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 October 1, 2005


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

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

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
YES þ NO 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 1, 2005, 133,377,534 shares of the Registrant’s common stock, no par value, were issued and outstanding.

PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)


	Three Months Ended						Nine Months Ended
	October 1, 2005			September 25, 2004			October 1, 2005			September 25, 2004
Net sales	$	338,878		$	415,935		$	1,008,203		$	1,017,016
Cost of sales		191,684			214,824			549,578			521,620

Gross profit		147,194			201,111			458,625			495,396
Operating expenses:
Selling, general and administrative		53,365			49,585			155,450			139,213
Research and development		61,263			68,202			186,823			190,630
Restructuring and other charges (benefits)		3,361			(923	)		3,287			(923	)
Acquired in-process research and development		—			—			—			6,124
Legal settlement		¾			2,900			¾			5,400

Total operating expenses		117,989			119,764			345,560			340,444

Operating income		29,205			81,347			113,065			154,952
Interest income, net		4,596			1,872			11,943			6,995
Other income (loss), net		(2,191	)		7,854			(2,395	)		8,376

Interest and other income, net		2,405			9,726			9,548			15,371

Income before income taxes		31,610			91,073			122,613			170,323
Provision for income taxes		8,195			26,411			35,496			51,169

Net income	$	23,415		$	64,662		$	87,117		$	119,154

Net income per share:
Basic net income per share	$	0.17		$	0.45		$	0.63		$	0.80

Diluted net income per share	$	0.17		$	0.45		$	0.62		$	0.79

Shares used in basic per share calculation		137,848			142,333			138,602			148,119

Shares used in diluted per share calculation		138,895			143,574			139,646			150,353

See accompanying notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)


	October 1,			December 31,
	2005			2004 *
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	38,531		$	106,117
Short-term investments		692,463			481,645
Accounts receivable, net		343,884			395,522
Inventories		205,607			261,046
Deferred tax assets, net		105,892			110,644
Prepaid and other current assets		30,205			14,350

Total current assets		1,416,582			1,369,324
Property and equipment, net		440,917			476,492
Restricted cash and cash equivalents		148,545			176,708
Goodwill		265,398			278,972
Intangible and other assets		103,509			100,336

Total assets	$	2,374,951		$	2,401,832


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	59,676		$	70,446
Accrued payroll and related expenses		57,699			64,531
Accrued warranty		49,005			45,526
Other accrued liabilities		51,117			54,517
Income taxes payable		16,898			14,691
Deferred profit		69,869			71,216
Current obligations under lines of credit		6,225			3,103

Total current liabilities		310,489			324,030
Long term debt		125,752			161,103
Other liabilities		46,941			54,865

Total liabilities		483,182			539,998
Shareholders’ equity:
Common stock		1,465,078			1,473,829
Deferred stock compensation		(14,390	)		(17,159	)
Retained earnings		439,847			399,919
Accumulated other comprehensive income		1,234			5,245

Total shareholders’ equity		1,891,769			1,861,834

Total liabilities and shareholders’ equity	$	2,374,951		$	2,401,832


*		Amounts as of December 31, 2004 are derived from the December 31, 2004 audited financial statements.

See accompanying notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)


	Nine Months Ended
	October 1,			September 25,
	2005			2004
Cash flows from operating activities:
Net income	$	87,117		$	119,154
Adjustments to reconcile net income to net cash provided by operating activities:
Gain on sale of an investment		¾			(353	)
Non-cash portion of restructuring charges		8,538			(923	)
Non-cash portion of legal settlement		¾			(8,076	)
Loss on disposal of fixed assets		663			1,188
Depreciation and amortization		62,772			64,660
Deferred income taxes		9,963			(12,720	)
Stock-based compensation		2,700			2,987
Changes in operating assets and liabilities:
Accounts receivable		38,089			(186,456	)
Inventories		31,328			(39,636	)
Prepaid and other current assets		(4,800	)		(2,237	)
Accounts payable		(17,019	)		13,383
Accrued payroll and related expenses		(6,151	)		37,425
Accrued warranty		3,812			14,395
Other accrued liabilities		(4,407	)		8,401
Income taxes payable		5,038			43,997
Deferred profit		(1,091	)		25,176

Net cash provided by operating activities		216,552			80,365

Cash flows from investing activities:
Proceeds from sales of short-term investments		277,839			574,511
Proceeds from maturities of short-term investments		125,674			233,907
Purchases of short-term investments		(614,906	)		(762,111	)
Capital expenditures		(35,691	)		(17,238	)
Proceeds from sale of property and equipment		2,676			—
Increase in other assets		26,469			(177,596	)
Purchase of Peter Wolters AG, net of cash acquired		¾			(142,916	)

Net cash used in investing activities		(217,939	)		(291,443	)

Cash flows from financing activities:
Proceeds from employee stock compensation plans		26,920			21,576
Proceeds from (payments on) lines of credit, net		3,207			(7,624	)
Payments on long-term debt		(19,838	)		153,115
Repurchase of common stock		(82,791	)		(401,661	)

Net cash used in financing activities		(72,502	)		(234,594	)

Effects of exchange rate on cash and cash equivalents		6,303			381
Net increase (decrease) in cash and cash equivalents		(67,586	)		(445,291	)

Cash and cash equivalents at the beginning of the period		106,117			497,178

Cash and cash equivalents at the end of the period	$	38,531		$	51,887

See accompanying notes to condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended October 1, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. 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, 2004.

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

The accompanying condensed consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries after the elimination of all significant intercompany account balances and transactions. Certain prior period balances have been reclassified to conform to the current period presentation.

In the third quarter of 2004, we acquired Peter Wolters AG, a manufacturer of high-precision machine manufacturing tools. The acquisition was accounted for as a purchase business combination in accordance with SFAS No. 141. Our consolidated financial statements for the periods ended October 1, 2005 include the financial position, results of operations and cash flows of Peter Wolters from the date of acquisition. Due to the divergence of Peter Wolters’ existing product lines and customer base from the operating segment in which we primarily operate, we have determined that we operate in two segments and have provided the related disclosures. We refer to this segment as our Industrial Applications Group.

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. The balance for allowance for doubtful accounts was $1.2 million and $8.2 million at October 1, 2005 and December 31, 2004, respectively. The decrease primarily results from a $6.1 million reduction in the allowance for doubtful accounts.

Forward Foreign Exchange Contracts

We use forward foreign exchange contracts to hedge against the short-term impact of foreign currency fluctuations on intercompany accounts payable denominated in U.S. dollars and exposures to variability in anticipated non-U.S.-dollar-denominated cash flows. The maturities of these instruments are generally less than 12 months. For these derivatives, the gain or loss from the effective portion of the hedge is reported as a component of other comprehensive income and is reclassified into earnings in the same period in which the hedged transaction affects earnings, and within the same income statement line item as the impact of the hedged transaction. The gain or loss from the ineffective portion of the hedge in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in interest and other, net during the period of change.

We also enter into forward foreign exchange contracts to buy and sell foreign currencies to hedge the parent’s intercompany balances denominated in a currency other than the U.S. dollar. In 2005 and 2004, these hedging contracts were denominated primarily in the Taiwanese Dollar, Singapore Dollar, the Euro and the Japanese Yen. The forward foreign exchange contracts we use are generally short-term in nature. The effect of exchange rate changes on forward exchange contracts is expected to offset the effect of exchange rate changes on the underlying hedged items. We believe these financial instruments do not subject us to speculative risk that would otherwise result from changes in currency exchange rates.

Stock-Based Compensation

We account for stock-based employee compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB No. 25, and have adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” or SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures.” Accordingly, no expense has been recognized for options granted to employees when the exercise price equals the market value of the stock on the date of grant.

In our consolidated statements of operations we recognize stock-based compensation, measured at the intrinsic value, on the graded vesting method over the vesting periods for nonvested stock awards and stock options, which is generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in greater expense recorded in earlier years than the straight-line method.

In the disclosure presented below we recognize stock-based compensation, measured at the fair value, on the graded vesting method over the vesting periods for restricted stock awards and stock options, which is generally four years, and for employee purchases of common stock under our employee stock purchase plan, which is generally six months.

SFAS No. 123 requires the use of option pricing models, most of which were not developed for use in valuing employee stock options. The Black-Scholes-Merton option-pricing model was developed for use in estimating the fair value of short-lived exchange-traded options that have no vesting restrictions and are freely transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Since our employee stock options have characteristics significantly different from those of traded options and since changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models may not necessarily provide a reliable single measure of the fair value of employee stock options.

Had compensation expense been determined based on the fair value as determined by the Black-Scholes-Merton model at the grant date for awards, consistent with the provisions of SFAS No. 123, we would have reported pro forma net income and net income per share as follows (in thousands, except per share data):


	Three Months Ended						Nine Months Ended
	October 1,			September 25,			October 1,			September 25,
	2005			2004			2005			2004
Net income as reported	$	23,415		$	64,662		$	87,117		$	119,154
Add:
Intrinsic value method expense included in reported net income, net of related tax effects		306			998			1,890			2,977
Less:
Fair value method expense, net of related tax effects		(6,853	)		(11,240	)		(25,592	)		(39,071	)

Pro-forma net income	$	16,868		$	54,420		$	63,415		$	83,060

Pro-forma basic net income per share	$	0.12		$	0.38		$	0.46		$	0.56

Pro-forma diluted net income per share	$	0.12		$	0.38		$	0.45		$	0.56

Basic net income per share as reported	$	0.17		$	0.45		$	0.63		$	0.80

Diluted net income per share as reported	$	0.17		$	0.45		$	0.62		$	0.79

The fair value of each stock option is estimated on the date of grant using the Black-Scholes-Merton option-pricing model, with the following weighted-average assumptions for grants made in the three and nine months ended October 1, 2005 and September 25, 2004:

Three Months Ended

Nine Months Ended

October 1,

September 25,

October 1,

September 25,

2005

2004

2005

2004

Dividend yield

None

Expected volatility

69%

74%

70%

76%

Risk free interest rate

3.6%

2.7%

3.4%

2.5%

Expected lives

3.7 years

3.5 years

The weighted-average fair value of stock options granted during the period was $13.92 and $13.94 for the three and nine months ended October 1, 2005, respectively, and $14.09 and $16.42 for the three and nine months ended September 25, 2004, respectively.

The pro forma net income and net income per share data listed above include expense related to the Employee Stock Purchase Plan, referred to herein as the Purchase Plan. The fair value of issuances under the Purchase Plan is estimated on the date of issuance using the Black-Scholes-Merton option-pricing model, with the following weighted-average assumptions:

Three Months Ended

Nine Months Ended

October 1,

September 25,

October 1,

September 25,

2005

2004

2005

2004

Dividend yield

None

Expected volatility

33%

45%

36%

45%

Risk free interest rate

2.3%

1.3%

2.2%

1.3%

Expected lives

.5 year

The weighted-average fair value of purchase rights was $5.82 and $6.36 for the three and nine months ended October 1, 2005, and $7.92 and $8.78 for the three and nine months ended September 25, 2004, respectively.

Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (EITF) issued EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” or EITF No. 03-1. EITF No. 03-1 includes guidance for determining and recording impairment for both debt and equity securities. EITF No. 03-1 also requires additional disclosure for investments that are deemed to be temporarily impaired under the standard. In September 2004, the FASB Staff issued FASB Staff Position (FSP) EITF 03-1-1, or FSP EITF 03-1-1. Effective upon issuance, FSP EITF 03-1-1 delayed, indefinitely, certain measurement and recognition guidance contained in EITF No. 03-1. We are currently in the process of assessing the impact, if any, of this guidance.

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, or Statement 123(R), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” or Opinion 25, and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in the unrevised Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. In April 2005, the Securities and Exchange Commission (SEC) deferred the effective date of Statement 123(R) until the first fiscal year beginning after June 15, 2005, with early adoption permitted. We expect to adopt Statement 123(R) on January 1, 2006. We are in the process of evaluating which transition method and pricing model to apply at adoption.

As permitted by the unrevised Statement 123, we currently account for share-based payments to employees using Opinion 25’s intrinsic value method, under which we generally do not record compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The precise impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend, in part, on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 1 to our Condensed Consolidated Financial Statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net

financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior years for such excess tax deductions was zero in 2004 and 2003, and $19.4 million in 2002.

In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107. SAB 107 provides guidance related to share-based payment transactions with non-employees, transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), accounting for certain redeemable financial instruments issued under share-based payment arrangements, classification of compensation expense, non-GAAP financial measures, first-time adoption of Statement 123(R) in an interim period, capitalization of compensation cost related to share-based payment arrangements, accounting for income tax effects of share-based payment arrangements upon adoption of Statement 123(R), modification of employee share options prior to adoption of Statement 123(R) and disclosures in Management’s Discussion and Analysis (“MD&A”) subsequent to adoption of Statement 123(R). We are currently in the process of assessing the impact of this guidance.

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 shares of restricted stock subject to repurchase.

Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding, including shares of nonvested common stock subject to repurchase and, when dilutive, potential shares from stock options to purchase common stock using the treasury stock method.

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


	Three Months Ended				Nine Months Ended
	October 1,		September 25,		October 1,		September 25,
	2005		2004		2005		2004
Numerator:
Net income	$	23,415	$	64,662	$	87,117	$	119,154

Denominator:
Basic weighted-average shares outstanding		137,848		142,333		138,602		148,119
Employee stock options and restricted stock		1,047		1,241		1,044		2,234

Diluted weighted-average shares outstanding		138,895		143,574		139,646		150,353

Basic net income per share	$	0.17	$	0.45	$	0.63	$	0.80

Diluted net income per share	$	0.17	$	0.45	$	0.62	$	0.79

Options to purchase approximately 19.1 million and 20.2 million shares of common stock at a weighted-average exercise price of $34.96 and $35.10 per share were outstanding for the three and nine months ended October 1, 2005, respectively. Options to purchase approximately 20.3 million and 12.5 million shares of common stock at a weighted-average exercise price of $36.39 and $40.92 per share were outstanding for the three and nine months ended September 25, 2004, respectively. These options were not included in the computation of diluted net income per common share because the respective exercise prices of these options were greater than the average respective market prices of the common shares and, therefore, the effect would be anti-dilutive.

3. OTHER INCOME (LOSS), NET

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


	Three Months Ended						Nine Months Ended
	October 1,			September 25,			October 1,			September 25,
	2005			2004			2005			2004
Other income	$	212		$	146		$	441		$	1,123
Other expense		(303	)		(103	)		(434	)		(430	)
Litigation proceeds		—			8,000			—			8,000
Foreign currency loss, net		(2,100	)		(189	)		(2,402	)		(317	)

Total other income (loss), net	$	(2,191	)	$	7,854		$	(2,395	)	$	8,376

4. INVENTORIES

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


	October 1,		December 31,
	2005		2004
Purchased and spare parts	$	161,997	$	192,935
Work-in-process		26,367		54,586
Finished goods		17,243		13,525

Total inventories	$	205,607	$	261,046

5. GOODWILL AND INTANGIBLE ASSETS

Goodwill

A summary of changes in goodwill during the periods ended October 1, 2005 and September 25, 2004 is as follows (in thousands):


	2005
				Industrial
	Semiconductor			Applications
	Group			Group			Total
Balance at December 31, 2004	$	162,230		$	116,742		$	278,972
SpeedFam-IPEC adjustment		(1,170	)		—			(1,170	)
Foreign currency translation		—			(4,093	)		(4,093	)

Balance at April 2, 2005	$	161,060		$	112,649		$	273,709
SpeedFam-IPEC adjustment		(1,170	)		¾			(1,170	)
Foreign currency translation		¾			(7,455	)		(7,455	)

Balance at July 2, 2005	$	159,890		$	105,194		$	265,084
SpeedFam-IPEC adjustment		(1,170	)		—			(1,170	)
Peter Wolters adjustment		—			1,946			1,946
Foreign currency translation		—			(462	)		(462	)

Balance at October 1, 2005	$	158,720		$	106,678		$	265,398


	2004
				Industrial
	Semiconductor			Applications
	Group			Group		Total
Balance at June 26, 2004	$	173,267		$	¾	$	173,267
SpeedFam-IPEC adjustment		(799	)		—		(799	)
Peter Wolters acquisition		¾			104,221		104,221
Foreign currency translation		¾			1,233		1,233

Balance at September 25, 2004	$	172,468		$	105,454	$	277,922

During the three and nine months ended October 1, 2005, we reduced valuation allowances by approximately $1.2 million and $3.5 million, respectively, against certain net operating loss carryforwards recorded during the acquisition of SpeedFam-IPEC in 2002. Additionally, during the quarter ended October 1, 2005, we increased goodwill by $1.9 million as a result of an adjustment to the Peter Wolters purchase price allocation pertaining to inventory. For the six months ended June 26, 2004 there were no changes to goodwill.

In connection with our purchase of Peter Wolters, we deposited ten percent of the purchase price into escrow. The escrow amount was released to the former shareholders of Peter Wolters in June 2005, excluding $0.1 million which is being retained in escrow in connection with a tax accrual dispute.

We completed the annual goodwill impairment test in the fourth quarter of 2004 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 2004.

Intangible Assets

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


			Accumulated
October 1, 2005	Gross		Amortization			Net
Patents	$	4,197	$	(1,049	)	$	3,148
Developed technology		28,122		(10,285	)		17,837
Trademark		6,108		(764	)		5,344
Other intangible assets		138		(87	)		51

Total	$	38,565	$	(12,185	)	$	26,380


			Accumulated
December 31, 2004	Gross		Amortization			Net
Patents	$	4,197	$	(525	)	$	3,672
Developed technology		28,095		(6,928	)		21,167
Trademark		6,809		(340	)		6,469
Other intangible assets		138		(81	)		57

Total	$	39,239	$	(7,874	)	$	31,365

Our estimated amortization expense for the identifiable intangible assets for each of the next five fiscal years will be approximately $5.9 million for 2006, $6.0 million for 2007, $5.8 million for 2008, $3.1 million for 2009 and $1.7 million for 2010. As of October 1, 2005, we have no identifiable intangible assets with indefinite lives.

6. PRODUCT WARRANTY

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


	Three Months Ended						Nine Months Ended
	October 1,			September 25,			October 1,			September 25,
	2005			2004			2005			2004
Balance, beginning of period	$	50,493		$	38,264		$	45,526		$	28,805
Peter Wolters balance at acquisition		—			2,367			—			2,367
Warranties issued		15,059			22,589			57,609			59,926
Settlements		(22,729	)		(19,305	)		(63,032	)		(49,243	)
Changes in liability for pre-existing warranties, including expirations		6,182			1,064			8,902			3,124

Balance, end of period	$	49,005		$	44,979		$	49,005		$	44,979

7. RESTRUCTURING AND OTHER CHARGES

As of October 1, 2005, substantially all actions under our 2004, 2003, 2002 and 2001 restructuring plans had been completed, except for payments of future rent obligations of $32.5 million, which are to be paid in cash through 2017. During the quarter ended October 1, 2005, we recorded a benefit of $3.0 million due to a change in estimate of sublease income related to facilities previously included in our restructuring accrual. All restructuring and other charges are related to the Semiconductor Group.

In September 2005, we incurred a restructuring charge in an effort to consolidate operations and streamline our product offerings. In connection with this decision we recorded approximately $11.6 million in restructuring charges. Included in this charge is approximately $5.2 million related to an inventory write down included in cost of sales, approximately $0.2 million in severance-related charges and approximately $6.1 million related to the write-down of property and equipment and accelerated depreciation associated with certain leasehold improvements included in restructuring and other charges (benefits).

In 2004, we incurred a restructuring charge to align our research and development and manufacturing operations with business conditions. In the third quarter of 2003, we implemented a restructuring plan to align our cost structure with business conditions. Additional restructuring reserves recorded in 2002 were primarily related to exiting business activities of SpeedFam-IPEC that were recognized by us as liabilities assumed in the purchase business combination. In 2001, we implemented a restructuring plan that was driven by the decline in sales orders due to the contraction of the semiconductor capital equipment market.

The following table summarizes restructuring activity for the nine months ended October 1, 2005 (in thousands):

Inventory


										Acquisition					Inventory
	Facilities			Asset Charges			Severance			Expense		Total			Write-Down
Balance at December 31, 2004	$	41,681		$	163		$	160		$	198	$	42,202		$	¾
Cash payments		(2,209	)		(52	)		(62	)		—		(2,323	)		¾

Balance at April 2, 2005		39,472			111			98			198		39,879			¾
Cash payments		(1,806	)		(93	)		—			—		(1,899	)		¾
Adjustment		¾			¾			(74	)		¾		(74	)		¾

Balance at July 2, 2005		37,666			18			24			198		37,906			¾
Cash payments		(2,217	)		—			—			—		(2,217	)		¾
Restructuring charges		1,557			4,529			231			—		6,317			5,250
Non-cash adjustment		(4,513	)		(4,529	)		—			—		(9,042	)		(5,250	)

Balance at October 1, 2005	$	32,493		$	18		$	255		$	198	$	32,964		$	¾

8. LONG-TERM OBLIGATIONS

At October 1, 2005, we had borrowings of $125.8 million, denominated in Euros. These borrowings consisted of approximately $125.1 million and $0.7 million, with interest rates of 2.33% and 4.82%, respectively. Certain borrowings are required to be secured by cash or marketable securities on deposit. Our borrowings are due and payable on or before June 2009. Amounts to secure these borrowings are included within restricted cash on the consolidated balance sheets.

9. COMPREHENSIVE INCOME

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


	Three Months Ended						Nine Months Ended
	October 1,			September 25,			October 1,			September 25,
	2005			2004			2005			2004
Net income	$	23,415		$	64,662		$	87,117		$	119,154
Other comprehensive income:
Foreign currency translation adjustments, net of tax		(1,657	)		(947	)		(5,695	)		(1,370	)
Unrealized change in derivative instruments		(2,699	)		—			2,259			—
Realized gain on available-for-sale securities, net of tax		—			(12	)		—			(353	)
Unrealized gain (loss) on available-for-sale securities, net of tax		(24	)		1,043			(575	)		182

Comprehensive income	$	19,035		$	64,746		$	83,106		$	117,613

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


	October 1,			December 31,
	2005			2004
Foreign currency translation adjustments	$	537		$	6,232
Unrealized change in derivative instruments		2,259			—
Unrealized loss on available-for-sale securities		(1,562	)		(987	)

Accumulated other comprehensive income	$	1,234		$	5,245

10. PENSION PLAN

On June 28, 2004, we acquired Peter Wolters AG, including its existing pension plan. The pension balance at October 1, 2005 and December 31, 2004 was $6.3 million and $7.0 million, respectively. The changes in the obligation consisted of interest cost, service cost, benefit payments and currency translation adjustments, which were not significant.

11. 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 approximately $0.2 million and $0.4 million in rental expense for the three and nine months ended October 1, 2005, respectively, and approximately $0.2 million and $0.7 million for the three and nine months ended September 25, 2004, respectively.

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 each of the nine-month periods ended October 1, 2005 and September 25, 2004. No grants were provided during each of the three-month periods ended October 1, 2005 and September 25, 2004. Mr. Hill is also a member of the Board of Directors of LTX Corporation. We recorded sublease income from LTX Corporation of approximately $0.4 million and $1.1 million for both the three and nine months ended October 1, 2005, respectively, and the three and nine months ended September 25, 2004, respectively.

During the three and nine months ended October 1, 2005 and September 25, 2004, Novellus employed, in non-executive positions, three immediate family members of our executive officers. The aggregate compensation amounts recognized for these immediate family members was approximately $0.1 million and $0.2 million for the three and nine months ended October 1, 2005, respectively and approximately $0.1 million and $0.5 million for the three and nine months ended September 25, 2004, respectively.

From time to time, we have made secured and unsecured loans to our executive officers, vice presidents and other key personnel. As of October 1, 2005, we do not have any outstanding loans to our “executive officers,” as defined by the Securities and Exchange Commission. However, we do have outstanding loans to non-executive vice presidents and other key personnel. As of October 1, 2005 and December 31, 2004, the total outstanding balance of loans to non-executive vice presidents and other key personnel was approximately $3.3 million and $5.0 million, respectively. Of the total amount outstanding at October 1, 2005, $2.6 million 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.

12. LITIGATION

Linear Technology Corporation

In March 2002, Linear Technology Corporation (Linear) filed a complaint against Novellus, among other parties, in the Superior Court of the State of California for the County of Santa Clara. The complaint seeks damages (including punitive damages) 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’s reply brief is due 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

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

13. OPERATING SEGMENTS

We operate primarily in one segment, the manufacturing, marketing and servicing of semiconductor equipment for thin film deposition, surface preparation and chemical mechanical planarization. This operating segment is referred to as the Semiconductor Group. In accordance with SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” our chief operating decision-maker is the Chairman and Chief Executive Officer. All semiconductor-related operating units qualify for aggregation under SFAS No. 131, due to their customer base and similarities in economic characteristics, nature of products and services, and procurement, manufacturing and distribution processes. In the third quarter of 2004, we acquired Peter Wolters AG. Due to the diversity of Peter Wolters’ existing product lines and customer base from the Semiconductor Group, we have determined that the qualitative thresholds required for aggregation under SFAS No. 131 have not been met. As a result, we have included a new segment in our disclosures for the year ended December 31, 2004 and subsequent periods. This segment is referred to as the Industrial Applications Group. This segment had no reportable activity prior to the acquisition of Peter Wolters. Since we operated primarily in one segment, with one group of similar products and services prior to the third quarter of 2004, all financial segment and product line information required by SFAS No. 131 prior to the third quarter of 2004 can be found in the Condensed Consolidated Financial Statements.

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.


	Three months ended October 1, 2005						Nine months ended October 1, 2005
	(in thousands)						(in thousands)
			Industrial						Industrial
	Semiconductor		Applications				Semiconductor		Applications
	Group		Group		Consolidated		Group		Group		Consolidated
Sales to unaffiliated customers	$	313,389	$	25,489	$	338,878	$	923,911	$	84,292	$	1,008,203

Operating income	$	26,763	$	2,442	$	29,205	$	100,357	$	12,708	$	113,065

Long-lived assets	$	424,031	$	16,886	$	440,917	$	424,031	$	16,886	$	440,917
All other identifiable assets		1,764,418		169,616		1,934,034		1,764,418		169,616		1,934,034

Total assets	$	2,188,449	$	186,502	$	2,374,951	$	2,188,449	$	186,502	$	2,374,951


	Three months ended September 25, 2004							Nine months ended September 25, 2004
	(in thousands)							(in thousands)
			Industrial							Industrial
	Semiconductor		Applications					Semiconductor		Applications
	Group		Group			Consolidated		Group		Group			Consolidated
Sales to unaffiliated customers	$	394,219	$	21,716		$	415,935	$	987,088	$	29,928		$	1,017,016

Operating income (loss)	$	83,183	$	(1,836	)	$	81,347	$	155,737	$	(785	)	$	154,952

Long-lived assets	$	464,888	$	21,341		$	486,229	$	464,888	$	21,341		$	486,229
All other identifiable assets		1,714,996		197,208			1,912,204		1,714,996		197,208			1,912,204

Total assets	$	2,179,884	$	218,549		$	2,398,433	$	2,179,884	$	218,549		$	2,398,433

14. SUBSEQUENT EVENT

In the period from October 2, 2005 to November 1, 2005 we repurchased approximately 5.1 million shares of our common stock at an average repurchase price of $21.53.

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

This Quarterly Report on Form 10-Q contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included 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 significant impact on our results of operations, net operating cash flows and net financing cash flows resulting from our expected adoption of Statement 123(R); our estimated amortization expense for each of the next five fiscal years; the payment of our future rent obligations through 2017; 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 focus on improving gross margins; our continued outsourcing of manufacturing functions; our belief that we will experience a higher level of warranty costs for another quarter with improvements thereafter; our expectation that sustainable improvement in gross margins may be realized after several quarters; our continued belief that significant investment in research and development is required to remain competitive; ; our intention to consolidate operations and streamline our CMP product offerings; our belief that most of the Company’s deferred tax assets will be realized due to anticipated future income; our expectation that the effect of exchange rate changes on forward exchange contracts will offset the effect of exchange rate changes on the underlying hedged items; our belief that our forward foreign exchange contracts do not subject us to the speculative risk of changes in currency exchange rates; our belief that our current cash position, cash generated through operations and equity offerings, and available borrowing capacity will be sufficient to meet our needs through the next twelve months; our belief that the ultimate outcome of the Linear Technology Corporation litigation and various other litigations that have arisen in the normal course of business will not have a material adverse effect on our business, financial condition or results of operations; and our intent to continue pursuing the legal defense of our proprietary technology primarily through patent and trade secret protection.

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: significant compensation charges resulting from the adoption of SFAS 123(R); 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; 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; economic developments that result in a delay in the consolidation of our operations and the streamlining of our CMP product offerings; inaccuracies in management’s assessment of the amount of the Company’s valuation allowance for deferred tax assets; the ineffectiveness of our foreign exchange contracts to protect against adverse exchange rate movements; unanticipated need for additional liquid assets in the next twelve months; our failure to accurately predict the effect of the ultimate outcome of current litigation on our business, financial condition or results of operations; inherent uncertainty in the outcome of litigation matters; and our potential inability to enforce our patents and protect our trade secrets.

The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties set forth under the heading “Risk Factors” in this Item 2 of Part I, and are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of 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, 2004 and in our other filings with the Securities and Exchange Commission (SEC), including our Forms 10-Q and 8-K and our Annual Report to Shareholders.

Introduction

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

	•		Overview of our Business and Industry;

	•		Results of Operations;

	•		Critical Accounting Policies;

	•		Liquidity and Capital Resources;

	•		Related Party Transactions; and

	•		Risk Factors.

Overview of Our Business and Industry

Novellus is 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 as a leading supplier of semiconductor processing equipment. 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 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
	2005						2004
	First		Second		Third		First		Second		Third		Fourth
	Quarter		Quarter		Quarter		Quarter		Quarter		Quarter		Quarter
Net sales	$	339,740	$	329,585	$	338,878	$	262,862	$	338,219	$	415,935	$	340,272
Gross profit		153,869		157,562		147,194		124,605		169,680		201,111		169,734
Net income		30,471		33,231		23,415		16,681		37,811		64,662		37,536
Diluted net income per share		0.22		0.24		0.17		0.11		0.25		0.45		0.27
Net orders		301,594		309,214		286,929		346,793		397,598		422,692		331,347

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 2004, we experienced a significant increase in demand for our products. In the first three quarters of 2004, we experienced sequential increases in net orders of 26%, 15%, and 6%, respectively. The net order growth in

2004 was driven primarily by strengthening demand for corporate and consumer electronic devices, which resulted in an increase in our customers’ capacity utilization. In the fourth quarter of 2004, demand began to slow and we experienced a 22% decrease in net orders, followed by a 9% sequential decrease in net orders in the first quarter of 2005, a 3% sequential increase in net orders in the second quarter of 2005 and a 7% sequential decrease in net orders for the third quarter of 2005. 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
(dollars in thousands)

At the beginning of the third quarter of 2004, we acquired Peter Wolters AG, a manufacturer of high-precision machine manufacturing tools. The acquisition was accounted for as a purchase business combination in accordance with SFAS No. 141. Our consolidated financial statements include the financial position, results of operations and cash flows of Peter Wolters from the beginning of the third quarter of 2004.

Net Sales


	Three Months Ended									Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
Net sales	$	338,878		$	415,935		$	329,585		$	1,008,203		$	1,017,016
International net sales %		75	%		78	%		76	%		74	%		78	%

As compared to the prior year period, net sales during the three months ended October 1, 2005 decreased by $77.0 million. This net decrease is comprised of a decrease of $80.8 million in the Semiconductor Group offset by an increase of $3.8 million in the Industrial Applications Group. The decrease in net sales in the Semiconductor Group is primarily attributable to lower volumes resulting from reduced capital spending by our customers.

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


	Three Months Ended						Nine Months Ended
	October 1, 2005		September 25, 2004		July 2, 2005		October 1, 2005		September 25, 2004
North America		25%		22%		24%		26%		22%
Europe		13%		11%		8%		10%		9%
Asia		62%		67%		68%		64%		69%

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									Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
Gross profit	$	147,194		$	201,111		$	157,562		$	458,625		$	495,396
% of net sales		43	%		48	%		48	%		45	%		49	%

Our gross profit is affected by the treatment of certain product sales in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition.” 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 decline in the gross profit percentage in the three and nine months ended October 1, 2005 from the prior year comparable periods is primarily related to the $5.2 million inventory write-down related to the restructuring of our CMP product portfolio, higher warranty costs associated with new 300mm tools during the early period of installation, lower absorption of manufacturing overhead, reductions in product selling price and other timing-related effects.

We are focused on improving our gross margins. This process involves 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. We believe that we will experience a higher level of warranty costs for another quarter with improvement thereafter. The effort to make sustainable improvement in gross margins may take several quarters.

Selling, General and Administrative (SG&A)


	Three Months Ended									Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
SG&A expense	$	53,365		$	49,585		$	50,325		$	155,450		$	139,213
% of net sales		16	%		12	%		15	%		15	%		14	%

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 nine months ended October 1, 2005 from last year’s comparable periods is primarily due to higher selling costs and the increased expense from our IAG segment, which was formed subsequent to the acquisition of Peter Wolters AG. SG&A expenses for the IAG segment were essentially flat in the three months ended October 1, 2005, but contributed an extra $9.5 million in expense for the nine months ended October 1, 2005 due to the additional periods that Peter Wolters is reflected in our consolidated financial statements. SG&A expense for the nine months ended October 1, 2005 was positively impacted by the reduction of our allowance for doubtful accounts by $6.1 million. SG&A expense for the three and nine months ended September 25, 2004 was positively impacted by a credit of $8.1 million for the reversal of amounts previously accrued in connection with our favorable settlement with Applied Materials, Inc.

Research and Development (R&D)


	Three Months Ended						Nine Months Ended
	October 1, 2005		September 25, 2004		July 2, 2005		October 1, 2005		September 25, 2004
R&D expense	$61,263		$68,202		$63,512		$186,823		$190,630
% of net sales	18	%	16	%	19	%	19	%	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. Changes in R&D expense, as a percentage of sales, for the three and nine months ended October 1, 2005 from the comparable prior year periods are primarily due to changes in sales volume. The IAG segment R&D expense was slightly down in the three months ended October 1, 2005, but contributed an extra $2.3 million in expense for the nine months ended October 1, 2005 due to the additional periods that Peter Wolters is reflected in our consolidated financial statements. Our significant investment in R&D over the past several years reflects 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 are reviewing our R&D portfolio to determine if the current programs are forecasted to produce an acceptable return on investment.

Restructuring and Other Charges


	Three Months Ended						Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
Restructuring and other charges	$	3,361		$	(923	)	$	(74	)	$	3,287		$	(923	)
% of net sales		1	%	Less than 1		%	Less than 1		%	Less than 1		%	Less than 1		%

During the quarter ended October 1, 2005, we announced that we intend to consolidate operations and streamline our CMP product offerings. In connection with this decision, we recorded a charge of approximately $6.3 million, primarily related to the write-down of property and equipment and accelerated depreciation associated with certain leasehold improvements. This charge was offset by a $3.0 million reversal of a previously recorded restructuring accrual. During the period ended September 25, 2004, we reversed approximately $0.9 million of a previously recorded restructuring accrual.

Legal Settlement


	Three Months Ended									Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
Legal settlement	$	—		$	2,900		$	—		$	—		$	5,400
% of net sales		—	%		1	%		—	%		—	%		1	%

The results for the three-month period ended September 25, 2004 included a $2.9 million legal settlement related to litigation with Semitool, Inc. The results for the nine-month period ended September 25, 2004 included, in addition to the above-mentioned settlement, a charge for $2.5 million for the then-pending settlement of an overtime class action lawsuit filed by field service engineers. No such charges were incurred in the comparable periods presented.

Acquired in-process research and development


	Three Months Ended									Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
Acquired in-process research and development	$	—		$	—		$	—		$	—		$	6,124
% of net sales		—	%		—	%		—	%		—	%		1	%

The results for the nine months ended September 25, 2004 included a charge of $6.1 million for acquired in-process research and development in connection with the acquisition of Angstron Systems, Inc. We incurred no such charges in the other periods presented.

Interest and Other Income, Net


	Three Months Ended									Nine Months Ended
	October 1, 2005			September 25, 2004			July 2, 2005			October 1, 2005			September 25, 2004
Interest and other income, net	$	2,405		$	9,726		$	3,674		$	9,548		$	15,371
% of net sales		1	%		2	%		1	%		1	%		2	%

Interest and other income, net, includes interest income, interest expense and other non-operating items. The decrease in interest and other income, net, in absolute dollars for the three and nine months ended October 1, 2005 compared to the three and nine months ended September 25, 2004 is primarily due to the cash receipt of $8.0 million in connection with the settlement of the Applied Materials, Inc. litigation during the three months ended September 25, 2004. This was partially offset by increased interest income associated with a rise in interest rates during the three and nine months ended October 1, 2005, as compared to the prior year periods.

Income Taxes

Our effective tax rates were 25.9% and 29.0% for the three months ended October 1, 2005 and September 25, 2004. Our effective tax rates were 28.9% and 30.0% for the nine months ended October 1, 2005 and September 25, 2004, respectively. The effective tax rate for the third quarter and nine-month period of 2005 includes the tax benefits from our restructuring charges of approximately $8.6 million at the applicable statutory tax rate. The effective tax rate for the second quarter of 2004 includes a $6.1 million in-process R&D charge, which is not deductible for income tax purposes and has no tax benefit. Excluding 2005 restructuring charges and a

2004 in-process R&D charge, our effective tax rates were 28.7% and 29.0% for the three months ended October 1, 2005 and September 25, 2004, and 29.6% and 29.0% for the nine months ended October 1, 2005 and September 25, 2004, respectively. Our future effective income tax rate depends on various factors, such as the company’s profits (losses) before taxes, tax legislation, the geographic composition of pre-tax income, and non-deductible expenses incurred in connection with acquisitions.

Critical Accounting Policies

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, inventory valuation, goodwill and other intangible assets, deferred tax assets, warranty obligations and restructuring and impairment charges. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the current circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition,” or SAB 104. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable, and collectibility is reasonably assured.

Certain of our equipment sales are accounted for as multiple-element arrangements. A multiple-element arrangement is a transaction which may involve the delivery or performance of multiple products, services, or rights to use assets, and performance may occur at different points in time or over different periods of time. Our equipment sales generally have two elements: delivery of the equipment and installation of the equipment/customer acceptance. If we have met defined customer acceptance experience levels with both the customer and the specific type of equipment, we recognize revenue for the equipment element upon shipment and transfer of title, with the installation and acceptance element recognized at customer acceptance. All costs associated with equipment sales accounted for as multiple-element arrangements are recognized upon shipment and transfer of title. All revenue and associated costs for all other equipment sales are recognized upon customer acceptance.

Installation services are not essential to the functionality of the delivered equipment. In accordance with EITF 00-21, “Revenue Arrangements with Multiple Deliverables,” we allocate revenue based on the residual method as a fair value has been established for installation services. However, since final payment is not typically billable until customer acceptance, we defer revenue for the final payment until customer acceptance.

Revenue related to sales of spare parts is recognized upon shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Unearned maintenance and service contract revenue is included in other accrued liabilities.

Inventory Valuation

We periodically assess the recoverability of all inventories, including raw materials, work-in-process, finished goods, and spare parts, to determine whether adjustments for impairment are required. Inventory that is obsolete or in excess of our forecasted usage is written down to its estimated realizable value based on assumptions about future demand and market conditions. If actual demand is lower than our forecast, additional inventory write-downs may be required.

Goodwill and Other Intangible Assets

We review our long-lived assets, including goodwill and other intangible assets, for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Our annual goodwill impairment test was completed in the fourth quarter of 2004. The first step of the test identifies when impairment may have occurred, while the second step of the test measures the amount of the impairment, if any. The results of our impairment tests did not indicate impairment.

Deferred Tax Assets

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. As of October 1, 2005, we had approximately $117.8 million of deferred tax assets, net of a valuation allowance of $76.8 million principally related to acquired net operating loss carryforwards and foreign tax credits that are not realizable until 2007 and beyond. The valuation allowance includes $40.4 million related to acquired deferred tax assets of SpeedFam-IPEC, which will be credited to goodwill when realized and $32.9 million related to stock option deductions, which will be credited to equity when realized. Management believes the net deferred tax assets will be realized due to anticipated future income. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. If in the future we determine that we would not be able to realize all or part of our net deferred tax assets, an increase to the valuation allowance for deferred tax assets would decrease income in the period in which such determination is made.

Warranty Obligations

Our warranty policy generally states that we will provide warranty coverage for a predetermined amount of time on systems and modules for material and labor to repair and service the equipment. We record the estimated cost of warranty coverage to cost of sales upon system shipment. The estimated cost of warranty is determined by the warranty term, as well as the average historical labor and material costs for a specific product. Should actual product failure rates or material usage differ from our estimates, revisions to the estimated warranty liability may be required. These revisions could have a positive or negative impact on gross profit. We have experienced a decline in our gross margins, partly as a result of changes in our liability for pre-existing warranties. These adverse changes to our liability may continue, causing negative affects on our future operating results. We review the actual product failure rates and material usage rates on a quarterly basis and adjust our warranty liability as necessary.

Restructuring and Impairment Charges

Restructuring activities initiated prior to December 31, 2002 were recorded in accordance with Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring),” and restructuring activities after December 31, 2002 were recorded under the provisions of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” or SFAS No. 146; SFAS No. 112, “Employers’ Accounting for Postemployment Benefits”; and SAB 100, “Restructuring and Impairment Charges,” or SAB 100. SFAS No. 146 requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred, rather than when the exit or disposal plan is approved.

We account for business combination restructurings under the provisions of EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” and SAB 100. Accordingly, restructuring accruals are recorded when management initiates an exit plan that will cause the Company to incur costs that have no future economic benefit. Certain restructuring charges related to long-lived asset impairments are recorded in accordance with SFAS No. 144.

The restructuring accrual related to vacated facilities is calculated net of estimated sublease income. Sublease income is estimated based on current market quotes for similar properties and expected occupancy dates. If we are unable to sublet these vacated properties as forecasted, if we are forced to sublet them at rates below our current estimates due to changes in market conditions, or if we change our sublease income estimate, we will adjust the restructuring accruals accordingly.

Foreign Currency Accounting

The local currency is the functional currency for all foreign operations. Accordingly, translation gains or losses related to our foreign subsidiaries are included as a component of accumulated other comprehensive income.

Foreign Exchange Contracts

We conduct portions of our business in various foreign currencies. We use forward foreign exchange contracts to hedge against the short-term impact of foreign currency fluctuations on intercompany accounts payable denominated in U.S. dollars and exposures to variability in anticipated non-U.S.-dollar-denominated cash flows. The maturities of these instruments are generally less than 12 months. For these derivatives, the gain or loss from the effective portion of the hedge is reported as a component of other comprehensive income and is reclassified into earnings in the same period in which the hedged transaction affects earnings, and within

the same income statement line item as the impact of the hedged transaction. The gain or loss from the ineffective portion of the hedge in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in interest and other, net during the period of change. We also enter into forward foreign exchange contracts to buy and sell foreign currencies to hedge the parent’s intercompany balances denominated in a currency other than the U.S. dollar. In 2005 and 2004, these hedging contracts were denominated primarily in the Taiwanese Dollar, the Singapore Dollar, the Euro and the Japanese Yen. The forward foreign exchange contracts we use are generally short-term in nature and the effect of exchange rate changes on these contracts is expected to offset the effect of exchange rate changes on the underlying hedged items. We believe these financial instruments do not subject us to speculative risk that would otherwise result from changes in currency exchange rates. Net foreign currency gains and losses for effective and ineffective hedges have not been material to our results of operations.

Liquidity and Capital Resources

We have historically financed our operating and capital resource requirements through cash flows from operations, sales of equity securities and borrowings. Our primary source of cash at October 1, 2005 consisted of $731.0 million of cash, cash equivalents and short-term investments. This amount represents an increase of $143.2 million from $587.8 million at December 31, 2004. The increase was due primarily to net cash provided by operating activities of $216.6 million, offset by our repurchases of common stock for $82.8 million.

Net cash provided by operating activities during the nine months ended October 1, 2005 was $216.6 million. This amount consisted primarily of $87.1 million provided by net income, adjusted for non-cash items. The net changes in working capital accounts provided $44.8 million.

Net cash used in investing activities for the nine months ended October 1, 2005 was $217.9 million, which consisted primarily of purchases of short-term investments of $615 million, offset by proceeds from short-term investment sales and maturities of $403.5 million. As of October 1, 2005, we had no significant commitments to purchase property or equipment.

Net cash used in financing activities for the nine months ended October 1, 2005 was $72.5 million, primarily for the repurchase of common stock for $82.8 million and payments on long-term debt of $19.8 million, offset by proceeds from employee stock compensation plans of $26.9 million and net proceeds from lines of credit of $3.2 million.

Effective June 25, 2004, two of our European subsidiaries entered into a credit arrangement that allowed for borrowings of up to $153.1 million. On June 28, 2004, we borrowed the entire amount available to fund the acquisition of Peter Wolters AG and for general corporate purposes. Borrowings are secured by cash or marketable securities on deposit and included within restricted cash on the consolidated balance sheet. As of October 1, 2005, $125.1 million of the loan was outstanding. All borrowings under the credit arrangement are due and payable on or before June 28, 2009.

Our subsidiaries in Asia and Europe have lines of credit with various banks with total borrowing capacity of $48.2 million. The lines of credit bear interest at various rates, expire on various dates through August 2006 and can be used for general operating purposes. Borrowings of $6.2 million were outstanding under these credit facilities as of October 1, 2005.

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

Risk Factors

Set forth below and elsewhere in this Quarterly Report on Form 10-Q and in other documents we file with the Securities and Exchange Commission, are risks and uncertainties that could cause actual results to differ materially from the results expressed or implied by the forward-looking statements contained in this Quarterly Report.

Cyclical Downturns in the Semiconductor Industry

Our business depends predominantly on the capital expenditures of semiconductor manufacturers, which in turn depend on current and anticipated market demand for integrated circuits and the products that use them. The semiconductor industry has historically been very cyclical and has experienced periodic downturns that have had a material adverse effect on the demand for semiconductor processing equipment, including equipment that we manufacture and market. The rate of changes in demand is accelerating, rendering

the global semiconductor industry increasingly volatile. During periods of reduced and declining demand, we must be able to quickly and effectively align our costs with prevailing market conditions, as well as motivate and retain key employees and maintain a stable management team. In particular, our inventory levels during periods of reduced demand have at times been higher than optimal, relative to the current levels of production demand. 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 and/or develop sufficient manufacturing capacity to meet customer demand, and hire and assimilate a sufficient number of qualified people. In each of 2001 through 2005, we have implemented restructuring plans to align our business with fluctuating conditions, and future restructuring plans may be required to respond to accelerating changes. Net orders and net sales may be adversely affected if we fail to respond to changing industry cycles in a timely and effective manner. After experiencing a significant increase in demand throughout the first, second and third quarters of 2004, we experienced a downturn in demand in the fourth quarter of 2004 and the first quarter of 2005, with a slight increase in the second quarter of 2005 and a decrease in the third quarter of 2005. We cannot assure our investors that this increase will be sustainable, and our net sales and operating results may be adversely affected if demand does not continue to recover and if downturns or slowdowns in the rate of capital investment in the semiconductor industry occur in the future.

The Semiconductor Industry is Extremely Competitive and Capital-Intensive

We face substantial competition in the industry, from both potential new market entrants as well as established competitors. Competitors may have greater financial, marketing, technical or other resources, and greater ability to respond to pricing pressures, than we do, as well as broader product lines, greater customer service capabilities, or larger and more established sales organizations and customer bases. To maintain or capture a leadership 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, which increases the likelihood of continued relationships with select 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 — both of which typically involve a significant capital commitment. From time to time, we have experienced delays in finalizing system sales following initial system qualification. Due to these and other factors, our systems typically have a lengthy sales cycle, during which we may expend substantial funds and management effort. Heightened competition may also force price reductions that could adversely affect our results of operations.

Rapidly Changing Technology

We devote a significant portion of our personnel and financial resources to research and development programs, and we seek to maintain close relationships with our customers in order to remain responsive to their product needs. Our success will depend 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 that addresses changing customer needs in a range of materials, including copper and aluminium, at ever-smaller nodes, while maintaining our focus on manufacturing 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.

As is typical in the semiconductor capital equipment market, technological innovations have long development cycles and we have experienced delays from time to time in the introduction of, and certain technical and manufacturing difficulties with, certain of our products and product enhancements. In addition, we may experience delays and 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 and providing competitive incentives for highly qualified design and engineering personnel, timely and efficient completion of product design and development and implementation of manufacturing and assembly processes, product performance in the field, and effective sales and marketing. There can be no assurance that we will be successful in selecting, developing, manufacturing and marketing new products, or in enhancing our existing products. 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 and warranty expenses may result. Any of these events could materially adversely affect our business, financial condition or results of operations.

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;

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

	•		Governmental controls, either by the United States or other countries, that restrict or make costly the operation of our business overseas and the import or export of semiconductor products;

	•		Longer payment cycles and difficulties in collecting accounts receivables 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;

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

	•		Fluctuations in interest and foreign currency exchange rates, creating the need to enter into forward foreign exchange contracts to hedge against the short-term impact of foreign currency fluctuations, specifically yen-denominated transactions. 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 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.

Variability of Quarterly Operating Results

We have experienced and expect to continue experiencing significant fluctuations in our quarterly operating results, which may adversely affect our share price. These fluctuations are due to a number of factors that 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;

	•		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;

	•		Fluctuation in warranty costs; and

	•		Overall business conditions in the semiconductor equipment industry.

Changes in Tax Rates or Liabilities Could Affect Future Results

We are subject to taxation in the U.S. and other foreign 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 and other tax authorities. 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 than the treatment reflected in our historical income tax provisions and accruals.

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.

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 acquisition of Peter Wolters 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, relative to 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 significant employees, customers or suppliers, that are necessary to compete in or lead 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.

Concentration of Net Sales

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

Intellectual Property

We intend to continue to seek legal protection, primarily through patents and trade secrets, for our proprietary technology. 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 rights granted thereunder will provide competitive advantages to us, given the speed with which technology becomes obsolete in the semiconductor industry. Our competitors may develop and obtain patents to 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 proprietary rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties, or prevent us from manufacturing or selling our products. However, we are not aware of any significant claim of infringement by our products of any patent or proprietary rights of others. Regardless of the merit of any legal disputes, we incur substantial costs to prosecute or defend our intellectual property rights. In addition, 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 consultants and other parties. If these agreements are breached, our remedies may not be sufficient to cover our losses.

Supply Shortages

We use numerous suppliers to obtain parts, components and sub-assemblies for the manufacture and support of our products. Although we make reasonable efforts to ensure that such parts are available from multiple suppliers, certain key parts may only be obtained from 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 and/or a small group of other companies in the semiconductor industry. Our supply channels may be vulnerable to disruption. Any such disruption that may result in a prolonged inability to obtain certain parts, or termination of supplier relationships may adversely effect our operations and ability to meet customer demands.

Outsourcing Activities

We also outsource the manufacture of major 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 and manufacturing disruptions 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 will affect our ability to respond to pricing pressures from competitors and customers, and our profitability.

Outside Audit Firm Independence

Our independent registered public accounting firm communicates with us at least annually regarding any relationships between the firm and Novellus that, in the firm’s professional judgment, might have a bearing on the firm’s independence with respect to Novellus.

If our independent registered public accounting firm finds that it cannot confirm that it is independent of Novellus based on existing securities laws and registered public accounting firm independence standards, we could experience delays or otherwise fail to meet our regulatory reporting obligations.

Costs of Corporate Governance and Financial Reporting Compliance

To comply with the requirements of the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and adopted by Nasdaq in response to Sarbanes-Oxley, we have made changes to our financial reporting, securities disclosure and corporate governance practices. We may incur increased legal and financial compliance costs due to these new and evolving rules, regulations, and listing requirements, and management time and resources may be re-directed to ensure current and implement future compliance initiatives. These rules may make it more difficult for us to attract and retain qualified executive officers and members of our Board of Directors, particularly to serve on our audit committee, as well as make it more costly to obtain liability coverage for our officers and directors.

Third-Party Indemnification

From time to time, in the normal course of business, we indemnify third parties with whom we enter into contractual relationships, including customers, lessors, and parties to other transactions with us, with respect to certain matters. We have agreed, under certain conditions, to hold these third parties harmless against specified losses, such as those arising from a breach of representations or covenants, other third party claims that our products when used for their intended purposes infringe the intellectual property rights of such other third parties or other claims made against certain parties. If our customers become involved in legal disputes in which they contend that we allegedly have indemnification obligations, we may be subject to potential liability. It is not possible 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. Historically, payments made by us under these obligations have not been material.

Changes in Accounting Standards for Stock Option Plans

Beginning in our first fiscal quarter of 2006, SFAS 123(R) will require us to recognize compensation expense in our statement of operations for the fair value of unvested employee stock options at the date of adoption and new stock options granted to our employees after the adoption date over the related vesting periods of the stock options. The requirement to expense stock options granted to employees reduces their attractiveness because the expense associated with these grants may result in future compensation charges. In addition, the expenses recorded may not accurately reflect the value of our stock options because the option pricing models required by SFAS 123(R) were not developed for use in valuing employee stock options and are based on highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Alternative compensation arrangements that can replace stock option programs may also negatively impact profitability. Stock options remain an important employee recruitment and retention tool, and we may not be able to attract and retain key personnel if we reduce the scope of our employee stock option program following the adoption of SFAS 123(R). Our employees are critical to our ability to develop and design systems that advance our productivity and technology goals, increase our sales goals and provide support to customers. Accordingly, as a result of the requirement under SFAS 123(R) to recognize the fair value of stock options as compensation expense, beginning in the first quarter of 2006, our future profitability can be expected to be reduced.

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 enquiries 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. Also, the securities in which the fund may invest may not be registered under the Securities Act 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 adversely impact our business, financial condition and operating results.

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, 2004. Our exposure related to market risk has not changed materially since December 31, 2004.

ITEM 4: CONTROLS AND PROCEDURES

Quarterly Evaluation of Our Disclosure Controls and Internal Controls

As of the end of the period covered by this Quarterly Report on Form 10-Q, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures and our internal controls and procedures for financial reporting. This controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Rules adopted by the Securities and Exchange Commission, or the SEC, require that in this section of the Quarterly Report on Form 10-Q, we present the conclusions of the CEO and the CFO about the effectiveness of our disclosure controls and internal controls for financial reporting based on and as of the date of the controls evaluation.

CEO and CFO Certifications

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

Disclosure Controls and Internal Controls for Financial Reporting

Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, or the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Internal controls for financial reporting are procedures which are designed with the objective of providing reasonable assurance that our transactions are properly authorized, our assets are safeguarded against unauthorized or improper use and our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with U.S. generally accepted accounting principles.

Limitations on the Effectiveness of Controls

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

Scope of the Controls Evaluation

The evaluation of our disclosure controls and our internal controls for financial reporting by our Chief Executive Officer and our Chief Financial Officer included a review of the 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. generally accepted accounting principles.

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 October 1, 2005. For more detailed information on litigation matters outstanding please see Item 3 “Legal Proceedings,” in our Annual Report on Form 10-K for the year ended December 31, 2004.

Linear Technology Corporation

Other Litigation

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

Repurchase of Company Securities

Total

Number of

Approximate

Shares

Dollar Value

Purchased

of Shares

as Part of

that May Yet

Total

Publicly

Be Purchased

Number of

Average Price

Announced

Under the

Shares

Paid per

Plans or

Period

Purchased

Share

Programs

July 3, 2005 to August 6, 2005

—

$1,020.1 million

August 7, 2005 to September 3, 2005

—

$1,020.1 million

September 4, 2005 to October 1, 2005

500,000

26.24

500,000

$1,007.0 million

Total

500,000

26.24

500,000

$1,007.0 million

On February 23, 2004 we announced that our Board of Directors had approved a stock repurchase plan that authorized the repurchase of up to $500.0 million of our outstanding common stock through February 13, 2007. On September 20, 2004 we announced that our Board of Directors had authorized an additional $1.0 billion for repurchase of our outstanding common stock through September 14, 2009. We may repurchase shares from time to time in the open market, through block trades or otherwise. The repurchases may be commenced or suspended at any time or from time to time without prior notice depending on prevailing market conditions and other factors.

ITEM 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 4, 2005 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 4, 2005 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 4, 2005 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 4, 2005 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 October 1, 2005 and September 25, 2004		3
Condensed Consolidated Balance Sheets as of October 1, 2005 and December 31, 2004		4
Condensed Consolidated Statements of Cash Flows for the nine months ended October 1, 2005 and September 25, 2004		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		28
Item 4: Controls and Procedures		28
Part II: Other Information
Item 1: Legal Proceedings		29
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 and Chief Accounting Officer) November 4, 2005

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents