities and depreciation. Our significant investments in R&D over the past several years reflect our strong commitment to the continuous improvement of our current product lines and the development of new products and technologies. We continue to believe that significant investment in R&D is required to remain competitive, and we plan to continue to invest in new products and enhancement of our current product lines.

R&D expense increased as a percentage of sales in the third quarter 2007 compared to the second quarter 2007 and the third quarter of 2006 substantially due to a decrease in net sales. R&D expense was also affected by the reclassification discussed above.

Interest and Other Income, Net


										% Change From
	Q3 2007			Q2 2007			Q3 2006			Q2 2007			Q3 2006			YTD 2007			YTD 2006			% Change
	(Dollars In thousands)															(Dollars In thousands)
Interest and other income, net	$	8,933		$	14,597		$	9,574			(39	)%		(7	)%	$	34,637		$	23,264			49	%
% of net sales		2	%		4	%		2	%								3	%		2	%

Interest and other income, net includes interest income, interest expense and other non-operating items. Interest and other income, net decreased from the second quarter 2007 as a result of decreased gains on foreign currency transactions and the write-down of a short-term investment in the amount of $1.8 million. The increase for the nine months ended September 29, 2007 over the same period in the prior year is principally due to an increase in interest income on higher balances of cash and short-term investments and higher yields on those interest-bearing investments.

Income Taxes

Our effective tax rate was 33.2%, 34.3% and 35.0% for the three months ended September 29, 2007, June 30, 2007 and September 30, 2006, respectively. Our effective tax rate was 33.1% and 35.2% for the nine months ended September 29, 2007 and September 30, 2006, respectively. The lower effective tax rate for the three and nine months ended September 29, 2007 as compared to the same periods in 2006 results primarily from increased tax-exempt interest income and from the federal research and development credit. Our future effective income tax rate depends on various factors, such as our profits (losses) before taxes, tax legislation, the geographic composition of pre-tax income, and non-deductible expenses incurred in connection with acquisitions.

Critical Accounting Policies

The preparation of financial statements in conformity with U.S. GAAP requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our assumptions and estimates, including those related to recognition of revenue, valuation of inventory, valuation of goodwill and other intangible assets, valuation of deferred tax assets, adequacy of warranty obligations, measurement of restructuring and impairment charges, compliance with hedge accounting for derivatives, measurement of stock-based compensation expense and litigation. We base our estimates on historical experience and on various 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. We discuss our critical accounting policies in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2006. There have been no significant changes in our critical accounting policies or estimates since the end of fiscal 2006.

Liquidity and Capital Resources

Cash, Cash Equivalents and Short-Term Investments


	September 29,		December 31,
	2007		2006
	(Dollars In thousands)
Cash and cash equivalents	$	105,651	$	58,463
Short-term investments		751,811		794,865

Total cash, cash equivalents and short-term investments	$	857,462	$	853,328

We have historically financed our operating and capital resource requirements through cash flows from operations, sales of equity securities and borrowings. Our primary source of liquidity as of September 29, 2007 consisted of $857.5 million of cash, cash equivalents and short-term investments. This amount represents an increase of $4.1 million from $853.3 million as of December 31, 2006.

Cash Flow Summary


	2007 YTD			2006 YTD
	(Dollars In thousands)
Net cash provided by (used in):
Operating activities	$	236,039		$	263,808
Investing activities		4,654			1,094
Financing activities		(194,319	)		(224,798	)
Effects of exchange rate changes on cash and cash equivalents		814			2,992

Net increase in cash and cash equivalents	$	47,188		$	43,096

Operating

Net cash provided by operating activities during the nine months ended September 29, 2007 was $236.0 million. This amount consisted primarily of $160.8 million provided by net income, adjusted for non-cash items of $109.7 million and decreases in working capital accounts of $34.5 million. The decrease in year-to-date 2007 cash flows from operating activities compared to 2006 is primarily the result of decreased net sales. Accounts receivable increased by $48.9 million from year-end levels primarily because we

factored more in the fourth quarter 2006 than in the third quarter 2007. The increase in inventory levels of $28.2 million compared to year end is primarily the result of IAG building inventory to meet current and forecasted shipment demands.

Investing

Net cash provided by investing activities during the nine months ended September 29, 2007 was $4.7 million, which consisted primarily of net sales and maturities of short-term investments of $38.9 million and capital expenditures of $26.9 million.

Financing

Net cash used in financing activities during the nine months ended September 29, 2007 was $194.3 million. This amount consisted primarily of repurchases of common stock of $216.9 million and payments on lines of credit of $12.0 million, offset by proceeds from employee stock compensation plans of $33.8 million.

Liquidity

In December 2006, we entered into a credit agreement with certain lenders (the Agreement), which established a senior unsecured five-year revolving credit line with an aggregate committed amount of $150.0 million with the option to increase the total line by up to an additional $100.0 million under certain circumstances. We expect to use the proceeds for working capital and other general corporate purposes, including the repurchase of shares. The Agreement contains customary affirmative and negative covenants, financial covenants, representations and warranties, and events of default, which are subject to various exceptions and qualifications. We were in compliance with these covenants as of September 29, 2007. No amounts were outstanding under the Agreement as of September 29, 2007.

During 2004, we entered into a credit arrangement denominated in Euros to fund the acquisition of Peter Wolters AG and for general corporate purposes. Borrowings as of September 29, 2007 under this credit arrangement were $136.4 million and were primarily secured by cash or short-term investments on deposit, which are included within restricted cash and cash equivalents on our Condensed Consolidated Balance Sheets. All borrowings under this credit arrangement are due and payable on or before June 25, 2009. This credit arrangement requires us to maintain certain financial covenants, with which we were in compliance as of September 29, 2007.

We have available short-term credit facilities with various financial institutions totaling $89.1 million, of which $55.7 million was unutilized as of September 29, 2007. These credit facilities bear interest at various rates, expire on various dates through December 2007 and are used for general corporate purposes. As of September 29, 2007, our subsidiaries had $7.7 million of borrowings outstanding under the short-term lines of credit at a weighted-average interest rate of 1.0%.

Our current available long-term credit facilities, including the long-term credit facilities described above, total $331.5 million, of which $193.8 million was unutilized as of September 29, 2007. These credit facilities bear interest at a weighted-average rate of 4.9% and expire through December 2037. As of September 29, 2007, we had $137.7 million in long-term debt outstanding.

We believe that our current cash position, cash generated through operations and equity offerings, and available borrowings will be sufficient to meet our needs at least through the next 12 months.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For quantitative and qualitative disclosures about market risk affecting Novellus, see Item 7A: “Quantitative and Qualitative Disclosures about Market Risk” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. Our exposure related to market risk has not changed materially since December 31, 2006.

ITEM 4: CONTROLS AND PROCEDURES

Quarterly Evaluation of Our Disclosure Controls and Internal Controls

As of the end of the period covered by this Quarterly Report on Form 10-Q, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures and our internal controls and procedures for financial reporting. This control evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and Chief

Financial Officer. Rules adopted by the SEC require that in this section of the Quarterly Report on Form 10-Q, we present the conclusions of the Chief Executive Officer and the Chief Financial Officer about the effectiveness of our disclosure controls and internal controls for financial reporting based on and as of the date of the controls evaluation.

CEO and CFO Certifications

The certifications of the Chief Executive Officer and the Chief Financial Officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are filed as exhibits to this Quarterly Report on Form 10-Q. This section of the Quarterly Report on Form 10-Q is the information concerning the controls evaluation referred to in the Section 302 certifications and this information should be read in conjunction with the Section 302 certifications for a more complete understanding of the topics presented.

Disclosure Controls and Internal Controls for Financial Reporting

Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Internal controls for financial reporting are procedures which are designed with the objective of providing reasonable assurance that our transactions are properly authorized, our assets are safeguarded against unauthorized or improper use and our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with U.S. GAAP.

Limitations on the Effectiveness of Controls

Our management, including the Chief Executive Officer and the Chief Financial Officer, does not expect that our disclosure controls or our internal controls for financial reporting will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Scope of the Controls Evaluation

The evaluation of our disclosure controls and our internal controls for financial reporting by our Chief Executive Officer and our Chief Financial Officer included a review of the objective and design of the controls, our implementation of the controls and the effect of the controls on the information generated for use in this Quarterly Report on Form 10-Q. In accordance with SEC requirements, the Chief Executive Officer and the Chief Financial Officer note that, during our most recent fiscal quarter, there have been no changes in our internal controls for financial reporting that have materially affected or are reasonably likely to materially affect our internal controls for financial reporting.

Conclusions

Based upon the controls evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls are effective to ensure that material information relating to the Company is made known to management, including the Chief Executive Officer and the Chief Financial Officer, particularly during the period when our periodic reports are being prepared, and that our internal controls for financial reporting are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with U.S. GAAP.

PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

The following identifies the litigation matters for which a material development has occurred during the quarter ended September 29, 2007.

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 actions involving alleged breach of contract, fraud, unfair competition and breach of warranty. On September 3, 2004, Novellus filed a demurrer to all causes of action in the complaint, arguing that some claims should be dismissed for lack of subject matter jurisdiction and others should be dismissed for failure to state a cause of action. The Superior Court granted the demurrer, without leave to amend, on October 5, 2004. On January 11, 2005, Linear filed a notice of appeal of the court’s order and the appeal was heard on April 19, 2007. On June 18, 2007, the Court of Appeal issued its ruling, affirming in part and reversing in part the judgment of the trial court. The Court of Appeal affirmed the trial court’s judgment with respect to the claims for fraud and unfair competition, but reversed the trial court’s judgment with respect to the breach of contract and breach of warranty claims, finding that the Superior Court had erred in concluding that it lacked subject matter jurisdiction over these claims. On October 19, 2007 the California Supreme Court decided not to review the judgment of the Court of Appeal. As a result, Novellus expects to litigate these claims in the Superior Court. This ruling does not affect the substance of any non-jurisdictional defenses that Novellus may assert to Linear’s claims. 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 the litigation process, we are unable to estimate a range of loss, if any, at this time.

ITEM 1A: RISK FACTORS

Set forth below and elsewhere in this Quarterly Report on Form 10-Q, and in other documents we file with the SEC, are risks and uncertainties that could cause actual results to differ materially from the results expressed or implied by the forward-looking statements contained in this Quarterly Report. The risk factor set forth below entitled “We are subject to litigation proceedings that could adversely affect our business” has been updated from the prior statement in our Annual Report on Form 10-K for the year ended December 31, 2006, filed with the SEC on March 1, 2007. The update deletes all reference to the derivative litigation described therein. The risk factors “Corporate governance and financial reporting requirements have led and may continue to lead to increased costs and may make it more difficult to attract qualified executive officers and directors,” “We face risks related to the valuation of stock-based compensation,” and “If our outside audit firm does not maintain its independence, we may be unable to meet our regulatory reporting obligations” have been removed from the prior statement of risk factors as set forth in our Annual Report on Form 10-K for the year ended December 31, 2006, filed with the SEC on March 1, 2007.

Rapid technological change in the semiconductor industry requires substantial research and development expenditures and responsiveness to customer needs.

We devote a significant portion of our personnel and financial resources to research and development programs, and we seek to maintain close relationships with our customers in order to remain responsive to their product and manufacturing process needs. Our success depends in part on our ability to accurately predict evolving industry standards, to develop innovative solutions and improve existing technologies, to win market acceptance of our new and advanced technologies and to manufacture our products in a timely and cost-effective manner. Our products and processes must address changing customer needs in a range of materials, including copper and aluminum, at ever-smaller line widths and feature sizes, while maintaining our focus on manufacturing efficiency and product reliability. If we do not continue to gain market acceptance for our new technologies and products, or develop and introduce improvements in a timely manner in response to changing market conditions or customer requirements, or remain focused on research and development efforts that will translate into greater revenues, our business could be seriously harmed.

In the semiconductor capital equipment market, technological innovations tend to have long development cycles. We have experienced delays and technical and manufacturing difficulties from time to time in the introduction of certain of our products and product enhancements. In addition, we may experience delays and technical and manufacturing difficulties in future introductions or volume production of our new systems or enhancements. The increased costs and reduced efficiencies that may be associated with the development, manufacture, sale and support of future products or product enhancements relative to our existing products may adversely affect our operating results.

Our success in developing, introducing and selling new and enhanced systems depends upon a variety of factors, including product selection; hiring, retaining and motivating highly qualified design and engineering personnel; timely and efficient completion of product design and development; implementation of manufacturing and assembly processes; achieving specified product performance in the field; and effective sales and marketing. There can be no assurance that we will be successful in selecting, developing, manufacturing and marketing new products, or in enhancing our existing products. There can be no assurance that revenue from future products or product enhancements will be sufficient to recover our investments in research and development. To ensure the functionality and reliability of our future product introductions or product improvements, we incur substantial research and development costs early in development cycles, before we can confirm the technical feasibility or commercial viability of a product or product improvement. If new products have reliability or quality problems, reduced orders, or higher manufacturing costs, delays in collecting accounts receivable and additional service may result and warranty expenses may rise, affecting our gross margins. Any of these events could materially and adversely affect our business, financial condition or results of operations.

Cyclical downturns in the semiconductor industry negatively impact demand for our equipment.

Our business depends predominantly on the capital expenditures of semiconductor manufacturers, which in turn depend on current and anticipated market demand for integrated circuits and the products that use them. The semiconductor industry has historically been cyclical and has experienced periodic downturns that reduced the demand for semiconductor processing equipment, including equipment that we manufacture and market. The rate of changes in demand has accelerated, rendering the global semiconductor industry more volatile. During periods of reduced and declining demand, we must be able to quickly and effectively align our costs with prevailing market conditions, and at the same time motivate and retain key employees and maintain a stable management team. Our inventory levels during periods of reduced demand have at times been higher than optimal. We cannot provide any assurance that we will not be required to make inventory valuation adjustments in future periods. During periods of rapid growth, we must be able to acquire or develop sufficient manufacturing capacity, and hire and assimilate a sufficient number of qualified people to meet customer demand. In the period from 2001 through 2006, we implemented restructuring plans to align our business with fluctuating conditions. Future restructurings may be required to respond to future changes. Net orders, net sales and operating results may be adversely affected if we fail to respond to changing industry cycles in a timely and effective manner. We experienced an increase in demand in the first quarter of 2006 through the third quarter of 2006, and a decrease in the fourth quarter of 2006 through the third quarter of 2007. We cannot provide any assurance that demand will increase, and as a result, our net sales and operating results may be adversely affected if downturns or slowdowns in the rate of capital investment in the semiconductor industry continue to occur in the future.

The competitive and capital-intensive nature of the semiconductor industry increases the difficulty of maintaining gross margin and maintaining and capturing market share.

We face substantial competition in the industry, from both potential new market entrants and established competitors. Competitors may have greater financial, marketing, technical or other resources, and greater ability to respond to pricing pressures, than we do. They may also have broader product lines, greater customer service capabilities, or larger and more established sales organizations and customer bases. To maintain or capture a position in the market, we must develop new and enhanced systems and introduce them at competitive prices on a timely basis, while managing our research and development and warranty costs. Semiconductor equipment manufacturers incur substantial costs to install and integrate capital equipment into their production lines. This increases the likelihood of continuing relationships with chosen equipment vendors, including our competitors, and the difficulty of penetrating new customer accounts. In addition, sales of our systems depend in significant part upon a prospective customer’s decision to increase or expand manufacturing capacity — which typically involves a significant capital commitment. From time to time, we have experienced delays in finalizing system sales following initial system qualification. Due to these and other factors, our systems typically have a lengthy sales cycle, during which we may expend substantial funds and management effort. Heightened competition may also force price reductions that could adversely affect our results of operations.

We are exposed to risks associated with outsourcing activities, which could result in supply shortages that could affect our ability to meet customer demands.

We outsource the manufacture of most subassemblies, which enables us to focus on performing system design, assembly and testing in-house, thereby minimizing our fixed costs and capital expenditures. Although we make reasonable efforts to ensure that third party providers will perform to our standards, our reliance on suppliers and subcontractors limits our control over quality assurance and delivery schedules. Defects in workmanship, unacceptable yields, manufacturing disruptions and difficulties in obtaining export and import approvals may impair our ability to manage inventory and cause delays in shipments and cancellation of orders that may adversely affect our relationships with current and prospective customers and enable competitors to penetrate our customer accounts. In addition, third party providers may prioritize capacity for larger competitors or increase prices to us, which may adversely affect our profitability and our ability to respond to pricing pressures from competitors and customers.

Our growth and ability to meet customer demands depend in part on our ability to obtain from our suppliers timely deliveries of parts, components and subassemblies for the manufacture and support of our products. Although we make reasonable efforts to ensure that such parts are available from multiple suppliers, certain key parts may be obtained only from a single source or from limited sources. These suppliers are in some cases thinly capitalized, independent companies who derive a significant amount of their business from us or from a small group of companies in the semiconductor industry. Our supply channels may be vulnerable to disruption. Any such disruption to or termination of our supplier relationships may result in a prolonged inability to secure adequate supplies at reasonable prices or of acceptable quality, and may adversely affect our ability to bring new products to market and deliver them to customers in a timely manner. As a result, our revenues and operations may be adversely affected.

The loss of key employees could harm our business and operations.

Our employees are extremely important to our success, and our key management, engineering and other employees may be difficult to replace. The expansion of high technology companies has increased demand and competition for qualified personnel. If we are unable to retain key personnel, or to attract, assimilate and retain additional highly qualified employees to meet our needs in the future, our business and operations could be harmed.

We face risks related to concentration of net sales.

We sell to a limited number of customers, and we expect that sales to relatively few customers will continue to account for a high percentage of our net sales in the foreseeable future. Although the composition of the group comprising our largest customers varies from year to year, the loss of a significant customer or any reduction in orders from any significant customer, including reductions due to customer departures from recent buying patterns, as well as economic or competitive conditions in the semiconductor industry, could materially and adversely affect our business, financial condition or results of operations.

We are exposed to the risks of global operations.

We serve an increasingly global market. Substantial operations outside of the United States and export sales expose us to certain risks that may adversely affect our operating results and net sales, including, but not limited to:

•		Tariffs and other trade barriers;

•		Challenges in staffing and managing foreign operations and providing prompt and effective field support to our customers outside of the United States;

•		Difficulties in managing foreign distributors;

•		Potential adverse tax consequences, including withholding tax rules that may limit the repatriation of our earnings, and higher effective income tax rates in foreign countries where we conduct business;

•		Governmental controls, either by the United States or other countries, that restrict our business overseas or the import or export of semiconductor products, or increase the cost of our operations;

•		Longer payment cycles and difficulties in collecting accounts receivable outside of the United States;

•		Inadequate protection or enforcement of our intellectual property and other legal rights in foreign jurisdictions;

•		Global or regional economic downturns; and

•		Geo-political instability, natural disasters, acts of war or terrorism.

We enter into foreign currency forward exchange contracts to hedge against the short-term impact of currency fluctuations, including forecasted sales transactions denominated in Japanese yen. There is no assurance that our hedging program will be effective. Exchange rate volatility may also increase the cost of our exported products for international customers and inhibit demand.

There can be no assurance that any of these factors will not have a material adverse effect on our business, financial condition or results of operations. In addition, each region in the global semiconductor equipment market exhibits unique market characteristics that can cause capital equipment investment patterns to vary significantly from period to period. We derive a substantial portion of our revenues from customers in Asia. Any negative economic developments or geo-political instability in Asia, including the possible outbreak of hostilities or epidemics involving Singapore, China, Taiwan, Korea or Japan, could result in the cancellation or delay by certain significant customers of orders for our products, which could adversely affect our business, financial condition or results of operations. Our continuing expansion in Asia renders us increasingly vulnerable to these risks.

We face risks related to intellectual property.

We intend to continue to seek legal protection, primarily through patents and trade secrets, for our proprietary technology. Seeking patent protection is a lengthy and costly process, and there can be no assurance that patents will be issued from any pending applications, or that any claims allowed from existing or pending patents will be sufficiently broad to protect our proprietary technology. There is also no guarantee that any patents we hold will not be challenged, invalidated or circumvented, or that the patent rights granted will provide competitive advantages to us. Our competitors have developed and may continue to develop and obtain patents for technologies that are similar or superior to our technologies. In addition, the laws of foreign jurisdictions in which we develop, manufacture or sell our products may not protect our intellectual property rights to the same extent as do the laws of the United States.

Adverse outcomes in current or future legal disputes regarding patent and intellectual property rights could result in the loss of our intellectual property rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties on terms that may not be reasonable or favorable to us, prevent us from manufacturing or selling our products, or compel us to redesign our products to avoid incorporating third parties’ intellectual property. As a result, our product offerings may be delayed, and we may be unable to meet customers’ requirements in a timely way. Regardless of the merit of any legal disputes, we incur and may be required to incur in the future substantial costs to prosecute or defend our intellectual property rights. Even in the absence of infringement by our products of third parties’ intellectual property rights, we have elected in the past and may in the future elect to seek licenses or enter into settlements to avoid the costs of protracted litigation and the diversion of resources and management attention. However, if the terms of settlements entered into with certain of our competitors are not observed or enforced, we may suffer further costs. Any of these circumstances could have a material adverse effect on our business, financial condition or results of operations.

Our ability to develop intellectual property depends on hiring, retaining and motivating highly qualified design and engineering staff with the knowledge and technical competence to advance our technology and productivity goals. To protect our trade secrets and proprietary information generally, we have entered into confidentiality or invention assignment agreements with our employees, as well as with consultants and other parties. If these agreements are breached, our remedies may not be sufficient to cover our losses.

Changes in tax rates or liabilities could negatively impact our future results.

We are subject to taxation in the United States and other countries. Our future tax rates could be affected by changes in the composition of earnings in countries with differing tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in the tax laws. We are also subject to regular examination of our tax returns by the Internal Revenue Service (IRS) and other tax authorities. The IRS and other tax authorities have increasingly focused attention on intercompany transfer pricing with respect to sales of products and services and the use of intangible assets. We could face significant future challenges on these transfer pricing issues in one or more jurisdictions. We regularly assess the likelihood of favorable or unfavorable outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. Although we believe that our tax estimates are reasonable, there can be no assurance that any final determination will not be materially different from the treatment reflected in our historical income tax provisions and accruals. Factors that could cause estimates to be materially different include, but are not limited to:

•

Changes in the regulatory environment;

•		Changes in accounting and tax standards or practices; and

•		Overall business conditions in the semiconductor equipment industry.

We are subject to litigation proceedings that could adversely affect our business.

Intellectual Property Litigation

We are currently involved in certain legal proceedings and may become involved in other such proceedings in the future. These proceedings may involve claims against us of infringement of intellectual property rights of third parties. It is inherently difficult to assess the outcome of litigation, and there can be no assurance that we will prevail in any specific proceedings. Any such litigation could result in substantial cost to us, including diversion of the efforts of our technical and management personnel, and this could have a material adverse effect on our business, financial condition and operating results. If we are unable to successfully defend against such claims, we could be required to expend significant resources to develop or license alternative non-infringing technology or to obtain a license to the subject technology. There is no guarantee that we will be successful with such development, or that a license will be available on terms acceptable to us, if at all. Without such a license, we could be enjoined from future sales of the infringing product or products, which could materially and adversely affect our business, financial condition and operating results.

Other Litigation

In addition to the litigation risks mentioned above, we are currently involved or may become subject to legal claims or proceedings related to securities, employment, customer or third party contracts, environmental regulations, product liability or other matters. If we are required to defend against a legal claim or deem it necessary or advisable to initiate a legal proceeding to protect our rights, the expense and distraction of such a claim or proceeding, whether or not resolved in our favor, could materially and adversely affect our business, financial condition and operating results. Further, if a claim or proceeding were resolved against us or if we were to settle any such dispute, we could be required to pay damages or refrain from certain activities, which could have a material adverse impact on our business, financial condition and operating results.

We are exposed to risks associated with our diversification strategy.

Our core business and expertise has historically been in the development, manufacture, sale and support of deposition technologies, and more recently, wafer surface preparation and chemical mechanical planarization technologies. Our acquisitions of Peter Wolters and Voumard and the establishment of our Industrial Applications Group represent the first expansion of our business beyond the semiconductor equipment industry. We lack experience in the high-precision machine manufacturing equipment market, compared with our knowledge of the semiconductor equipment industry, and cannot give any assurance that we can maintain or improve the quality of products, level of sales, or relations with key employees and significant customers or suppliers that are necessary to compete in the market for high-precision machine manufacturing tools. Our efforts to integrate and develop the Industrial Applications Group may divert capital, management attention, research and development and other critical resources away from, and adversely affect, our core business.

We are exposed to risks associated with our investment activities.

Our ability to compete in the semiconductor manufacturing industry depends on our success in developing new and enhanced technologies that advance the productivity and innovation advantages of our products. To further these goals, we have formed the Novellus Development Company, a venture fund that enables us to invest in emerging technologies and strengthen our technology portfolio for both existing and potentially new market opportunities. Although the fund intends to make inquiries reasonably necessary to make an informed decision as to the companies and technologies in which it will invest, we cannot provide any assurance as to any future return on investment or ability to bring new technologies to market. There are risks inherent in investing in start-up companies, which may lack a stable management team, operating history or adequate cash flow. The securities in which the fund may invest may not be registered under the Securities Act of 1933, as amended, or any applicable state securities laws, and may be subject to restrictions on marketability or transferability. Given the nature of the investments that may be contemplated by the fund, there is a significant risk that it will be unable to realize its investment objectives by sale or other disposition, or will otherwise be unable to identify or develop any commercially viable technology. In particular, these risks could arise from changes in the financial condition or prospects, management inexperience and lack of research and development resources of the companies in which investments are made, and evolving technological standards. Investments contemplated by the fund may divert management time and attention, as

well as capital, away from our core operating business. Any future losses on investments attributable to the fund may materially and adversely impact our business, financial condition and operating results.

We are exposed to risks related to our indemnification of third parties.

From time to time, in the normal course of business, we indemnify third parties with whom we enter into contractual relationships, including customers and lessors with respect to certain matters. We have agreed, under certain conditions, to hold these third parties harmless against specified losses, such as those arising from a breach of representations or covenants, other third party claims that our products when used for their intended purposes infringe the intellectual property rights of such other third parties or other claims made against certain parties. We have been, and in the future may be, compelled to enter into or accrue for probable settlements of alleged indemnification obligations or subject to potential liability arising from our customer’s involvements in legal disputes. It is difficult to determine the maximum potential amount of liability under any indemnification obligations, whether or not asserted, due to our limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in each particular claim. Our business, financial condition and results of operations in a reported fiscal period could be materially adversely affected if we expend significant amounts in defending or settling any purported claims, regardless of their merit or outcomes.

We face risks associated with acquisitions.

We have made, and may in the future make, acquisitions of or significant investments in businesses with complementary products, services and/or technologies. Acquisitions involve numerous risks, including, but not limited to:

•		Difficulties in integrating the operations, technologies, products and personnel of acquired companies;

•		Lack of synergies or the inability to realize expected synergies and cost-savings;

•		Revenue and expense levels of acquired entities differing from those anticipated at the time of the acquisitions;

•		Difficulties in managing geographically dispersed operations;

•		The potential loss of key employees, customers and strategic partners of acquired companies;

•		Claims by terminated employees, shareholders of acquired companies or other third parties related to the transaction;

•		The issuance of dilutive securities, assumption or incurrence of additional debt obligations or expenses, or use of substantial portions of our cash;

•		Diversion of management’s attention from normal daily operations of the business; and

•		The impairment of acquired intangible assets as a result of technological advancements, or worse-than-expected performance of acquired companies.

Acquisitions are inherently risky, and we cannot provide any assurance that our previous or future acquisitions will be successful. The inability to effectively manage the risks associated with previous or future acquisitions could materially and adversely affect our business, financial condition or results of operations.

Our quarterly operating results and stock price are unpredictable.

We have experienced and expect to continue to experience significant fluctuations in our quarterly operating results, which may adversely affect our stock price. Our future quarterly operating results and stock price may not align with past trends. The factors that could lead to fluctuations in our results include, but are not limited to:

•		Building our systems according to forecast, instead of limited backlog information, which hinders our ability to plan production and inventory levels;

•		Unpredictability of demand for and variability of mix of our products in our forecast, which can cause unexpected positive or negative inventory adjustments in a particular period;

•		Variability in manufacturing yields;

•		Failure to receive anticipated orders in time to permit shipment during the quarter;

•		Timing and cancellation of customer orders and shipments, including deferring orders of our existing products due to new product announcements by us and/or our competitors;

•		Changing demand for and sales of lower-margin products relative to higher-margin products;

•		Competitive pricing pressures;

•		The effect of revenue recognized upon acceptance with little or no associated costs; and

•		Fluctuation in warranty costs.

Compliance with current and future environmental regulations may be costly.

We may be subject to environmental and other regulations in certain states and countries where we produce or sell our products. We also face increasing complexity in our product design and procurement operations as we adjust to new and prospective requirements relating to the materials composition of our products, including the restrictions on lead and certain other substances in electronics that apply to specified electronics products put on the market in the European Union after July 1, 2006 (Restriction of Hazardous Substances in Electrical and Electronic Equipment Directive (EU RoHS)). The European Union has also finalized the Waste Electrical and Electronic Equipment Directive (WEEE), which makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for enacting and implementing this directive by individual European Union governments was August 13, 2004, although extensions were granted in some countries. Producers became financially responsible under the national WEEE legislation beginning in August 2005. Other countries, such as the United States, China and Japan, have enacted or may enact laws or regulations similar to the EU RoHS or the WEEE Directive. These and other future environmental regulations could require us to reengineer certain of our existing products.

ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Repurchase of Company Securities

Approximate

Dollar Value of

Shares that

Total

May yet be

Number of

Purchased

Shares

Under the

Purchased as

Plans or

Part of

Programs (not

Publicly

including the

Total Number

Average

Announced

October 29,

of Shares

Price Paid

Plans or

2007

Period

Purchased

Per Share

Programs

Authorization)

July 1, 2007 through August 3, 2007

1,409,465

29.69

1,409,465

$514.8 million

August 4, 2007 through September 1, 2007

2,641,804

26.99

2,641,804

$443.8 million

September 2, 2007 through September 29, 2007

2,110,495

27.22

2,110,495

$386.4 million

Total

6,161,764

27.60

6,161,764

$386.4 million

All shares were purchased pursuant to publicly announced plans. On February 24, 2004 we announced that our Board of Directors approved a stock repurchase plan that authorized the repurchase of up to $500.0 million of our outstanding common stock through February 13, 2007. On September 20, 2004 we announced that our Board of Directors authorized an additional $1.0 billion for repurchase of our outstanding common stock through September 14, 2009. On October 29, 2007 we announced that our Board of

Directors authorized an additional $1.0 billion for repurchase of our outstanding common stock through October 26, 2011.

In addition to shares repurchased above, we withheld 3,575 shares through net share settlements during the three months ended September 29, 2007 upon the vesting of restricted stock awards to cover tax withholding obligations.

ITEM 6: EXHIBITS

(a) Exhibits

	31.1		Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc. dated November 6, 2007 in accordance with Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	31.2		Certification of William H. Kurtz, Executive Vice President and Chief Financial Officer of Novellus Systems, Inc. dated November 6, 2007 in accordance with Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	32.1		Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc. dated November 6, 2007 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	32.2		Certification of William H. Kurtz, Executive Vice President and Chief Financial Officer of Novellus Systems, Inc. dated November 6, 2007 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


	Page
Part I: Financial Information
Item 1: Condensed Consolidated Financial Statements		3
Condensed Consolidated Statements of Operations for the three and nine months ended September 29, 2007 and September 30, 2006		3
Condensed Consolidated Balance Sheets as of September 29, 2007 and December 31, 2006		4
Condensed Consolidated Statements of Cash Flows for the nine months ended September 29, 2007 and September 30, 2006		5
Notes to Condensed Consolidated Financial Statements		6
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations		15
Item 3: Quantitative and Qualitative Disclosures About Market Risk		21
Item 4: Controls and Procedures		21
Part II: Other Information
Item 1: Legal Proceedings		23
Item 1A: Risk Factors		23
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds		29
Item 6: Exhibits		30
Signatures		31
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


		NOVELLUS SYSTEMS, INC.

		By:		/s/ William H. Kurtz

				William H. Kurtz Executive Vice President and Chief Financial Officer (Principal Financial Officer)
				November 6, 2007

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