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 July 1, 2006

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

For the transition period from                 to

NOVELLUS SYSTEMS, INC.

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 August 4, 2006, 123,245,465 shares of the Registrant’s common stock, no par value, were issued and outstanding.

 

 

NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED JULY 1, 2006

TABLE OF CONTENTS

		Page
Part I: Financial Information
Item 1: Condensed Consolidated Financial Statements
Condensed Consolidated Statements of Operations for the three and six months ended July 1, 2006 and July 2, 2005			3
Condensed Consolidated Balance Sheets as of July 1, 2006 and December 31, 2005			4
Condensed Consolidated Statements of Cash Flows for the six months ended July 1, 2006 and July 2, 2005			5
Notes to Condensed Consolidated Financial Statements			6
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3: Quantitative and Qualitative Disclosures About Market Risk			30
Item 4: Controls and Procedures			30
Part II: Other Information
Item 1: Legal Proceedings			31
Item 1A: Risk Factors			32
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds			38
Item 4: Submission of Matters to a Vote of Security Holders			38
Item 6: Exhibits			39
Signatures
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOVELLUS SYSTEMS, INC.

		Three Months Ended								Six Months Ended
		July 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
Net sales		$	410,073			$	329,585			$	775,979			$	669,325
Cost of sales			205,309				172,023				403,675				357,894
Gross profit			204,764				157,562				372,304				311,431
Operating expenses:
Selling, general and administrative			66,311				50,325				124,793				102,085
Research and development			63,298				63,512				127,081				125,560
Restructuring and other charges (benefits)			—				(74	)			12,629				(74	)
Legal settlement			—				—				3,250				—
Total operating expenses			129,609				113,763				267,753				227,571
Operating income			75,155				43,799				104,551				83,860
Interest income, net			5,168				4,287				10,200				7,347
Other income (loss), net			2,443				(613	)			3,490				(204	)
Interest and other income, net			7,611				3,674				13,690				7,143
Income before provision for income taxes and cumulative effect of a change in accounting principle			82,766				47,473				118,241				91,003
Provision for income taxes			30,061				14,242				41,767				27,301
Income before cumulative effect of a change in accounting principle			52,705				33,231				76,474				63,702
Cumulative effect of a change in accounting principle, net of tax of $594 for the six months ended July 1, 2006			—				—				948				—
Net income		$	52,705			$	33,231			$	77,422			$	63,702
Net income per share:
Basic:
Income before cumulative effect of a change in accounting principle		$	0.42			$	0.24			$	0.60			$	0.46
Cumulative effect of a change in accounting principle			—				—				0.01				—
Basic net income per share		$	0.42			$	0.24			$	0.61			$	0.46
Diluted:
Income before cumulative effect of a change in accounting principle		$	0.42			$	0.24			$	0.59			$	0.45
Cumulative effect of a change in accounting principle			—				—				0.01				—
Diluted net income per share		$	0.42			$	0.24			$	0.60			$	0.45
Shares used in basic per share calculations			125,124				138,068				128,113				138,979
Shares used in diluted per share calculations			125,910				138,944				129,087				140,022

See accompanying notes to condensed consolidated financial statements.

NOVELLUS SYSTEMS, INC.

		July 1,				December 31,
		2006				2005 *
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	63,312			$	40,403
Short-term investments			460,180				608,837
Accounts receivable, net			439,521				397,534
Inventories			213,827				193,787
Deferred tax assets, net			101,512				88,563
Prepaid and other current assets			26,521				34,388
Total current assets			1,304,873				1,363,512
Property and equipment, net			399,678				423,749
Restricted cash and cash equivalents			147,595				140,212
Goodwill			259,553				255,584
Intangibles and other assets			105,434				107,192
Total assets		$	2,217,133			$	2,290,249
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	84,917			$	83,710
Accrued payroll and related expenses			61,562				57,450
Accrued warranty			60,083				54,553
Other accrued liabilities			59,840				58,271
Income taxes payable			22,474				5,898
Deferred profit			80,220				68,718
Current obligations under lines of credit			16,456				15,744
Total current liabilities			385,552				344,344
Long-term debt			127,911				124,858
Other non-current liabilities			43,146				41,764
Total liabilities			556,609				510,966
Shareholders’ equity:
Common stock			1,330,001				1,393,805
Retained earnings			331,875				388,015
Accumulated other comprehensive income			(1,352	)			(2,537	)
Total shareholders’ equity			1,660,524				1,779,283
Total liabilities and shareholders’ equity		$	2,217,133			$	2,290,249

See accompanying notes to condensed consolidated financial statements.

NOVELLUS SYSTEMS, INC.

		Six Months Ended
		July 1,				July 2,
		2006				2005
Cash flows from operating activities:
Net income		$	77,422			$	63,702
Adjustments to reconcile net income to net cash provided by operating activities:
Loss on disposal of fixed assets			1,665				657
Reversal of previously accrued restructuring charges			—				(74	)
Non-cash portion of restructuring and other charges			10,199				—
Depreciation and amortization			36,959				42,318
Deferred income taxes			(11,334	)			1,843
Stock-based compensation			18,230				2,262
Tax benefit from equity awards			12,251				—
Excess tax benefit from stock-based compensation			(7,393	)			—
Cumulative effect of a change in accounting principle			(1,542	)			—
Changes in operating assets and liabilities:
Accounts receivable			(38,753	)			64,167
Inventories			(27,414	)			8,298
Prepaid and other current assets			8,202				(8,025	)
Accounts payable			791				(11,507	)
Accrued payroll and related expenses			7,404				(12,860	)
Accrued warranty			5,351				5,284
Other accrued liabilities			703				(3,007	)
Income taxes payable			18,376				7,935
Deferred profit			11,439				3,198
Net cash provided by operating activities			122,556				164,191
Cash flows from investing activities:
Proceeds from sales of short-term investments			300,248				152,525
Proceeds from maturities of short-term investments			98,314				100,913
Purchases of short-term investments			(245,011	)			(343,455	)
Capital expenditures			(20,890	)			(26,980	)
Proceeds from sale of property and equipment			—				2,591
Decrease (increase) in other assets			3,289				(2,701	)
Decrease (increase) in restricted cash and cash equivalents			(7,483	)			12,503
Net cash provided by (used in) investing activities			128,467				(104,604	)
Cash flows from financing activities:
Proceeds from employee stock compensation plans			9,538				16,638
Proceeds from lines of credit, net			712				8,980
Payments on long-term debt			(4,435	)			(13,007	)
Repurchases of common stock			(239,897	)			(69,669	)
Excess tax benefit from stock-based compensation			7,393				—
Net cash used in financing activities			(226,689	)			(57,058	)
Effects of exchange rate changes on cash and cash equivalents			(1,425	)			5,376
Net change in cash and cash equivalents			22,909				7,905
Cash and cash equivalents at beginning of period			40,403				106,117
Cash and cash equivalents at end of period		$	63,312			$	114,022

See accompanying notes to condensed consolidated financial statements.

NOVELLUS SYSTEMS, INC.

1. BASIS OF PRESENTATION

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. The interim financial information is unaudited and does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six months ended July 1, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.

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

The accompanying condensed consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries after the elimination of all significant intercompany account balances and transactions.

Allowance for Doubtful Accounts

We evaluate our allowance for doubtful accounts based on a combination of factors. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations, we provide a specific allowance for bad debt against the amount due to reduce the net recognized receivable to the amount we reasonably believe will be collected. We charge accounts receivable balances against our allowance for doubtful accounts once we have concluded our collection efforts. We maintained an allowance for doubtful accounts of $1.3 million and $1.0 million at July 1, 2006 and December 31, 2005, respectively.

Derivatives

To address increasing international growth and related currency risks, the Company expanded its foreign currency exposure management policy in the second quarter of 2006 to include the Company’s net investment in certain foreign currency functional subsidiaries. The Company’s policy is to enter into foreign exchange forward contracts with maturities of less than 12 months to mitigate the impact of currency fluctuations on existing non-functional currency monetary asset and liability balances; probable anticipated system sales denominated in yen; and the Company’s net investment in certain foreign functional subsidiaries. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) all derivatives are recorded on the balance sheet at fair value.

Cash Flow Hedging – The Company designates and documents foreign exchange forward contracts to hedge the margin on transactions where costs are U.S. dollar denominated and the related revenues are generated in Japanese Yen as cash flow hedges. The Company evaluates and calculates 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 until the system related cost of sales are recognized. The Company records any ineffectiveness, along with the excluded time value of the forward contracts in cost of sales on its consolidated statement of operations, which was approximately $0.5 million in the second quarter of 2006. In the event it becomes probable that a hedged

anticipated transaction will not occur, the gains or losses on the related cash flow hedges will immediately be reclassified from Other Comprehensive Income (“OCI”) to Other Income (Expense).

The following table summarizes impact of cash flow hedges on OCI (pre-tax) during the second quarter of 2006 (in thousands).

Balance as of April 2, 2006			(41	)
Net change on cash flow hedges			1,813
Reclassification to cost of sales			48
Balance as of July 1, 2006			1,820

The Company anticipates reclassifying the entire gain/loss in OCI to earnings within 12 months.

Net Investment Hedging – In the second quarter of 2006 the Company began to hedge its net investment in certain foreign subsidiaries to reduce economic currency risk. The foreign exchange forward 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 (as defined) when currency pairs and notional amounts on the forwards are properly aligned with the subsidiaries net investment. Changes in the spot to spot value of the derivative are recorded in the equity section of the financial statements as Foreign Currency Translation Adjustment. Ineffectiveness, if any, along with the excluded time value of the forward contracts are recorded in Other Income (Expense), and was approximately $0.3 million in the second quarter of 2006. Derivative losses included in the equity account in the second quarter of 2006 were $1.3 million. The Company did not hedge this exposure prior to March 31, 2006.

Non-Designated Hedges – The Company enters into forward foreign exchange contracts to hedge intercompany balances denominated in currencies other than the U.S. dollar that are remeasured each period in income. The maturities of these instruments are generally less than 12 months. These contracts do not require special hedge accounting treatment under SFAS 133 as the gains or losses are recorded in other income (expense) each period where they are expected to substantially offset the remeasurement gain or loss on the intercompany balances.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 (“SFAS 151”). The standard clarifies that certain abnormal amounts be expensed as incurred, rather than included as a cost of inventory. SFAS 151 also requires that the allocation of fixed overhead costs to inventory be based upon a normal production capacity. The Company adopted the standard effective January 1, 2006, which resulted in an increased carrying value of inventory and decreased cost of sales of approximately $1.6 million, net of tax, or $0.01 per diluted share for the six months ended July 1, 2006. The effect was insignificant during the three months ended July 1, 2006.

In June 2006, the Emerging Issues Task Force (“EITF”) issued EITF Issue 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 the employee is entitled to paid time off after working for an entity for a specified period of time. The provisions of EITF 06-2 are effective for us as of January 1, 2007. We are currently evaluating the impact of adopting EITF 06-2 on our financial statements.

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 creates a single model to address uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. In addition, FIN 48 clearly scopes out income taxes from Financial Accounting Standards Board Statement No. 5, Accounting for Contingencies. The provisions of FIN 48 are effective for us as of January 1, 2007. We are currently evaluating the impact of adopting FIN 48 on our financial statements.

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.

Diluted earnings per share is computed by dividing net income for the period by the weighted-average number of common shares outstanding during the period, plus the dilutive effect of unvested restricted stock awards, outstanding options and shares issuable under our employee stock purchase plans (“ESPP”) using the treasury stock method.

The following table provides a reconciliation of the numerators and denominators of the basic and diluted per share computations (in thousands, except per share amounts):

		Three Months Ended								Six Months Ended
		July 1,				July 2,				July 1,				July 2,
		2006				2005				2006				2005
Numerator:
Net income		$	52,705			$	33,231			$	77,422			$	63,702
Denominator:
Basic weighted-average shares outstanding			125,124				138,068				128,113				138,979
Employee stock options and other			786				876				974				1,043
Diluted weighted-average shares outstanding			125,910				138,944				129,087				140,022
Basic net income per share		$	0.42			$	0.24			$	0.60			$	0.46
Diluted net income per share		$	0.42			$	0.24			$	0.60			$	0.45

Weighted-average options to purchase approximately 21.6 million and 22.0 million shares of common stock at a weighted-average exercise price of $32.79 and $32.86 per share were outstanding for the three and six months ended July 1, 2006, respectively. Weighted-average options to purchase approximately 20.3 million and 21.0 million shares of common stock at a weighted-average exercise price of $35.06 and $34.96 per share were outstanding for the three and six months ended July 2, 2005, respectively. These options were not included in the computation of diluted net income per common share because the effect would have been anti-dilutive. Restricted stock awards representing 0.2 million weighted-average shares were excluded from the computation of diluted shares outstanding for both the three and six months ended July 1, 2006, respectively, as the shares were subject to performance conditions that had not been met.

3. STOCK-BASED COMPENSATION

     Adoption of SFAS 123(R)

The Company has adopted several stock plans that provide equity instruments to our employees and non-employee directors. Our plans include incentive and non-statutory stock options and restricted stock awards. 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 a five-year period, excluding certain awards that vest upon the achievement of specific revenue performance targets. The Company’s ESPP allow qualified employees to purchase Company shares at 85% of the fair market value on specified dates.

Prior to January 1, 2006, we accounted for these stock-based employee compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, and related Interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). With the exception of certain options assumed in acquisitions and grants of restricted stock awards, we generally recorded no stock-based compensation expenses during periods prior to January 1, 2006 as all stock-based grants had exercise prices equal to the fair market value of our common stock on the date of grant. We also recorded no compensation expense in connection with our ESPP as they qualified as non-compensatory plans following the guidance provided by APB 25. In accordance with SFAS 123 and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”), later in this Note 3 we disclose our net income and net income per share for the three and six months ended July 2, 2005 as if we had applied the fair value-based method in measuring compensation expense for our stock-based compensation plans.

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”) using the modified prospective transition method. Under that transition method, compensation expense that we recognized for the three and six months ended July 1, 2006 included: (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 123(R). Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123(R), 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 123(R), 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 awards and our ESPP in our results from continuing operations (in thousands):

		Three Months				Six Months
		Ended				Ended
		July 1, 2006				July 1, 2006
Cost of sales		$	538			$	846
Selling, general and administrative			5,590				11,029
Research and development			2,664				5,725
Stock-based compensation expense before income taxes (1)			8,792				17,600
Income tax benefit			(3,385	)			(6,776	)
Total stock-based compensation expense after income taxes		$	5,407			$	10,824

During the three and six months ended July 1, 2006, we capitalized stock-based compensation costs of $0.3 million and $0.6 million, respectively, which were included as components of inventory, deferred profit and property and equipment.

The following table presents the impact of our adoption of SFAS 123(R) on the selected condensed consolidated statement of operations line items (in thousands, except per share data):

		Three Months Ended								Six Months Ended
		July 1, 2006								July 1, 2006
		SFAS 123(R)				As				SFAS 123(R)				As
		Adjustments				Reported				Adjustments				Reported
Income from operations		$	(7,054	)		$	75,155			$	(14,131	)		$	104,551
Income before income taxes			(7,054	)			82,766				(14,131	)			118,241
Income before cumulative effect of a change in accounting principle, net of tax			(4,338	)			52,705				(8,691	)			76,474
Net Income			(4,338	)			52,705				(7,743	)			77,422
Basic earnings per share
Prior to cumulative effect of a change in accounting principle		$	(0.03	)		$	0.42			$	(0.07	)		$	0.60
Cumulative effect of a change in accounting principle			—				—				0.01				0.01
		$	(0.03	)		$	0.42			$	(0.06	)		$	0.61
Diluted earnings per share
Prior to cumulative effect of a change in accounting principle		$	(0.03	)		$	0.42			$	(0.07	)		$	0.59
Cumulative effect of a change in accounting principle			—				—				0.01				0.01
		$	(0.03	)		$	0.42			$	(0.06	)		$	0.60

Prior to the adoption of SFAS 123(R), we presented deferred compensation as a separate component of shareholders’ equity. In accordance with the provisions of SFAS 123(R), on January 1, 2006, we reclassified the balance in deferred compensation to common stock on the balance sheet.

The adoption of SFAS 123(R) resulted in a benefit from a cumulative effect of a change in accounting principle of $0.9 million, net of tax. The benefit consists of a reduction of the cumulative expense recorded for restricted stock awards through December 31, 2005 in order to reflect estimated future forfeitures. Prior to the Adoption of SFAS 123(R), we recorded forfeitures as they occurred as previously permitted under SFAS 123 and APB 25.

The following table illustrates the effect on our net income and net income per share for the three and six months ended July 2, 2005 if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation using the Black-Scholes valuation model (in thousands, except per share data):

		Three Months				Six Months
		Ended				Ended
		July 2, 2005				July 2, 2005
Net income as reported		$	33,231			$	63,702
Add:
Intrinsic value method expense included in reported net income, net of related tax effects			734				1,584
Less:
Fair value method expense, net of related tax effects			(8,166	)			(18,740	)
Pro-forma net income		$	25,799			$	46,546
Pro-forma basic and diluted net income per share		$	0.19			$	0.33
Basic net income per share as reported		$	0.24			$	0.46
Diluted net income per share as reported		$	0.24			$	0.45

     Valuation and Other Assumptions for Stock Options

Valuation and Amortization Method. We estimate the fair value of stock options granted before and after the adoption of SFAS 123(R) using the Black-Scholes option valuation model. For options granted before January 1, 2006, we estimated the fair value using the multiple option approach and we are amortizing the fair value of options expected to vest on a graded vesting (or accelerated) basis. For options granted on or after January 1, 2006, we estimate the fair value using a single option approach and amortize the fair value on a straight-line basis for options expected to vest. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods.

Expected Term. The expected term of options granted represents the period of time that they are expected to be outstanding. We estimate the expected term of options granted based on our historical experience of grants, exercises and post-vesting cancellations. Contractual term expirations have not been significant.

Expected Volatility. We estimate the volatility of our stock options at the date of grant using a combination of historical and implied volatilities, consistent with SFAS 123(R) and Securities and Exchange Commission Staff Accounting Bulletin No. 107 “Share-Based Payment.” Historical volatilities are calculated based on the historical prices of our common stock over a period at least equal to the expected term of our option grants, while implied volatilities are derived from publicly traded options of our common stock. Prior to the adoption of SFAS 123(R), we relied exclusively on the historical prices of our common stock in the calculation of expected volatility.

Risk-Free Interest Rate. We base the risk-free interest rate that we use in the Black-Scholes option valuation model 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 our option grants.

Dividends. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model.

Forfeitures. We use historical data to estimate pre-vesting option forfeitures. As required by SFAS 123(R), we record stock-based compensation expense only for those awards that are expected to vest. For the three and six months ended July 1, 2006, our estimated annual forfeiture rate was 8.9%.

We used the following weighted-average valuation assumptions to estimate the fair value of options granted for the three and six months ended July 1, 2006 and July 2, 2005, respectively:

		Three Months Ended								Six Months Ended
		July 1,				July 2,				July 1,				July 2,
		2006				2005				2006				2005
Risk-free interest rate			5.1	%			3.3	%			4.9	%			3.3	%
Expected volatility			49.4	%			70.0	%			49.2	%			70.0	%
Expected term		4.3 years				3.7 years				4.3 years				3.7 years
Expected dividends		None				None				None				None

The weighted-average grant-date fair value of options granted was $10.85 and $11.12 per option for the three and six months ended July 1, 2006, respectively, and $12.82 and $13.88 per option for the three and six months ended July 2, 2005, respectively.

     Stock Options

A summary of stock option activity during the six months ended July 1, 2006 is as follows (in thousands, except years and per-share amounts):

										Weighted-Average
		Number								Remaining
		of				Weighted-Average				Contractual				Aggregate
		Shares				Exercise Price				Term (in Years)				Intrinsic Value
Outstanding at January 1, 2006			24,137			$	31.79
Grants			274				24.57
Exercises			(320	)			17.62
Forfeitures or expirations			(1,485	)			33.58
Outstanding at July 1, 2006			22,606			$	31.79				6.2			$	12,205
Vested and expected to vest at July 1, 2006			21,907			$	31.98				6.1			$	12,036
Exercisable at July 1, 2006			17,248			$	33.49				5.5			$	11,077

The aggregate intrinsic value of options outstanding at July 1, 2006 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 1.9 million shares that had exercise prices that were lower than the market price of our common stock as of July 1, 2006. The total intrinsic value of options exercised during the three and six months ended July 1, 2006 was $0.8 million and $3.3 million, respectively, determined as of the date of exercise. The total cash received from employees as a result of stock option exercises during the three and six months ended July 1, 2006 was $0.7 million and $5.6 million, respectively. In connection with these exercises, the tax benefit realized by the Company for the three and six months ended July 1, 2006 was $0.1 million and $0.7 million, respectively. The Company settles employee stock option exercises with newly issued common shares.

As of July 1, 2006, there was $31.9 million of total unrecognized compensation cost related to unvested stock options, which is expected to be recognized over a weighted-average period of 2.4 years.

In November 2005, we accelerated the vesting on approximately 3.8 million under-water options that were priced at $30.00 or above. By doing this, we reduced our future compensation expense by approximately $24.3 million on a pre-tax basis through 2008. Each of the Company’s executive officers at the time the acceleration became effective and whose options were accelerated entered into a Resale Restriction Agreement which imposes restrictions on the sale of any shares received through the exercise of accelerated options until the earlier of (i) the original vesting dates set forth in the option or (ii) the executive officer’s termination of employment.

     Restricted Stock Awards

The following table summarizes our restricted stock award activity for the six months ended July 1, 2006 (in thousands, except per share amounts):

		Number				Weighted-Average
		of				Grant Date
		Shares				Fair Value
Unvested restricted stock at January 1, 2006			1,197			$	27.58
Granted			48				23.88
Vested			(60	)			31.54
Forfeited			(66	)			27.84
Unvested restricted stock at July 1, 2006			1,119			$	27.20

As of July 1, 2006, there was $15.8 million of total unrecognized compensation cost related to restricted stock, which is expected to be recognized over a weighted-average period of 2.4 years. The total fair value of restricted stock awards vested during the three and six months ended July 1, 2006 was $0.3 million and $1.6 million, respectively. As of July 1, 2006, there were a total of 0.2 million restricted shares subject to performance conditions that will result in forfeiture if the conditions are not realized.

     ESPP

Under our ESPP, qualified employees are entitled to purchase shares at 85% of the fair market value on specified dates. ESPP awards were valued using the Black-Scholes model with expected volatility calculated using a six-month historical volatility. During the three and six months ended July 1, 2006 and July 2, 2005, ESPP awards were valued using the following weighted-average assumptions:

		Three Months Ended								Six Months Ended
		July 1,				July 2,				July 1,				July 2,
		2006				2005				2006				2005
Risk-free interest rate			5.0	%			2.5	%			5.0	%			2.5	%
Expected volatility			32.0	%			36.0	%			32.0	%			36.0	%
Expected term		6 months				6 months				6 months				6 months
Expected dividends		None				None				None				None

The weighted-average fair value of ESPP shares was $6.07 for both the three and six months ended July 1, 2006 and $6.33 for both the three and six months ended July 2, 2005.

As of July 1, 2006, there was $0.8 million of total unrecognized compensation costs related to the ESPP, which is expected to be fully recognized during the next two fiscal quarters.

4. OTHER INCOME (LOSS), NET

The components of other income (loss), net within the condensed consolidated statements of operations are as follows (in thousands):

		Three Months Ended								Six Months Ended
		July 1,				July 2,				July 1,				July 2,
		2005				2006				2006				2005
Other income		$	640			$	111			$	1,157			$	229
Other expense			(12	)			(6	)			(271	)			(131	)
Foreign currency gain (loss), net			1,815				(718	)			2,604				(302	)
Total other income (loss), net		$	2,443			$	(613	)		$	3,490			$	(204	)

5. INVENTORIES

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

		July 1,				December 31,
		2006				2005
Purchased and spare parts		$	162,360			$	152,763
Work-in-process			37,061				27,110
Finished goods			14,406				13,914
Total inventories		$	213,827			$	193,787

6. GOODWILL AND INTANGIBLE ASSETS

Goodwill

A summary of changes in goodwill during the six months ended July 1, 2006 and July 2, 2005 is as follows (in thousands):

		2006
						Industrial
		Semiconductor				Applications
		Group				Group				Total
Balance at December 31, 2005		$	150,664			$	104,920			$	255,584
SpeedFam-IPEC adjustment			(2,340	)			—				(2,340	)
Foreign currency translation			—				6,309				6,309
Balance at July 1, 2006		$	148,324			$	111,229			$	259,553

		2005
						Industrial
		Semiconductor				Applications
		Group				Group				Total
Balance at December 31, 2004		$	162,230			$	116,742			$	278,972
SpeedFam-IPEC adjustment			(2,340	)			—				(2,340	)
Foreign currency translation			—				(11,548	)			(11,548	)
Balance at July 2, 2005		$	159,890			$	105,194			$	265,084

During each of the six months ended July 1, 2006 and July 2, 2005, we reduced valuation allowances by approximately $2.3 million against certain net operating loss carryforwards recorded during the acquisition of SpeedFam-IPEC in 2002.

We completed the annual goodwill impairment test in the fourth quarter of 2005 in accordance with our policy. The first step of the test identifies when impairment may have occurred, while the second step of the test measures the amount of the impairment, if any. The results of our impairment tests did not indicate impairment. There have been no significant events or circumstances affecting the valuation of goodwill subsequent to our impairment test performed in the fourth quarter of 2005.

Intangible Assets

The following tables provide details of our acquired intangible assets (in thousands):

						Accumulated
July 1, 2006		Gross				Amortization				Net
Patents		$	4,201			$	(1,579	)		$	2,622
Developed technology			28,616				(13,964	)			14,652
Trademark			6,430				(1,276	)			5,154
Other intangible assets			162				(109	)			53
Total		$	39,409			$	(16,928	)		$	22,481

						Accumulated
December 31, 2005		Gross				Amortization				Net
Patents		$	4,201			$	(1,225	)		$	2,976
Developed technology			28,042				(11,422	)			16,620
Trademark			6,065				(903	)			5,162
Other intangible assets			161				(99	)			62
Total		$	38,469			$	(13,649	)		$	24,820

Our estimated amortization expense for the identifiable intangible assets for each of the next five fiscal years will be approximately $6.2 million for 2007, $5.9 million for 2008, $3.3 million for 2009, $1.8 million for 2010 and $0.7 million for 2011. As of July 1, 2006, we have no identifiable intangible assets with indefinite lives.

7. ACQUISITION

In November 2005, we acquired 90% of the outstanding stock of Voumard Machine Co. SA (“Voumard”), a privately-held manufacturer of high-precision machine manufacturing tools based in Neuchâtel, Switzerland. The acquisition of Voumard further enhances the product offerings in our Industrial Applications Group. We funded the purchase price of the acquisition with existing cash resources. Under the terms of the purchase agreement, we retained approximately $0.6 million. This amount will be released to the former shareholders of Voumard on the first anniversary of the purchase agreement, to the extent we have not made claims against the escrow for pre-acquisition contingencies.

The acquisition of Voumard was accounted for as a business combination in accordance with SFAS No. 141, “Business Combinations.” Tangible and intangible assets and liabilities were recorded at their estimated fair value. We will report changes related to the amounts described below in subsequent filings, as this information becomes available. We do not anticipate recording significant intangible assets as a result of this acquisition nor do we expect that the final purchase price allocation will differ significantly from this preliminary allocation.

The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows (in thousands):

Cash consideration		$	6,369
Estimated transaction costs			435
Total purchase price		$	6,804
Assets acquired		$	19,393
Liabilities assumed			(12,589	)
Total net assets acquired		$	6,804

8. PRODUCT WARRANTY

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

		Three Months Ended								Six Months Ended
		July 1,				July 2,				July 1,				July 2,
		2006				2005				2006				2005
Balance, beginning of period		$	55,822			$	47,979			$	54,553			$	45,526
Warranties issued			24,386				20,920				44,786				42,550
Settlements			(19,882	)			(19,999	)			(40,995	)			(40,303	)
Changes in liability for pre-existing warranties, including expirations			(243	)			1,593				1,739				2,720
Balance, end of period		$	60,083			$	50,493			$	60,083			$	50,493

9. RESTRUCTURING AND OTHER CHARGES

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

During the third quarter of 2005, we implemented a restructuring plan to relocate operations from Chandler, Arizona to San Jose, California and Tualatin, Oregon. In connection with this plan, we recorded restructuring charges of $6.0 million related to future lease payments, $1.3 million related to accelerated depreciation of leasehold improvements and $0.2 million related to other charges during the quarter ended April 1, 2006. The charges were partially offset by a $3.9 million benefit due to a change in estimate of sublease income related to facilities previously included in our restructuring accrual.

During the first quarter of 2006, we implemented a restructuring plan to dispose of certain owned facilities located in San Jose, California. As the anticipated period to close the sale of these assets is in excess of one year, the facilities did not qualify as held for sale at the end of the quarter. However, we did consider the change in planned use of the facilities as an indicator of impairment and determined that two of the properties were impaired. As a result, we recorded impairment charges of $8.9 million to write these two facilities down to their estimated fair value during the quarter ended April 1, 2006. The other properties were not impacted as our analysis did not indicate an impairment.

All amounts are included in restructuring and other charges on our condensed consolidated statements of operations and are related to the Semiconductor Group.

The following table summarizes restructuring activity for the six months ended July 1, 2006 (in thousands):

		Facility				Asset
		Exit Costs				Impairments				Severance				Total
Balance at December 31, 2005		$	27,239			$	—			$	863			$	28,102
Restructuring charges			6,235				10,199				51				16,485
Cash payments			(2,408	)			—				(484	)			(2,892	)
Non-cash adjustment			1,161				(10,199	)			—				(9,038	)
Adjustment of prior restructuring costs			(3,856	)			—				—				(3,856	)
Balance at April 1, 2006			28,371				—				430				28,801
Cash payments			(2,491	)			—				(13	)			(2,504	)
Balance at July 1, 2006		$	25,880			$	—			$	417			$	26,297

As of July 1, 2006, substantially all actions under our 2001 through 2005 restructuring plans had been completed, except for payments of future rent obligations. 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 over the remaining lease terms, which expire on various dates through 2017.

10. LONG-TERM OBLIGATIONS

At July 1, 2006, we had long-term borrowings of $127.9 million, denominated in Euros and Swiss Francs. These borrowings consisted of approximately $126.6 million and $1.3 million with interest rates of 3.1% and 4.0%, respectively. Substantially all of our borrowings are required to be secured by cash or marketable securities on deposit and are due and payable on or before June 30, 2009. Amounts to secure these borrowings are included within restricted cash on the condensed consolidated balance sheets.

During the quarter we entered into a one year $50.0 million revolving credit agreement to provide for unsecured borrowings at various rates based on Eurodollar deposit rates plus a margin or the bank’s Base Rate (a rate indexed to Prime, CD, or Federal Funds rates). The credit agreement requires compliance with two financial covenants and certain non-financial covenants all of which we were in compliance with on July 1, 2006. There were no outstanding balances under this credit agreement on July 1, 2006.

11. COMPREHENSIVE INCOME

SFAS No. 130, “Reporting Comprehensive Income,” establishes standards for reporting and displaying comprehensive net income and its components in shareholders’ equity. Comprehensive income includes all changes in equity (net assets) during a period from non-owner sources. The change in accumulated other comprehensive income (loss) for all periods presented resulted, net of tax, from foreign currency translation adjustments, unrealized gains and losses on investments, and unrealized changes in derivative instruments.

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

		Three Months Ended								Six Months Ended
		July 1,				July 2,				July 1,				July 2,
		2006				2005				2006				2005
Net income		$	52,705			$	33,231			$	77,422			$	63,702
Other comprehensive income (loss):
Foreign currency translation adjustments, net of tax			(760	)			(1,294	)			968				(4,038	)
Unrealized gain (loss) on available-for-sale securities, net of tax			869				737				2,032				(551	)
Unrealized change in derivative instruments, net of tax			(1,856	)			4,958				(1,815	)			4,958
Comprehensive income		$	50,958			$	37,632			$	78,607			$	64,071

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

		July 1,				December 31,
		2006				2005
Foreign currency translation adjustments, net of tax		$	321			$	(647	)
Unrealized gain (loss) on marketable securities, net of tax			142				(1,890	)
Unrealized change in derivative instruments, net of tax			(1,815	)			—
Accumulated other comprehensive loss		$	(1,352	)		$	(2,537	)

12. PENSION PLAN

On June 28, 2004, we acquired Peter Wolters AG, including its existing pension plan. The pension balances at both July 1, 2006 and December 31, 2005 were $7.3 million. The changes in the obligation during the three and six months ended July 1, 2006 consisted of interest cost, service cost, benefit payments and currency translation adjustments, which were not significant.

13. RELATED PARTY TRANSACTIONS

We lease an aircraft from NVLS I, LLC, a third-party entity wholly owned by Richard S. Hill, our Chairman and Chief Executive Officer. Under the leasing agreement, we incurred rental expense of approximately $0.2 million and $0.4 million for the three and six months ended July 1, 2006, respectively, and $0.1 million for the six months ended July 2, 2005. The aircraft was not operational during the three months ended July 2, 2005 and as a result, we did not incur any costs during this period.

Mr. Hill is a member of the Board of Directors of the University of Illinois Foundation. Novellus regularly provides research funding to certain groups, including the University of Illinois. Novellus provided research grants to the University of Illinois and certain of its professors in the amount of approximately $0.1 million for the six months ended July 2, 2005. No grants were provided during the three and six months ended July 1, 2006 or during the three months ended July 2, 2005.

Mr. Hill also served as a member of the Board of Directors of LTX Corporation. We recorded sublease income from LTX Corporation of approximately $0.4 million and $0.7 million for the three and six months ended July 2, 2005. In November 2005, Mr. Hill did not stand for reelection as a member of the Board of Directors of LTX Corporation.

During the three and six months ended July 1, 2006 and July 2, 2005, Novellus employed, in non-executive positions, three immediate family members of our executive officers. The aggregate compensation recognized for these immediate family members was approximately $0.1 million and $0.2 million for the three and six months ended July 1, 2006, respectively, and approximately $0.1 million and $0.1 million for the three and six months ended July 2, 2005, respectively.

Historically, we have made secured and unsecured loans to our executive officers, vice presidents and other key personnel. Current regulations prohibit Company loans to “executive officers,” as defined by the SEC. While we have no loans to our executive officers, we do have outstanding loans to non-executive vice presidents and other key personnel. As of July 1, 2006 and December 31, 2005, the total outstanding balance of loans to non-executive vice presidents and other key personnel was approximately $1.5 million. At July 1, 2006, approximately all of the outstanding balance was secured by collateral. Loans typically bear interest, except for those used for employee relocation purposes. We have not realized material bad debts related to the loans to our personnel.

14. LITIGATION

     Derivative Litigation

     Teitelbaum v. Hill et al. On May 31, 2006, a complaint titled “Joshua Teitelbaum, in the right of and for the benefit of Novellus Systems, Inc., v. Richard S. Hill, Jeffrey C. Benzing, D. James Guzy, Tom Long, Robert H. Smith, Neil R. Bonke, Youssef A. El-Mansy, J. David Litster, Yoshio Nishi, Glen G. Possley, Ann D. Rhoads, William R. Spivey and Delbert A. Whitaker, as defendants, and the Company as a Nominal Defendant” was filed in the United States District Court, Northern District of California, Case No. C-06-3514. The complaint alleges that, when granting stock options to executives, the Company’s stock option dating practices caused a diversion of assets from the Company to the executives and caused the Company to make false and misleading statements to the SEC. The complaint also alleges, among other things, violations of sections 10(b) and 14(a) of the Securities Exchange Act of 1934 (the “Exhange Act”), breach of fiduciary duty, abuse of control, gross mismanagement, corporate waste, and unjust enrichment. The complaint seeks unspecified monetary damages and other relief against the defendants. The Company has, through outside counsel, conducted an inquiry into each of the option grants referenced in the complaint. As a result of this inquiry, the Company and its Board of Directors believe the claims are without merit.

     Alaska Electrical Pension Fund v. Hill et al. On June 21, 2006, a complaint titled “Alaska Electrical Pension Fund, on behalf of Novellus Systems, Inc., v. Richard S. Hill, Jeffrey C. Benzing, William H. Kurtz, Neil R. Bonke, Youssef A. El-Mansy, J. David Litster, Yoshio Nishi, Glen G. Possley, Ann D. Rhoads, William R. Spivey and Delbert Whitaker, as defendants, and the Company as a Nominal Defendant” was filed in the United States District Court for the Northern District of California, Case No. C-06-3870. The complaint alleges, among other things, violations of sections 10(b), 14(a), and 20(a) of the Exchange Act, breach of fiduciary duty, abuse of control, constructive fraud, gross mismanagement, corporate waste, and unjust enrichment. The complaint seeks unspecified monetary damages and other relief against the defendants. The Company has, through outside counsel, conducted an inquiry into each of the option grants referenced in the complaint. As a result of this inquiry, the Company and its Board of Directors believe the claims are without merit.

     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) and

injunctions for causes of actions involving alleged breach of contract, fraud, unfair competition, breach of warranty and declaratory relief. On September 3, 2004, Novellus filed a demurrer to all causes of action in the complaint, which the Court granted without leave to amend on October 5, 2004. On January 11, 2005, Linear filed a notice of appeal of the court’s order granting judgment in favor of Novellus. On June 15, 2005, Linear filed its opening appellate brief. Novellus filed a responsive brief on September 28, 2005. Linear filed its reply on November 18, 2005. The Court of Appeal has not yet set a date for oral argument. Although we prevailed on these claims in the Superior Court, it is possible that the Court of Appeal will reverse the ruling of the Superior Court, in which case Novellus could face potential liability on these claims. We cannot predict how the Court of Appeal will rule on this issue or, if it does rule against Novellus, estimate a range of potential loss, if any, due to the uncertainty of the appeals process.

     Other Litigation

During the quarter ended July 1, 2006, we reached an agreement to settle a customer indemnity claim. The cost of this settlement, $3.3 million, was included in the results of operations for the quarter ended April 1, 2006, as a subsequent event due to the settlement occurring prior to the filing of our Form 10-Q.

We are a defendant or plaintiff in various actions that arose in the normal course of business. We believe that the ultimate disposition of these other 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.

15. 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. Our Semiconductor Group develops, manufactures, sells and supports equipment used in the fabrication of integrated circuits, commonly called microchips, or chips. Our Industrial Applications Group is a supplier of lapping, grinding, polishing and deburring products for fine-surface optimization.

Segment information for the periods presented is as follows (in thousands):

		Three Months Ended July 1, 2006												Six Months Ended July 1, 2006
						Industrial												Industrial
		Semiconductor				Applications								Semiconductor				Applications
		Group				Group				Total				Group				Group				Total
Sales to unaffiliated customers		$	380,333			$	29,740			$	410,073			$	724,425			$	51,554			$	775,979
Operating income		$	71,932			$	3,223			$	75,155			$	100,813			$	3,738			$	104,551
Long-lived assets		$	382,423			$	17,255			$	399,678			$	382,423			$	17,255			$	399,678
All other identifiable assets			1,629,648				187,807				1,817,455				1,629,648				187,807				1,817,455
Total assets		$	2,012,071			$	205,062			$	2,217,133			$	2,012,071			$	205,062			$	2,217,133

		Three Months Ended July 2, 2005												Six Months Ended July 2, 2005
						Industrial												Industrial
		Semiconductor				Applications								Semiconductor				Applications
		Group				Group				Total				Group				Group				Total
Sales to unaffiliated customers		$	307,345			$	22,240			$	329,585			$	610,523			$	58,802			$	669,325
Operating income		$	39,695			$	4,104			$	43,799			$	73,593			$	10,267			$	83,860
Long-lived assets		$	441,957			$	15,562			$	457,519			$	441,957			$	15,562			$	457,519
All other identifiable assets			1,748,999				175,147				1,924,146				1,748,999				175,147				1,924,146
Total assets		$	2,190,956			$	190,709			$	2,381,665			$	2,190,956			$	190,709			$	2,381,665

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; anticipated dates for required compliance with certain accounting policies; our estimated amortization expense for each of the next five fiscal years; the fact that we do not anticipate recording significant intangible assets as a result of the acquisition of Voumard Machine Co. SA; our intention to report changes related to the allocation of assets acquired and liabilities assumed with respect to the acquisition of Voumard Machine Co. SA and our expectation that the final purchase price allocation will not differ significantly from our preliminary allocation; the payment of our future rent obligations through 2017; our estimates of reduced expenses as a result of our restructuring plans; our goal to use our expertise to increase our market share and strengthen our position as a leading supplier of semiconductor process equipment; our endeavor to provide our customers with highly reliable products; our efforts to continue to deliver innovative products; our expectation that net orders will continue to vary; our plan to continue to focus on expanding our market presence in Asia; our belief that significant additional growth potential exists in the Asia region over the long term; our ongoing endeavor to improve gross margins; our continued outsourcing of manufacturing functions; our anticipation it will take an excess of one year to close the sale of assets associated with our restructuring plan to dispose of certain owned facilities located in San Jose, California; our continued 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 most of the Company’s deferred tax assets will be realized due to anticipated future income; the fact that we do not anticipate paying any cash dividends in the foreseeable future; our expectation that the hedge of forecasted intercompany transactions will offset potential changes to cash flows; our expectation that unrecognized compensation costs in the amount of $31.9 million related to unvested stock options will be recognized over a weighted average period of 2.4 years; our expectation that unrecognized compensation costs in the amount of $15.8 million related to restricted stock awards will be recognized over a weighted average period of 2.4 years; our expectation that unrecognized compensation costs in the amount of $0.8 million related to the ESPP will be fully recognized during the next two fiscal quarters; our intention to maintain close relationships with our customers in order to remain responsive to their product needs; an increasingly global market; our expectation that significant fluctuations in our quarterly operating results will continue; our expectation that a few customers will continue to account for a high percentage of our net sales in

the foreseeable future; our intention to continue to seek legal protection through patents and trade secrets for our proprietary technology; our expectation that our future profitability will be reduced as a result of requirements of SFAS 123(R); 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 Derivative litigation matters are without merit; 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 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; inaccurate calculations regarding the allocation of assets acquired and liabilities assumed in connection with acquisitions; an increase in the number of competitors; our inability to compete with the greater financial, marketing and technical capabilities of certain competitors; inaccurate valuation of the assumptions underlying our estimated amortization expense for each of the next five fiscal years; unintended defaults in payment of our future rent obligations under our restructuring plans; unanticipated difficulties in implementing and inability to realize savings from our restructuring plans; sustained decrease in or leveling off of customer demand; inability to anticipate cyclical changes in customers’ capacity utilization and demand; a shift in focus away from expansion of our market presence in Asia in response to slower economic development in the region; the negative impact of higher cost of services and ineffective pricing techniques on gross margins; inability to realize efficiencies from outsourcing; sustained technical and performance difficulties of our products; our inability to allocate substantial resources to R&D; inability to develop and timely introduce new and enhanced products; inaccuracies in management’s assessment of the amount of the Company’s valuation allowance for deferred tax assets; inaccurate calculations with respect to unrecognized compensation costs; inability to accurately assess the changing product needs of our customers; loss of a major customer; inaccuracies in our estimates of costs associated with compensation charges resulting from the adoption of SFAS 123(R); inadequate efforts to develop the necessary patents and trade secrets to protect our proprietary technology; unanticipated need for additional liquid assets in the next twelve months; our failure to accurately predict the effect of the ultimate outcome of current litigation on our business, financial condition or results of operations; inherent uncertainty in the outcome of litigation matters; and our potential inability to enforce our patents and protect our trade secrets.

The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties set forth under the heading “Risk Factors” in 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, 2005 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;
	•		Results of Operations;
	•		Critical Accounting Policies;
	•		Liquidity and Capital Resources; and
	•		Risk Factors.

Overview of Our Business and Industry

We are a global supplier of semiconductor processing equipment used in the fabrication of integrated circuits. We develop, manufacture, sell and service equipment used by manufacturers of integrated circuits, or chips, who either incorporate the chips in their own products or sell the chips to other companies for use in electronic devices. We also are a supplier of lapping, grinding, polishing and deburring products for fine-surface optimization. Our goal is to use our expertise to increase our market share and

strengthen our position in the markets we serve. To accomplish this, we endeavor to provide our customers with highly reliable products which help them compete effectively in their business by reducing their costs and increasing their productivity.

Our semiconductor processing equipment business primarily depends on capital expenditures made by chip manufacturers, who in turn are dependent on corporate and consumer demand for chips and the products which use them. The industry in which we operate is driven by spending for electronic products. As a consequence, our business is 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 an impact on our business. In addition, the industry is characterized by intense competition and rapidly changing technology. We have worked closely with our customers and made 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 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. Net orders are used to forecast and plan future operations. Net orders consist of current period orders less current period cancellations. We report an order when a firm purchase order (or, in Japan, a letter of intent) is received and the agreed-upon delivery date is within twelve months (twenty-four months for the Industrial Applications Group).

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

		Quarterly Financial Data
		2006								2005
		Second				First				Fourth				Third				Second				First
		Quarter				Quarter				Quarter				Quarter				Quarter				Quarter
Net sales		$	410,073			$	365,906			$	332,268			$	338,878			$	329,585			$	339,740
Gross profit		$	204,764			$	167,540			$	140,501			$	147,194			$	157,562			$	153,869
Net income		$	52,705			$	24,717			$	22,990			$	23,415			$	33,231			$	30,471
Diluted net income per share		$	0.42			$	0.19			$	0.17			$	0.17			$	0.24			$	0.22
Net orders		$	457,545			$	416,710			$	351,018			$	286,929			$	309,214			$	301,594

The semiconductor equipment industry is subject to cyclical conditions which play a major role in demand, as defined by net orders. Order fluctuations, in turn, affect our net sales. In 2005, demand for our products was volatile. In the first quarter of 2005, we experienced a sequential decrease in net orders of 9%, followed by a sequential increase of 3% in the second quarter, and a sequential decrease of 7% in the third quarter. In the fourth quarter of 2005, demand for our products began to increase and we experienced a sequential increase in net orders of 22%, followed by sequential increases of 19% and 10% in the first and second quarters of 2006, respectively. During the first half of 2006, we continued to benefit from the net order growth that commenced in the fourth quarter of 2005, which was driven primarily by increases in the utilization of our customer’s production capacity. Due to the cyclical conditions in our industry, we expect that net orders will continue to vary sequentially.

The receipt of net orders in a particular quarter affects revenue in subsequent quarters. Net orders turn to revenue either at shipment or upon customer acceptance of the equipment. Our revenue recognition policy addresses the distinction between revenue recognized upon shipment and revenue recognized upon customer acceptance. Equipment generally ships within two or three months of receiving the related order. Customer acceptance, if applicable, is typically received three to six months after shipment. These time lines are general estimates and actual times may vary.

Results of Operations

Adoption of SFAS 123(R)

As discussed in Note 3, “Stock-Based Compensation,” in the notes to the condensed consolidated financial statements, we adopted the fair value recognition provisions of SFAS 123(R) using the modified prospective transition method effective January 1, 2006.

The following table summarizes the stock-based compensation expense for stock options, restricted stock and our ESPP (in thousands):

		Three Months Ended												Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
		(1)				(3)				(2)				(1)				(2)
Cost of sales		$	538			$	308			$	184			$	846			$	396
Selling, general and administrative			5,590				5,439				540				11,029				1,165
Research and development			2,664				3,061				325				5,725				701
Stock-based compensation expense before income taxes		$	8,792			$	8,808			$	1,049			$	17,600			$	2,262

Net Sales

		Three Months Ended												Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
						(in thousands, except percentages)
Net sales		$	410,073			$	365,906			$	329,585			$	775,979			$	669,325
International net sales %			71	%			66	%			76	%			69	%			74	%

Net sales during the three and six months ended July 1, 2006 increased by $80.5 million and $106.7 million, respectively, compared to the prior year comparable periods. This net increase for the quarter is comprised of an increase of $73.0 million in the Semiconductor Group and an increase of $7.5 million in the Industrial Applications Group. This net increase for the six months is comprised of an increase of $113.9 million in the Semiconductor Group offset by a decrease of $7.2 million in the Industrial Applications Group. The increase in net sales in the Semiconductor Group is primarily attributable to higher volumes resulting from increased production capacity demands on our customers.

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

		Three Months Ended												Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
North America			29	%			34	%			24	%			31	%			26	%
Europe			9	%			7	%			8	%			8	%			9	%
Asia			62	%			59	%			68	%			61	%			65	%

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, China and Taiwan. We plan to continue to focus on expanding our market presence in Asia, as we believe that significant additional growth potential exists in this region over the long term.

Gross Profit

		Three Months Ended												Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
						(in thousands, except percentages)
Gross profit		$	204,764			$	167,540			$	157,562			$	372,304			$	311,431
% of net sales			50	%			46	%			48	%			48	%			47	%

Our gross profit is affected by the treatment of certain product sales in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition” (“SAB 104”). For these sales, we recognize all of a product’s cost upon shipment even though a portion of a product’s revenue may be deferred until final payment is due, typically upon customer acceptance.

The gross profit percentage in the quarter ended July 1, 2006 increased from the quarter ended July 2, 2005. The increase is primarily attributable to the improvements in warranty costs and higher levels of absorption partially offset by increased stock-based compensation expense due to the adoption of SFAS 123(R). The adoption of Statement of Financial Accounting Standard (“SFAS”) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”), positively impacted gross margin by approximately $2.6 million, due to increased absorption, for the six months ended July 1, 2006.

We are focused on continuing to improve our gross margins. This process involves continuing our focus on reducing installation and warranty costs, improving our product differentiation in the marketplace, working with our vendors to minimize costs, reviewing our current and future anticipated facility requirements to determine if facility reduction is necessary to achieve greater economies of scale, and continuing to outsource to take full advantage of available highly efficient manufacturing. The effort to make sustainable improvement in gross margins is an ongoing endeavor.

Selling, General and Administrative (SG&A)

		Three Months Ended												Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
						(in thousands, except percentages)
SG&A expense		$	66,311			$	58,482			$	50,325			$	124,793			$	102,085
% of net sales			16	%			16	%			15	%			16	%			15	%

SG&A expense includes compensation and benefits for corporate, financial, marketing, and administrative personnel as well as travel expenses and professional fees. Also included are expenses for rents, utilities, and depreciation and amortization related to the assets utilized by these functions. The increase in SG&A expense, in absolute dollars, for the three and six months ended July 1, 2006 from the prior year comparable periods is primarily due to increased stock-based compensation expense, which reflects our adoption of SFAS 123(R), and increased compensation and employee-related benefits, which includes employee profit sharing. Our SG&A expense for the three and six months ended July 2, 2005 was positively impacted by the reduction of our allowance for doubtful accounts by $6.1 million based upon management’s ongoing analysis of reserves for doubtful accounts.

Research and Development (R&D)

		Three Months Ended													Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
						(in thousands, except percentages)
R&D expense		$	63,298			$	63,783			$	63,512			$	127,081			$	125,560
% of net sales			15	%			17	%			19	%			16	%			19	%

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. R&D expense remained fairly stable, in absolute dollars, for the three and six months ended July 1, 2006 from the prior year comparable periods. Increases in stock-based compensation expenses, which reflects our adoption of SFAS 123(R), and increased compensation and employee-related benefits, were offset by the realization of certain restructuring benefits and by reduced spending on R&D initiatives.

Restructuring and Other Charges

		Three Months Ended												Six Months Ended
		July 1, 2006				April 1, 2006				July 2, 2005				July 1, 2006				July 2, 2005
						(in thousands, except percentages)
Restructuring and other charges		$	—			$	12,629			$	(74	)		$	12,629			$	(74	)
% of net sales			—	%			3	%		Less than 1		%			2	%		Less than 1		%