Novellus Systems (NVLS) 10-Q 2008 Q2 Quarterly report

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 June 28, 2008

OR

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

For the transition period from              to             

Commission File Number 000-17157

NOVELLUS SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)

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

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

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

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

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

Large accelerated filer  þ	Accelerated filer  ¨	Non-accelerated filer  ¨	Smaller reporting company  ¨
		(Do not check if a smaller reporting company)

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

As of August 1, 2008, 99,149,924 shares of the Registrant’s common stock, no par value, were issued and outstanding.

NOVELLUS SYSTEMS, INC.

FORM 10-Q

QUARTER ENDED JUNE 28, 2008

TABLE OF CONTENTS

	Page
Part I: Financial Information
Item 1: Condensed Consolidated Financial Statements	3
Condensed Consolidated Statements of Operations for the three and six months ended June 28, 2008 and June  30, 2007	3
Condensed Consolidated Balance Sheets as of June 28, 2008 and December 31, 2007	4
Condensed Consolidated Statements of Cash Flows for the six months ended June 28, 2008 and June 30, 2007	5
Notes to Condensed Consolidated Financial Statements	6
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3: Quantitative and Qualitative Disclosures About Market Risk	24
Item 4: Controls and Procedures	24
Part II: Other Information
Item 1: Legal Proceedings	26
Item 1A: Risk Factors	26
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 4: Submission of Matters to a Vote of Security Holders	33
Item 6: Exhibits	34
Signatures	35
EXHIBIT 10.19
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

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PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended					Six Months Ended
	June 28, 2008			June 30, 2007		June 28, 2008		June 30, 2007
	(In thousands, except per share amounts)
Net sales	$	257,740		$	416,335	$	572,453	$	813,309
Cost of sales		146,777			208,225		316,550		410,290
Gross profit		110,963			208,110		255,903		403,019
Operating expenses:
Selling, general and administrative		62,530			72,011		122,859		139,111
Research and development		59,815			63,374		117,155		123,774
Total operating expenses		122,345			135,385		240,014		262,885
Operating income (loss)		(11,382	)		72,725		15,889		140,134
Interest and other income, net:
Interest income, net		2,277			8,418		5,079		16,388
Other income, net		2,639			6,179		946		9,316
Total interest and other income, net		4,916			14,597		6,025		25,704
Income (loss) before provision for income taxes		(6,466	)		87,322		21,914		165,838
Provision for (benefit from) income taxes		(4,081	)		29,977		8,770		54,710
Net income (loss)	$	(2,385	)	$	57,345	$	13,144	$	111,128
Net income (loss) per share:
Basic	$	(0.02	)	$	0.46	$	0.13	$	0.90
Diluted	$	(0.02	)	$	0.45	$	0.13	$	0.88
Shares used in basic per share calculations		98,202			123,788		99,429		123,887
Shares used in diluted per share calculations (1)		98,202			126,630		100,131		126,792

(1) Potentially dilutive shares of 0.7 million were excluded from the three months ended June 28, 2008 due to the Net loss recorded in the period, as their inclusion would have been anti-dilutive. See Note 2 to Condensed Consolidated Financial Statements.

See accompanying notes to Condensed Consolidated Financial Statements.

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NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	June 28, 2008		December 31, 2007 *
(In thousands)	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	191,773	$	175,071
Short-term investments		237,033		421,695
Accounts receivable, net		218,312		346,866
Inventories		229,116		212,995
Deferred tax assets, net		33,123		48,965
Restricted cash and cash equivalents, current		166,193		—
Prepaid and other current assets		27,317		18,366
Total current assets		1,102,867		1,223,958
Property and equipment, net		298,287		320,009
Restricted cash and cash equivalents		3,673		161,050
Investments		110,069		—
Goodwill		246,582		238,944
Intangible and other assets		119,460		132,982
Total assets	$	1,880,938	$	2,076,943
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	59,442	$	97,135
Accrued payroll and related expenses		45,094		73,273
Accrued warranty		41,361		54,857
Other accrued liabilities		43,984		50,183
Deferred profit		41,486		52,252
Current debt obligations		152,560		1,509
Total current liabilities		383,927		329,209
Long-term debt		1,447		143,267
Long-term income taxes payable		27,846		27,408
Other non-current liabilities		45,676		47,972
Total liabilities		458,896		547,856
Commitments and contingencies
Shareholders’ equity:
Common stock		1,173,198		1,219,533
Retained earnings		245,100		304,278
Accumulated other comprehensive income		3,744		5,276
Total shareholders’ equity		1,422,042		1,529,087
Total liabilities and shareholders’ equity	$	1,880,938	$	2,076,943

* Amounts are derived from the December 31, 2007 audited consolidated financial statements.

See accompanying notes to Condensed Consolidated Financial Statements.

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NOVELLUS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended
	June 28, 2008			June 30, 2007
	(In thousands)
Cash flows from operating activities:
Net income	$	13,144		$	111,128
Adjustments to reconcile net income to net cash provided by operating activities:
Loss on disposal of property and equipment		2,138			50
Depreciation and amortization		32,923			33,817
Deferred income taxes		13,094			15,910
Stock-based compensation		16,897			18,022
Tax benefit realized from stock-based compensation		692			2,836
Excess tax benefit from stock-based compensation		(56	)		(649	)
Other-than-temporary impairment of short-term investment		737			—
Other non-cash charges, net		1,259			1,392
Changes in operating assets and liabilities:
Accounts receivable		132,027			(112,119	)
Inventories		(9,797	)		(33,851	)
Prepaid and other assets		17,703			(15,331	)
Accounts payable		(23,624	)		10,135
Accrued payroll and related expenses		(24,666	)		(10,660	)
Accrued warranty		(13,795	)		3,257
Other liabilities		(21,889	)		29,324
Deferred profit		(11,613	)		14,160
Net cash provided by operating activities		125,174			67,421
Cash flows from investing activities:
Proceeds from sales of short-term and long-term investments		285,950			465,106
Proceeds from maturities of short-term investments		69,410			124,695
Purchases of short-term investments		(290,323	)		(593,364	)
Capital expenditures		(10,936	)		(20,528	)
Proceeds from sale of property and equipment		—			275
Increase in restricted cash and cash equivalents		(8,816	)		(4,432	)
Net cash provided by (used in) investing activities		45,285			(28,248	)
Cash flows from financing activities:
Proceeds from employee stock compensation plans		5,699			29,940
Repayments of lines of credit, net		(36	)		(1,941	)
Payments on long-term debt		—			(21	)
Repurchases of common stock		(160,153	)		(56,830	)
Excess tax benefit from stock-based compensation		56			649
Net cash used in financing activities		(154,434	)		(28,203	)
Effects of exchange rate changes on cash and cash equivalents		677			943
Net increase in cash and cash equivalents		16,702			11,913
Cash and cash equivalents at the beginning of the period		175,071			58,463
Cash and cash equivalents at the end of the period	$	191,773		$	70,376

See accompanying notes to Condensed Consolidated Financial Statements.

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NOVELLUS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. The interim financial information is unaudited and does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 28, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008 or any future period. The interim financial statements should be read in conjunction with the Consolidated Financial Statements and footnotes thereto included in Novellus’ Annual Report on Form 10-K for the year ended December 31, 2007.

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

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

Derivatives

Our policy is to enter into foreign currency forward exchange contracts with maturities of less than 12 months to mitigate the impact of currency exchange fluctuations (a) on probable anticipated system sales denominated in Japanese yen; (b) on our net investment in certain foreign subsidiaries; and (c) on existing monetary asset and liability balances denominated in foreign currencies. In accordance with Statement of Financial Accounting Standard (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), all derivatives are recorded at fair value in either Prepaid and other current assets or Other accrued liabilities. Cash flows from derivative instruments are reported in cash flows from operating activities. The income approach was used to value our derivative instruments using inputs other than quoted prices, including interest rates and credit risk, which are observable for the asset or liability.

Cash Flow Hedges

We designate and document as cash flow hedges foreign currency forward exchange contracts on sales transactions in which costs are denominated in U.S. dollars and the related revenues are generated in Japanese yen. We evaluate and calculate each hedge’s effectiveness at least quarterly, using the dollar offset method, comparing the change in the forward contract’s fair value on a spot-to-spot basis to the spot-to-spot change in the anticipated transaction. The effective change is recorded in Other comprehensive income (OCI) until the sale is recognized. Ineffectiveness, along with the excluded time value of the forward contracts, is recorded in Net sales as designated at the inception of the forward contract. During the three months ended June 28, 2008 and June 30, 2007, gains of $0.1 million and $1.3 million, respectively, were recorded in Net sales due to hedge ineffectiveness. During the six months ended June 28, 2008 and June 30, 2007, gains of $0.4 million and $1.9 million, respectively, were recorded in Net sales due to hedge ineffectiveness. In the event it becomes probable that an anticipated hedged transaction will not occur as a result of the associated shipment date pushing outside of the forecasted range, the gains or losses on the related cash flow hedges are immediately reclassified from accumulated OCI to Net sales in the Condensed Consolidated Statement of Operations. During each of the three and six months ended June 28, 2008 and June 30, 2007, we reclassified $0.7 million from OCI into Net sales as a result of the discontinuance of hedged anticipated transactions.

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The following table summarizes the pre-tax impact of cash flow hedges on OCI during the three and six months ended June 28, 2008 and June 30, 2007.

	Three Months Ended						Six Months Ended
	June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(In thousands)
Balance, beginning of period – losses	$	(2,261	)	$	(2,976	)	$	(2,578	)	$	(329	)
Effective portion of hedge remeasurement		1,359			3,868			(389	)		892
Reclassification to Cost of sales		—			—			—			329
Reclassification to Net sales		1,243			913			3,308			913
Balance, end of period – gains	$	341		$	1,805		$	341		$	1,805

We anticipate reclassifying the net gains recorded as of June 28, 2008 from OCI to Net sales within 12 months.

Net Investment Hedges

We hedge our net investment in certain foreign subsidiaries to reduce economic currency risk. The foreign currency forward exchange contracts used to hedge this exposure are designated and documented as net investment hedges. Effectiveness is evaluated at least quarterly, excluding time value, and hedges are highly effective when currency pairs and notional amounts on the forward exchange contracts are properly aligned with the net investment in subsidiaries. Changes in the spot-to-spot value are recorded as foreign currency translation adjustments within OCI. Ineffectiveness, if any, along with the excluded time value of the forward contracts, is recorded as foreign currency gain or loss in Other income, net, and resulted in gains of $0.2 million and $0.1 million in the three months ended June 28, 2008 and June 30, 2007, respectively, and gains of $0.5 million and $0.4 million in the six months ended June 28, 2008 and June 30, 2007, respectively. A gain of $2.2 million and a loss of $0.3 million were recorded in OCI for net investment hedges during the three months ended June 28, 2008 and June 30, 2007, respectively, and losses of $1.7 million and $0.4 million were recorded in OCI during the six months ended June 28, 2008 and June 30, 2007, respectively.

Other Foreign Currency Hedges

We enter into foreign currency forward exchange contracts to (a) hedge intercompany non-U.S. dollar balances, (b) hedge certain third-party receivables denominated in Japanese yen and (c) hedge anticipated sales denominated in foreign currency that do not qualify for special hedge accounting treatment under SFAS 133 due to uncertainty surrounding the timing of shipment. The maturities of these contracts are generally less than 12 months. Gains or losses arising from the remeasurement of these contracts to fair value each period are recorded in Other income, net. During the three months ended June 28, 2008 and June 30, 2007, we recorded derivative gains on these hedges of $4.9 million and $2.9 million, respectively, and during the six months ended June 28, 2008 and June 30, 2007, we recorded a derivative loss on these hedges of $4.2 million and a derivative gain of $2.5 million, respectively.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which establishes specific criteria for the fair value measurements of financial and nonfinancial assets and liabilities that are already subject to fair value under current accounting rules. SFAS 157 also requires expanded disclosures related to fair value measurements. In February 2008, the FASB approved FASB Staff Position (FSP) FAS 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2) which allows companies to elect a one-year delay in applying SFAS 157 to certain fair value measurements of non-financial instruments, except for those recognized or disclosed at fair value on at least an annual basis. We elected the delayed adoption date for the portions of SFAS 157 impacted by FSP 157-2 and, as a result, we partially adopted SFAS 157 on January 1, 2008. The partial adoption of SFAS 157 was prospective and did not have a significant effect on our Condensed Consolidated Financial Statements. See Note 3 for information about fair value measurements. We are currently evaluating the impact of applying the deferred portion of SFAS 157 to the nonrecurring fair value measurements of our nonfinancial assets and nonfinancial liabilities. In accordance with FSP 157-2, the fair value measurements for these items will be adopted effective January 1, 2009.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of SFAS 115” (SFAS 159). SFAS 159 permits a company to voluntarily elect to use fair value, instead of historic or original cost, to account for certain financial assets and liabilities. The fair value option is designated on an item-by-item basis, is irrevocable and requires that changes in fair value in subsequent periods be recognized in earnings in the period of change. We

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adopted SFAS 159 on January 1, 2008. The adoption had no impact on our Condensed Consolidated Financial Statements as we did not make a fair value election for any of our existing financial assets and liabilities. Any election to use the fair value method for future eligible transactions will be made on a case-by-case and instrument-by-instrument basis.

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

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

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

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

Note 2. Net Income (Loss) Per Share

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

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

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

	Three Months Ended					Six Months Ended
	June 28, 2008			June 30, 2007		June 28, 2008		June 30, 2007
	(In thousands, except per share amounts)
Numerator:
Net income (loss)	$	(2,385	)	$	57,345	$	13,144	$	111,128
Denominator:
Basic weighted-average shares outstanding		98,202			123,788		99,429		123,887
Dilutive common equivalent shares		—			2,842		702		2,905
Diluted weighted-average shares outstanding		98,202			126,630		100,131		126,792
Net income (loss) per share – Basic	$	(0.02	)	$	0.46	$	0.13	$	0.90
Net income (loss) per share – Diluted	$	(0.02	)	$	0.45	$	0.13	$	0.88

For the three months ended June 28, 2008 and June 30, 2007, 20.9 million and 10.0 million shares, respectively, and 20.6 million and 10.2 million shares for the six months ended June 28, 2008 and June 30, 2007, respectively, attributable to outstanding stock options

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were excluded from the calculation of diluted net income per share because their inclusion would have been anti-dilutive. Generally options are considered anti-dilutive when their exercise prices are greater than or equal to the average market value of our common shares during the period of measurement or when a Net loss is recorded for the period. Restricted stock awards representing 0.8 million and 0.7 million shares for the six months ended June 28, 2008 and June 30, 2007, respectively, were excluded from the computation of diluted shares outstanding as the shares underlying these awards were subject to performance conditions that had not been met.

Note 3. Financial Instruments

We measure certain financial instruments at fair value on a recurring basis. Assets and liabilities measured at fair value on a recurring basis are as follows at June 28, 2008:

			Fair Value Measurement at Reporting Date Using
	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(In thousands)
Assets
Money market funds	$	320,778	$	320,778	$	—	$	—
Municipal bonds		183,567		—		183,567		—
Variable-rate demand notes		38,445		—		38,445		—
Auction-rate securities		112,055		—		—		112,055
Derivative assets (1)		3,357		—		3,357		—
Total	$	658,202	$	320,778	$	225,369	$	112,055
Liabilities
Derivative liabilities (1)	$	1,251	$	—	$	1,251	$	—
Total	$	1,251	$	—	$	1,251	$	—

(1) See Note 1 to Condensed Consolidated Financial Statements.

The table below presents a reconciliation of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and six months ended June 28, 2008. We classify financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs. There were no realized and unrealized gains or losses recorded in Net income due to changes in fair value for Level 3 assets and liabilities for the three and six months ended June 28, 2008.

	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
	Three Months Ended June 30, 2008						Six Months Ended June 30, 2008
	Auction-rate Securities			Total			Auction-rate Securities			Total
	(In thousands)
Balance, beginning of period	$	117,634		$	117,634			—			—
Total net gains or losses (realized and unrealized)
Included in Net income (loss)		—			—			—			—
Included in Other comprehensive income (loss)		(1,359	)		(1,359	)		(7,145	)		(7,145	)
Purchases, issuances and settlements, net		(4,220	)		(4,220	)		(4,220	)		(4,220	)
Transfers in and/or out of Level 3		—			—			123,420			123,420
Balance, end of period	$	112,055		$	112,055		$	112,055		$	112,055

Money Market Funds

Money market funds includes $154.6 million classified as Cash and cash equivalents and $166.2 million classified as Restricted cash and cash equivalents, current on our Condensed Consolidated Balance Sheet.

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Municipal Bonds

Municipal bonds are bonds issued by state and local governments and other governmental entities such as authorities or special districts. Of the $183.6 million in municipal bonds, $4.8 million are classified as Cash and cash equivalents and $178.8 million are classified as Short-term investments on our Condensed Consolidated Balance Sheet. The portion in Cash and cash equivalents represent highly liquid debt instruments with insignificant interest rate risk and original maturities of ninety days or less. The market approach was used to value our municipal bonds. We classified these securities as Level 2 instruments due to either our usage of observable market prices in less active markets or, when observable market prices were not available, our use of non-binding market prices that are corroborated by observable market data or quoted market prices for similar instruments.

Variable-Rate Demand Notes

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

Auction-Rate Securities

We have included the fair value of our auction-rate securities, of which $2.0 million are classified as Short-term investments and $110.1 million are classified as non-current assets on our Condensed Consolidated Balance Sheet, in the Level 3 category, as there are significant unobservable inputs to our cash-flow-based valuation model. Our auction-rate securities include auction-rate notes and auction-rate preferred shares of tax-exempt closed-end municipal funds. Our auction-rate notes consist of student loans that are substantially backed by the federal government. Beginning in February 2008, many of our auction-rate securities became illiquid as their scheduled auctions failed to settle. An auction failure occurs when the parties wishing to sell securities cannot. As a result, the affected securities begin to pay interest under their default interest rate features. We will not have access to these funds unless (a) future auctions are successful, (b) the securities are called by the issuer, (c) we sell the securities in a secondary market, or (d) the underlying notes mature. Currently no secondary market is active. As of June 28, 2008 we have recorded a temporary impairment charge of $7.1 million within OCI based upon our assessment of the fair value of our auction-rate securities. Our valuation of these securities incorporated our assumptions about the anticipated term and the yield that a market participant would require to purchase such a security in the marketplace.

Note 4. Inventories

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

	June 28, 2008		December 31, 2007
	(In thousands)
Purchased and spare parts	$	152,991	$	147,475
Work-in-process		45,134		39,105
Finished goods		30,991		26,415
Total inventories	$	229,116	$	212,995

Note 5. Goodwill and Intangible Assets

Goodwill

A summary of changes in goodwill during the six months ended June 28, 2008 is as follows:

	Semiconductor Group		Industrial Applications Group		Total
	(In thousands)
Balance as of December 31, 2007	$	108,431	$	130,513	$	238,944
Foreign currency translation adjustments		—		7,638		7,638
Balance as of June 28, 2008	$	108,431	$	138,151	$	246,582

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

Intangible Assets

The following tables provide details of our acquired intangible assets:

June 28, 2008	Weighted Average Amortization Period	Gross		Accumulated Amortization			Net
	(Years)			(In thousands)
Patents and other intangibles	12	$	16,670	$	(2,401	)	$	14,269
Developed technology	6		30,958		(25,169	)		5,789
Trademark	10		7,910		(3,164	)		4,746
Total intangible assets	8	$	55,538	$	(30,734	)	$	24,804
December 31, 2007	Weighted Average Amortization Period	Gross		Accumulated Amortization			Net
	(Years)			(In thousands)
Patents and other intangibles	12	$	16,661	$	(1,679	)	$	14,982
Developed technology	6		30,270		(22,169	)		8,101
Trademark	10		7,473		(2,616	)		4,857
Total intangible assets	8	$	54,404	$	(26,464	)	$	27,940

Our estimated amortization expense for currently recognized identifiable intangible assets is approximately $3.5 million in the next two quarters of 2008, and $4.5 million, $3.3 million, $2.2 million, $2.2 million and $2.2 million for the years ending December 31, 2009, 2010, 2011, 2012 and 2013, respectively. As of June 28, 2008, we had no identifiable intangible assets with indefinite lives.

Note 6. Product Warranty

We record the estimated cost of warranty coverage to Cost of sales when revenue is recognized. The estimated cost of warranty is determined by the warranty term as well as the average historical labor and material costs for a specific product. We review the actual product failure rates and material usage rates on a quarterly basis and adjust our warranty liability as necessary. Changes in the accrued warranty liability were as follows:

	Three Months Ended						Six Months Ended
	June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(In thousands)
Balance, beginning of period	$	49,531		$	55,236		$	54,857		$	55,349
Warranties issued		16,616			24,535			31,860			42,896
Settlements		(24,068	)		(21,112	)		(43,238	)		(39,729	)
Net changes in liability for pre-existing warranties, including expirations		(718	)		(9	)		(2,118	)		134
Balance, end of period	$	41,361		$	58,650		$	41,361		$	58,650

Note 7. Restructuring and Other Charges

As of June 28, 2008, substantially all actions under our restructuring plans were completed, except for payments of future rent obligations. The remaining excess facility costs are stated at estimated fair value, net of estimated sublease income. We expect to pay remaining obligations in connection with vacated facilities no later than the expiration dates of the lease terms, which expire on various dates through 2017. An adjustment of prior restructuring costs was made due to changes in estimated sublease income over the remaining lease term related to facilities previously included in our restructuring liability. This adjustment is included within Selling, general and administrative expenses. All remaining restructuring activity relates to the Semiconductor Group (see Note 12. Operating Segments).

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The following table summarizes our facilities restructuring activity for the six months ended June 28, 2008 and June 30, 2007:

	Three Months Ended						Six Months Ended
	June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(In thousands)
Balance, beginning of period	$	16,502		$	16,464		$	17,654		$	17,503
Adjustment of prior restructuring costs		1,042			—			1,042			—
Cash payments		(721	)		(764	)		(1,873	)		(1,803	)
Balance, end of period	$	16,823		$	15,700		$	16,823		$	15,700

In addition to the restructuring activity above, results of operations for the three months ended June 28, 2008 include $13.6 million of charges as a result of strategic decisions to focus on our core products and reduce our cost structure going forward. These charges include: (a) impairments of inventory and evaluation systems of $6.4 million, (b) write-downs of certain research and development assets of $3.8 million and (c) reductions in workforce of $3.4 million. Of these charges, $6.5 million are in Cost of sales, $4.3 million are in Research and development expenses and $2.8 million are in Selling, general and administrative expenses.

Note 8. Debt Obligations

As of June 28, 2008, we had borrowings of $154.0 million denominated in Euros and Swiss francs. The weighted-average interest rate on these borrowings was 4.5% as of June 28, 2008. Substantially all of these borrowings are secured by cash and cash equivalents and are due and payable on or before June 25, 2009. Amounts to secure these borrowings are included within Restricted cash and cash equivalents, current on our Condensed Consolidated Balance Sheet.

Note 9. Other Income, Net

The components of other income, net are as follows:

	Three Months Ended				Six Months Ended
	June 28, 2008		June 30, 2007		June 28, 2008			June 30, 2007
	(In thousands)
Other income and expenses, net	$	1,653	$	3,588	$	3,083		$	4,916
Other-than-temporary impairment of short-term investment		—		—		(737	)		—
Foreign currency gain (loss), net		986		2,591		(1,400	)		4,400
Total other income, net	$	2,639	$	6,179	$	946		$	9,316

Note 10. Shareholders’ Equity

Other Comprehensive Income (Loss)

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

	Three Months Ended						Six Months Ended
	June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(In thousands)
Net income (loss)	$	(2,385	)	$	57,345		$	13,144		$	111,128
Other comprehensive income (loss):
Foreign currency translation adjustments		(2,498	)		(752	)		3,132			(330	)
Unrealized loss on short-term and long-term investments		(2,107	)		(886	)		(7,561	)		(1,121	)
Unrealized gain on derivative instruments		2,602			4,781			2,919			2,134
Unrealized gain (loss) on minimum pension liability adjustment		9			11			(22	)		7
Comprehensive income (loss)	$	(4,379	)	$	60,499		$	11,612		$	111,818

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The components of accumulated other comprehensive income are as follows:

	June 28, 2008			December 31, 2007
	(In thousands)
Foreign currency translation adjustments	$	11,196		$	8,064
Unrealized loss on short-term and long-term investments		(7,574	)		(13	)
Unrealized gain (loss) on derivative instruments		341			(2,578	)
Unrealized loss on minimum pension liability adjustment		(219	)		(197	)
Accumulated other comprehensive income	$	3,744		$	5,276

Common Stock Repurchase Program

The Board of Directors has authorized the repurchase of our outstanding common stock, including approvals of $1.0 billion on September 14, 2004 and another $1.0 billion on October 26, 2007. As of June 28, 2008, we had $874.7 million available for stock repurchases under these authorizations. For the six months ended June 28, 2008 and June 30, 2007, 6.3 million and 1.8 million shares, respectively, were repurchased under this plan at a weighted average purchase price of $23.11 and $31.04, respectively.

Note 11. Litigation

Linear Technology Corporation

In March 2002, Linear Technology Corporation (Linear) filed a complaint against Novellus, among other parties, in the Superior Court of the State of California for the County of Santa Clara. The complaint seeks damages (including punitive damages), declaratory relief and injunctions for causes of action involving alleged breach of contract, fraud, unfair competition and breach of warranty. The Superior Court dismissed Linear’s claims for fraud and unfair competition on October 5, 2004. The Court of Appeal affirmed this dismissal on June 18, 2007. Trial on the remaining claims is currently set for November 10, 2008. At this time, we cannot predict the ultimate outcome of this case, nor can we estimate a range of potential loss, if any. However, we believe that the ultimate disposition of these matters will not have a material adverse effect on our business, financial condition or operating results.

Other Litigation

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

Note 12. Income Taxes

Our effective tax rates were a benefit of 63.1% and a provision of 34.3% for the three months ended June 28, 2008 and June 30, 2007, respectively. Our effective tax rates were provisions of 40.0% and 33.0% for the six months ended June 28, 2008 and June 30, 2007, respectively. The changes in the effective tax rate for the three and six months ended June 28, 2008 as compared to the same periods in 2007 results from lower profitability for 2008, non-deductible expenses related to stock-based compensation and certain nonrecurring items.

Note 13. Stock-Based Compensation

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

	Three Months Ended				Six Months Ended
	June 28, 2008		June 30, 2007		June 28, 2008		June 30, 2007
	(In thousands)
	(1)		(2)		(1)		(2)
Cost of sales	$	799	$	565	$	1,417	$	1,075
Selling, general and administrative		5,253		5,248		10,508		10,945
Research and development		2,422		3,107		4,972		6,002
Stock-based compensation expense before income taxes		8,474		8,920		16,897		18,022
Income tax benefit		2,199		2,080		4,353		4,356
Total stock-based compensation expense after income taxes	$	6,275	$	6,840	$	12,544	$	13,666

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(1) Amounts include amortization expense related to stock options of $4.4 million and $8.8 million, employee stock purchase plan of $0.6 million and $1.4 million, and restricted stock awards of $3.5 million and $6.7 million for the three and six months ended June 28, 2008, respectively.

(2) Amounts include amortization expense related to stock options of $5.0 million and $9.9 million, employee stock purchase plan of $0.9 million and $1.4 million, and restricted stock awards of $3.1 million and $6.7 million for the three and six months ended June 30, 2007, respectively.

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

	Three Months Ended						Six Months Ended
Options	June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
Risk-free interest rate		2.9	%		4.8	%		2.7	%		4.8	%
Volatility		50.5	%		47.3	%		50.9	%		47.3	%
Expected term		4.3 years			4.4 years			4.3 years			4.4 years
Dividends		None			None			None			None
Weighted-average fair value at grant date	$	10.03		$	13.78		$	10.06		$	13.86
	Three Months Ended						Six Months Ended
ESPP	June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
Risk-free interest rate		2.6	%		5.0	%		3.3	%		5.1	%
Volatility		39.4	%		32.5	%		38.9	%		33.3	%
Expected term		6 months			6 months			6 months			6 months
Dividends		None			None			None			None
Weighted-average fair value at grant date	$	6.56		$	7.59		$	6.92		$	7.22

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

A summary of stock option activity during the six months ended June 28, 2008 is as follows:

	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (in Years)	Aggregate Intrinsic Value
	(In thousands)					(In thousands)
Outstanding as of December 31, 2007	21,774		$	31.99	5.62	$	17,187
Grants	91			22.98
Exercises	(69	)		13.43
Forfeitures or expirations	(1,379	)		32.42
Outstanding as of June 28, 2008	20,417		$	31.98	5.16	$	1,520
Vested and expected to vest as of June 28, 2008	19,771		$	32.10	5.04	$	1,520
Exercisable as of June 28, 2008	15,867		$	33.05	4.25	$	1,520

The aggregate intrinsic value of options outstanding as of June 28, 2008 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 0.4 million shares that had exercise prices that were lower than the market price of our common stock as of June 28, 2008. The total intrinsic value of options exercised, determined as of the date of exercise, was $0.5 million and $2.8 million during the three months ended June 28, 2008 and June 30, 2007, respectively, and $0.6 million and $6.8 million during the six months ended June 28, 2008 and June 30, 2007, respectively. The total cash received from employees as a result of stock option exercises was $0.6 million and $10.1 million during the three months ended June 28, 2008 and June 30, 2007, respectively, and $0.9 million and $25.4 million during the six months ended June 28, 2008 and June 30, 2007,

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respectively. In connection with these exercises and the disqualification of incentive stock options, we realized a tax benefit of $0.1 million and $0.8 million for the three months ended June 28, 2008 and June 30, 2007, respectively, and $0.1 million and $2.0 million for the six months ended June 28, 2008 and June 30, 2007, respectively. We settle employee stock option exercises with newly issued common shares.

As of June 28, 2008 there was $33.1 million of unrecognized compensation cost related to unvested stock options, of which $8.8 million is expected to be recognized in the next two quarters of 2008, and $12.7 million, $9.0 million, and $2.6 million is expected to be recognized in 2009, 2010, and 2011, respectively.

A summary of restricted stock award activity during the six months ended June 28, 2008 is as follows:

	Number of Shares		Weighted-Average Grant Date Fair Value
	(In thousands)
Unvested restricted stock awards as of December 31, 2007	2,765		$	28.45
Granted	223			23.28
Vested	(71	)		27.66
Forfeited	(195	)		28.61
Unvested restricted stock awards as of June 28, 2008	2,722		$	28.04

The unvested restricted stock awards at June 28, 2008 include 1.2 million of restricted stock units.

As of June 28, 2008 there was $27.6 million of unrecognized compensation cost related to restricted stock awards, of which $6.8 million is expected to be recognized in the two remaining quarters of 2008, and $10.1 million, $6.1 million, $4.5 million and $0.1 million, is expected to be recognized in 2009, 2010, 2011 and 2012, respectively. The total fair value of restricted stock awards that vested in each of the three month periods ended June 28, 2008 and June 30, 2007 was $1.1 million and $0.9 million, respectively, and $1.6 million and $1.5 million during the six month periods ended June 28, 2008 and June 30, 2007, respectively. In connection with the vesting of these awards, we realized tax benefits of $0.4 million and $0.3 million for the three months ended June 28, 2008 and June 30, 2007, respectively, and $0.6 million for each of the six month periods ended June 28, 2008 and June 30, 2007. As of June 28, 2008, there was a total of 0.8 million shares of restricted stock awards subject to performance conditions that will result in forfeiture if the conditions are not met.

Note 14. Operating Segments

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

Segment information for the periods presented is as follows:

	Three Months Ended June 28, 2008								Six Months Ended June 28, 2008
	(In thousands)
	Semiconductor Group			Industrial Applications Group		Consolidated			Semiconductor Group		Industrial Applications Group		Consolidated
Sales to unaffiliated customers	$	208,272		$	49,468	$	257,740		$	478,622	$	93,831	$	572,453
Operating income (loss)	$	(20,814	)	$	9,432	$	(11,382	)	$	1,023	$	14,866	$	15,889
	Three Months Ended June 30, 2007								Six Months Ended June 30, 2007
	(In thousands)
	Semiconductor Group			Industrial Applications Group		Consolidated			Semiconductor Group		Industrial Applications Group		Consolidated
Sales to unaffiliated customers	$	380,207		$	36,128	$	416,335		$	744,402	$	68,907	$	813,309
Operating income	$	69,142		$	3,583	$	72,725		$	133,285	$	6,849	$	140,134

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	June 28, 2008						December 31, 2007
	(In thousands)
	Semiconductor Group		Industrial Applications Group		Consolidated		Semiconductor Group		Industrial Applications Group		Consolidated
Total assets	$	1,603,302	$	277,636	$	1,880,938	$	1,792,443	$	284,500	$	2,076,943

Note 15. Related Party Transactions

We lease an aircraft from a third-party entity wholly owned by Richard S. Hill, our Chairman and Chief Executive Officer. Under the aircraft lease agreement, we incurred lease expenses of $0.3 million and $0.2 million for the three month periods ended June 28, 2008 and June 30, 2007, respectively, and $0.5 million and $0.3 million for the six month periods ended June 28, 2008 and June 30, 2007, respectively.

We recognized aggregate compensation expense of $0.1 million during each of the three month periods ended June 28, 2008 and June 30, 2007 and $0.2 million and $0.3 million for the six month periods ended June 28, 2008 and June 30, 2007, respectively, for immediate family members of certain of our executive officers employed in non-executive positions.

As of June 28, 2008 and December 31, 2007, we had outstanding loans to non-executive vice presidents and other key personnel of $1.1 million and $1.0 million, respectively. As of June 28, 2008, nearly all of the outstanding balance was secured by collateral. Loans typically bear interest, except for those made for employee relocation purposes. Bad debt expense related to loans to personnel has not historically been significant.

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

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q and certain information incorporated herein by reference contain forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included or incorporated by reference in this Quarterly Report, other than statements that are purely historical, are forward-looking statements. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “estimate,” and similar expressions also identify forward-looking statements. The forward-looking statements include, without limitation: our expectation that net orders will fluctuate due to the cyclicality of the semiconductor industry; our anticipation to reclassify net losses recorded as of June 28, 2008 from OCI to earnings within the next twelve months; our expectation that the adoption of certain accounting pronouncements will not have a significant impact on our Condensed Consolidated Financial Statements; our estimated amortization expense for currently recognized identifiable intangible assets for the years ending December 31, 2009, 2010, 2011,2012 and 2013, respectively; our expectation that the remaining obligations in connection with vacated facilities will be satisfied no later than the lease terms, which expire on various dates through 2017; our expectation that the ultimate disposition of the Linear litigation will not have a material adverse effect on our business, financial condition or operating results; our efforts to continue to work closely with our customers and make substantial investments in research and development in order to continue to deliver innovative products which enhance productivity for our customers to utilize the latest technology; our belief that our continued investment in research and development has positioned us for future growth; our belief that significant additional growth potential exists in the Asia region over the long term; our belief that significant investment in research and development is required to remain competitive; our plan to continue to invest in new products and enhancement of our current product lines; our expectation that $33.1 million of unrecognized compensation related to unvested stock options, of which $8.8 million is expected to be recognized in the two remaining quarters of 2008 and $12.7 million, $9.0 million, and $2.6 million will be recognized in 2009, 2010 and 2011, respectively; our expectation that $27.6 million of unrecognized compensation cost related to restricted stock awards, of which $6.8 million is expected to be recognized in the next two quarters of 2008, and $10.1 million, $6.1 million, $4.5 million and $0.1 million is expected to be recognized in 2009, 2010, 2011 and 2012, respectively; our belief that we will ultimately be able to liquidate our investments in auction-rate securities without significant loss through successful auctions, redemptions of securities by the issuers or upon maturity; our belief that the impairment of the auction-rate securities is temporary because they have either been guaranteed by the federal government or in the case of closed-end funds they are backed by more than 200% collateral; our anticipation that the illiquidity of the auction-rate securities will not negatively affect our ability to execute our current business plan; our intention to continue to seek legal protection through patents and trade secrets for our proprietary technology; our belief that our current cash position, cash generated through operations and equity

16

offerings, and available borrowing capacity will be sufficient to meet our needs through the next twelve months; our belief that the ultimate outcome of actions that have arisen in the normal course of business will not have a material adverse effect on our business, financial condition or results of operations; our expectation that sales of our products to relatively few customers will continue to account for a high percentage of our net sales in the foreseeable future; our expectation to continue to experience significant fluctuations in our quarterly operating results; our expectation to use the proceeds from certain credit agreements for working capital and other general corporate purposes, including the repurchase of shares; our expectation to repurchase shares from time to time in the open market, through block shares or otherwise; our expectation that our customers capital spending will increase over the long term as demand from various industries continues to steadily rise; our belief that the shift to DRAM and NAND products will drive the development of more efficient tools to satisfy our customer’s needs; our belief that our customers are seeking more affordable technology to drive down their prices so they can continue to grow the market demand for their products; our continued efforts to focus on our responsiveness to our customers by increasing efficiencies and producing products the market desires; our plan to leverage our position in the market with the introduction of new specialized platforms that meet the diverging needs of our customers; our intention to leverage our strength and position in the logic market; our intention to continue building product momentum and driving market share in anticipation of market growth over the long term; our continued focus on operational execution and a pairing down of certain research and development activities to improve profitability by reducing our cost structure; and our belief that we will achieve our goal of reducing quarterly operational expenses to approximately $110 million in the third quarter of 2008.

Our expectations, beliefs, objectives, intentions and strategies regarding the future, including, without limitation, those concerning expected operating results, revenues and earnings and current and potential litigation are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from results contemplated by the forward-looking statements. These risks and uncertainties include, but are not limited to: unanticipated trends with respect to the cyclicality of the semiconductor industry; inability to reclassify net losses from OCI to earnings within the next twelve months; inaccuracies regarding growth potential in the Asia region over the long term; sustained decrease in or leveling off of customer demand; inability to predict the impact of the Linear litigation on our business, financial conditions or operating results; inability to accurately predict the impact of new accounting pronouncements on our Condensed Consolidated Financial Statements; inability to accurately assess the period in which the Company can recognize unrecognized compensation related to unvested stock options and restricted stock awards; inaccuracies related to the satisfaction of remaining obligations related to vacated leases; inability of the Company to meet certain performance conditions that may result in forfeiture of certain restricted stock awards; inability to anticipate cyclical changes in customers’ capacity utilization and demand; the negative impact of higher cost of services on gross margins; inability to realize efficiencies from outsourcing; inability to invest in research and development of existing and new product lines; inability to introduce new and enhanced products in a timely way in order to remain competitive; inability to accurately assess the changing product needs of our customers; loss of a major customer; the need to seek new customers and diversify our customer base; unanticipated need for additional liquid assets in the next twelve months; our failure to accurately predict the effect of the ultimate outcome of current litigation on our business, financial condition, results of operations or material adjustment to our financial statements; inherent uncertainty in the outcome of litigation matters; our potential inability to enforce our patents and protect our trade secrets; inability to reduce operational expenses in the third quarter of 2008; inability to accurately predict our ability to recover the carrying value of our investment in auction-rate securities, market changes negatively affecting auction-rate securities and the government’s inability to guarantee the underlying securities; inability to accurately predict customers capital spending over the long term and continued customer capital spending reductions in the semiconductor industry; further periodic downturns in the semiconductor industry which could have a material adverse effect on the semiconductor industry’s demand for semiconductor processing equipment; inability to accurately predict mega-fabrication trends in memory manufacturing; uncertainties related to the acceptance of new technology into the memory market; unexpected increase in costs of manufacturing and production limiting efficiencies and impacting our ability to leverage our logic position; introduction of new products by competitors; inability to gain and leverage market position during the economic downturn; unexpected shift in market demands for both memory and logic products; uncertainties related to growth in the electronic industry; and inability to successfully select, develop, and market new products, or enhance existing products.

The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties set forth under the heading “Risk Factors” in Item 1A of Part II, and are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of the filing of this Quarterly Report on Form 10-Q. Readers should also review carefully the cautionary statements and risk factors listed in our Annual Report on Form 10-K for the year ended December 31, 2007 and in our other filings with the SEC, including our Forms 10-Q and 8-K and our Annual Report to Shareholders.

Introduction

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

• Overview of our Business and Industry;

• Financial Performance Overview;

• Results of Operations;

• Critical Accounting Policies; and

• Liquidity and Capital Resources.

Overview of Our Business and Industry

Novellus Systems, Inc. is a California corporation organized in 1984. At Novellus, we primarily develop, manufacture, sell and support equipment used in the fabrication of integrated circuits, commonly called chips or semiconductors. Customers for these products manufacture chips for sale or for incorporation in their own products, or provide chip-manufacturing services to third parties. The segment of our business serving this area is the Semiconductor Group.

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In 2004, we diversified by acquiring Peter Wolters AG, a German company specializing in lapping and polishing equipment for a number of industries. With the acquisition of Peter Wolters AG, Novellus entered into market sectors beyond semiconductor manufacturing. We call this segment the Industrial Applications Group (IAG). In November 2005 we acquired Voumard Machine Co. SA, a privately-held manufacturer of high-precision machine manufacturing tools based in Neuchatel, Switzerland, to expand our product offerings within IAG.

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

In the Industrial Applications Group, our business depends on capital expenditures made by manufacturers in sectors such as vehicles, aircraft and electronic products, parts and components. At the broadest level, machine tools demand is highly sensitive to macroeconomic conditions as our customer base includes some of the most cyclically sensitive industries in the economy. As a result, such variables as the outlook for overall economic growth, fixed investment and durable goods shipments directly affect the growth of our business. Our industrial business also depends on niche applications in addition to the general machine tool cycle. As we continue to expand our capabilities in this segment, our operations are increasingly impacted by the wafer industry which, similar to the semiconductor segment, is also characterized by intense competition and rapidly changing technology.

As a supplier to the global semiconductor and semiconductor-related industries, we are subject to business cycles and trends which are difficult to predict. As indicated above, our products are used to manufacture semiconductors that are used throughout the electronics industry, including the personal computer, mobile phone, consumer electronics and portable media player markets. Our revenues are driven largely from capital spending by our customers who operate principally in the semiconductor memory and logic markets.

The demand for our products is affected by the profitability of our customers which is driven by capacity and market supply for their products. In fiscal 2006 and 2007, our memory customers built excess capacity as they did not accurately predict the market’s demand for their products. As a result, memory capacity additions saturated the market and outpaced the rate of demand. The overcapacity of memory customers coupled with weak memory pricing, tight liquidity in the credit markets, and the negative economic environment has caused those customers to pause on capital spending. While we have seen our customers’ capital expenditures slow in recent past, we expect our customers’ capital spending to increase over the long term as demand from various industries continues to steadily rise.

We have also seen a shift in the proportion of total capital spending to the memory market. Specifically, we have begun to see a need and growing demand for DRAM and NAND. We believe this shift will drive the development of more efficient tools to satisfy our customers’ needs as memory requires tremendous economies of scale that involve leveraging large fabrication facilities. Alternatively, logic requirements are more complex as they have a high part member mix, multiple customers and applications, and do not have the capacity to grow mega-fabrication facilities like our memory customers. Our customers are continuously seeking more affordable technology to drive down their prices so they can continue to grow the market demand for their products.

We continue to focus on our responsiveness to customers by increasing efficiencies and producing products that the market desires. Part of this plan involves leveraging our position in the market with the introduction of new specialized platforms that meet the diverging needs of our customers. We have seen great acceptance of our memory products and intend to leverage our strength and position in the logic market. During this economic downturn, we intend to continue building product momentum and driving market share in anticipation of market growth over the long term.

Given the historically cyclical nature of the semiconductor industry, we continue to focus on operational execution and a paring down of certain research and development activities to improve profitability by reducing our cost structure. We made strategic decisions during the second quarter of 2008 to focus on our core products discussed in our Annual Report on Form 10-K. Accordingly, we incurred $13.6 million of additional expenses during the second quarter of 2008 related to impairments of inventory and evaluation systems, write-downs of certain research and development assets, and reductions in workforce. As a result, we anticipate achieving our goal of reducing quarterly operational expenses to approximately $110 million in the third quarter of 2008, excluding employee profit sharing expenses, as applicable, and any impact that results from adverse changes in the exchange rate between the U.S. dollar and the local currency where expenses are incurred.

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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. We also use certain non-GAAP measures, such as shipments and net orders, to assess business trends and performance. Shipments consist of products shipped to customers, without regard to net sales adjustments such as deferrals associated with customer acceptance. Net orders, which are also referred to as bookings, consist of current period orders less current period cancellations. Shipments and net orders are used to forecast and plan future operations. We do not report orders for systems with delivery dates more than 12 months from the latest balance sheet date.

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

	Quarterly Financial Data
	2008						2007
	Second Quarter			First Quarter			Fourth Quarter			Third Quarter			Second Quarter			First Quarter
Net sales	$	257,740		$	314,713		$	363,463		$	393,277		$	416,335		$	396,974
Gross profit	$	110,963		$	144,940		$	171,863		$	194,307		$	208,110		$	194,909
Net income (loss)	$	(2,385	)	$	15,529		$	52,861		$	49,711		$	57,345		$	53,783
Net income (loss) per share – Diluted	$	(0.02	)	$	0.15		$	0.47		$	0.41		$	0.45		$	0.42
Shipments	$	240,320		$	312,857		$	363,055		$	387,817		$	436,382		$	389,052
Change in shipments from prior quarter		(23	)%		(14	)%		(6	)%		(11	)%		12	%		(0	)%
Net orders	$	234,628		$	297,025		$	343,086		$	305,329		$	332,201		$	412,219
Change in net orders from prior quarter		(21	)%		(13	)%		12	%		(8	)%		(19	)%		(7	)%

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

Financial Performance Overview

The following is an overview of our financial performance for the six months ended June 28, 2008 compared to the six months ended June 30, 2007:

• Net sales decreased 29.6% to $572.5 million from $813.3 million;

• Net income decreased 88.2% to $13.1 million from $111.1 million;

• Diluted net income per share decreased to $0.13 from $0.88;

• Shipments decreased 33.0% to $553.2 million from $825.4 million; and

• Net orders decreased 28.6% to $531.7 million from $744.4 million.

As noted above, results of operations for the three months ended June 28, 2008 include $13.6 million of charges. These charges include: (a) impairments of inventory and evaluation systems of $6.4 million, (b) write-downs of certain research and development (R&D) assets of $3.8 million and (c) reductions in workforce of $3.4 million. Of these charges, $6.5 million are in Cost of sales, $4.3 million are in R&D expenses and $2.8 million are in Selling, general and administrative (SG&A) expenses.

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Results of Operations

Net Sales

	Three Months Ended						Six Months Ended
	June 28, 2008		March 29, 2008		June 30, 2007		June 28, 2008		June 30, 2007
	(In thousands)
Semiconductor Group	$	208,272	$	270,350	$	380,207	$	478,622	$	744,402
Industrial Applications Group		49,468		44,363		36,128		93,831		68,907
Net sales	$	257,740	$	314,713	$	416,335	$	572,453	$	813,309

The net sales we report are correlated to shipments and the timing of customer acceptance. Deferred revenue at the end of the second quarter of 2008 was $95.7 million. Net sales recorded in the Semiconductor Group decreased compared to prior periods as a result of ongoing weakness in the semiconductor industry as discussed above.

Industrial Applications Group (IAG) net sales are up from the first quarter of 2008 primarily as a result of delayed customer acceptances in the prior quarter, which were subsequently received in second quarter 2008. Year over year, IAG net sales are up 37% and 36% for the three and six months ended June 28, 2008, respectively, due to improved performance in the business and favorable exchange rate fluctuations. The primary functional currency of IAG is the Euro. Changes in the exchange rate had the effect of increasing IAG reported net sales by 14% and 13% for the three and six months ended June 28, 2008, respectively, over the same periods in the prior year.

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

	Three Months Ended						Six Months Ended
	June 28, 2008		March 29, 2008		June 30, 2007		June 28, 2008		June 30, 2007
Asia	61	%	62	%	65	%	62	%	68	%
North America	27	%	30	%	29	%	28	%	26	%
Europe	12	%	8	%	6	%	10	%	6	%

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

Gross Profit

	Three Months Ended									Six Months Ended
	June 28, 2008			March 29, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(Dollars in thousands)
Gross profit	$	110,963		$	144,940		$	208,110		$	255,903		$	403,019
Gross margin		43	%		46	%		50	%		45	%		50	%

The decrease in gross margin in the second quarter of 2008 compared to prior periods is primarily due to product mix and lower absorption of fixed overhead costs as shipment volumes decreased. In addition, we incurred $6.5 million of additional charges as discussed above which consisted primarily of inventory and evaluation system impairments. Gross margin in second quarter and year-to-date 2008 also decreased from prior periods as a result of an increase in the percentage of total sales represented by IAG products, whose margins are generally lower than Semiconductor Group products.

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Selling, General and Administrative (SG&A)

	Three Months Ended									Six Months Ended
	June 28, 2008			March 29, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(Dollars in thousands)
SG&A expense	$	62,530		$	60,329		$	72,011		$	122,859		$	139,111
% of net sales		24	%		19	%		17	%		21	%		17	%

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

SG&A expense increased in the second quarter of 2008 from the first quarter of 2008, primarily as a result of $2.8 million of additional charges incurred during the current quarter related to the reduction in workforce discussed above. The decrease in SG&A expense during the three and six months ended June 30, 2008 over the same prior year periods, is primarily due to lower profit sharing, commissions and other sales and marketing related costs as a result of decreased sales volumes. These reductions were offset by incremental charges incurred in 2008 related to the reduction in workforce. SG&A expense, as a percentage of net sales, increased compared to prior year periods primarily due to the decrease in net sales.

Research and Development (R&D)

	Three Months Ended									Six Months Ended
	June 28, 2008			March 29, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(Dollars in thousands)
R&D expense	$	59,815		$	57,340		$	63,374		$	117,155		$	123,774
% of net sales		23	%		18	%		15	%		20	%		15	%

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

The increase in R&D expense over first quarter 2008 levels was due to the write-down of certain R&D assets and the reduction of workforce totaling $4.3 million, as explained above. Excluding the aforementioned charges, R&D expense decreased by $2.3 million due to a reduction in headcount and profit sharing. R&D expense decreased during the three and six months ended June 28, 2008 from the prior year periods primarily as a result of reduced headcount resulting from our strategic business decision to focus on our core products. R&D expense, as a percentage of net sales, increased compared to prior year periods primarily due to the decrease in net sales.

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Interest and Other Income, Net

	Three Months Ended									Six Months Ended
	June 28, 2008			March 29, 2008			June 30, 2007			June 28, 2008			June 30, 2007
	(Dollars in thousands)
Interest and other income, net	$	4,916		$	1,109		$	14,597		$	6,025		$	25,704
% of net sales		2	%		Less than 1	%		4	%		1	%		3	%

Interest and other income, net, includes interest income, interest expense and other non-operating items. Interest and other income, net increased from the first quarter of 2008 primarily due to $3.4 million of increased gains on foreign currency transactions. During the three and six months ended June 28, 2008 interest and other income, net decreased compared to prior year periods. Interest income for the three and six months ended June 28, 2008 decreased by $6.0 million and $10.5 million, respectively, as a result of declining yields on interest bearing investments, lower balances of cash, cash equivalents and investments, and the transition to U.S. Treasuries that provided lower yields. Additionally, there were decreased gains on foreign currency transactions of $1.6 million and $5.8 million from the three and six months ended June 30, 2007, respectively.

Income Taxes

Our effective tax rates were a benefit of 63.1% and provisions of 45.3% and 34.3% for the three months ended June 28, 2008, March 29, 2008 and June 30, 2007, respectively. Our effective tax rates were provisions of 40.0% and 33.0% for the six months ended June 28, 2008 and June 30, 2007, respectively. The tax benefit in the second quarter of 2008 compared to the provision in the first of quarter 2008 is primarily due to the net loss for the three months ended June 28, 2008 and certain nonrecurring items for the quarter. In addition, the changes in the effective tax rate for the three and six months ended June 28, 2008 as compared to the same periods in 2007 results from lower profitability for 2008, non-deductible expenses related to stock-based compensation and certain nonrecurring items. Our future effective income tax rate depends on various factors, such as the company’s operating results before taxes, tax legislation, the geographic composition of pre-tax operating results, non-deductible expenses incurred in connection with acquisitions and items outside of the annual effective tax rate such as interest expense on uncertain tax positions and stock option and restricted stock-based deductions.

Critical Accounting Policies

The preparation of financial statements in conformity with U.S. GAAP requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our assumptions and estimates, including those related to recognition of revenue, valuation of investments, valuation of inventory, valuation of goodwill and other intangible assets, valuation of deferred tax assets, adequacy of warranty obligations, measurement of restructuring and impairment charges, compliance with hedge accounting for derivatives, measurement of stock-based compensation expense and litigation. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discuss our critical accounting policies in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2007. Except for the critical accounting policy set forth below entitled “Valuation of Investments,” there have been no other significant changes in our critical accounting policies or estimates since those reported in our Annual Report.

Valuation of Investments

In valuing our investments we predominantly use market data or data derived from market sources. When market data is not available, such as when the investment is illiquid, we employ a cash-flow-based modeling technique to arrive at the recorded fair value. This process involves incorporating our assumption about the anticipated term and the yield that a market participant would require to purchase the security in the marketplace. As of June 28, 2008 we have recorded a temporary impairment charge of $7.1 million within OCI based upon our assessment of the fair value of our auction-rate securities (see Note 3 to the Condensed Consolidated Financial Statements).

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Liquidity and Capital Resources

Cash, Cash Equivalents and Short-Term Investments

	June 28, 2008		December 31, 2007
	(In thousands)
Cash and cash equivalents	$	191,773	$	175,071
Short-term investments		237,033		421,695
Total cash, cash equivalents and short-term investments	$	428,806	$	596,766

We have historically financed our operating and capital resource requirements through cash flows from operations, sales of equity securities and borrowings. Our primary source of liquidity as of June 28, 2008 consisted of $428.8 million of cash, cash equivalents and short-term investments. This amount represents a decrease of $168.0 million from $596.8 million as of December 31, 2007.

As of June 28, 2008, we held approximately $112.1 million of tax-exempt auction-rate securities, $2.0 million of which was classified as short-term investments with the remainder classified as non-current assets, whose underlying assets are generally student loans substantially backed by the federal government or closed-end municipal funds. Beginning in February 2008, many of these auction-rate securities became illiquid because their scheduled auctions failed to settle. An auction failure occurs when the parties wishing to sell securities at auction cannot. As a result, we may have limited or no opportunities to liquidate these investments and fully recover their stated value in the near term. When an auction fails the affected securities begin to pay interest under their default interest rate terms. As a result of the illiquidity caused by the lack of an active market, $110.1 million of these investments were classified as non-current and a temporary unrealized loss of $7.1 million has been recorded as of June 28, 2008. We utilized a cash-flow-based valuation method in determining the fair value of these securities, which used significant unobservable inputs at June 28, 2008.

We believe the impairment of these securities is temporary because they have either been guaranteed by the federal government or in the case of closed-end funds they are backed by more than 200% collateral. Substantially all of our auction-rate securities are currently rated AAA, the highest rating by a rating agency. We believe we will ultimately be able to liquidate these investments without significant loss through successful auctions, redemptions of securities by the issuers, or upon maturity. However, it could take until the final maturity of the underlying notes (up to 49 years) to realize the investments’ full value. Based on our expected operating cash flows, and our other sources of cash, we do not anticipate that the current illiquidity of these investments will adversely affect our operations.

Cash Flow Summary

	2008 YTD			2007 YTD
	(In thousands)
Net cash provided by (used in):
Operating activities	$	125,174		$	67,421
Investing activities		45,285			(28,248	)
Financing activities		(154,434	)		(28,203	)
Effects of exchange rate changes on cash and cash equivalents		677			943
Net increase in cash and cash equivalents	$	16,702		$	11,913

Operating

Net cash provided by operating activities during the six months ended June 28, 2008 was $125.2 million. This amount consisted primarily of $13.1 million provided by net income, adjusted for non-cash expense items of $67.7 million and changes in working capital accounts of $44.3 million. The primary reason for the increase in cash flows from operating activities compared to the prior year period is a decrease in accounts receivable offset by lower net income. Accounts receivable decreased by $132.0 million from year-end levels due to reduced shipments and strong collections in the quarter.

Net cash provided by operating activities during the six months ended June 30, 2007 was $67.4 million. This amount consisted primarily of $111.1 million provided by net income, adjusted for non-cash items of $71.4 million and decreases in working capital accounts of $115.1 million. Accounts receivable increased by $112.1 million as a result of higher shipments in the second quarter 2007, as compared to the fourth quarter 2006, and because of extended payment terms for certain transactions. Inventory levels were higher than at year end by $33.9 million to meet current and forecasted shipment demands.

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Investing

Net cash provided by investing activities during the six months ended June 28, 2008 was $45.3 million, which consisted of net purchases, sales and maturities of short-term investments of $65.0 million, offset by capital expenditures of $10.9 million and an increase in restricted cash and cash equivalents of $8.8 million. As of June 28, 2008, we had no significant commitments to purchase property or equipment.

Net cash used in investing activities during the six months ended June 30, 2007 was $28.2 million, which consisted primarily of net purchases of short-term investments of $3.6 million and capital expenditures of $20.5 million. As of June 30, 2007, we had no significant commitments to purchase property or equipment.

Financing

Net cash used in financing activities during the six months ended June 28, 2008 was $154.4 million. This amount consisted primarily of repurchases of common stock of $160.2 million, offset by proceeds from employee stock compensation plans of $5.7 million.

Net cash used in financing activities during the six months ended June 30, 2007 was $28.2 million. This amount consisted primarily of repurchases of common stock of $56.8 million, offset by proceeds from employee stock compensation plans of $29.9 million.

Liquidity

We have short-term credit facilities with various financial institutions totaling $98.2 million. These credit facilities bear interest at various rates and expire on various dates through June 2009. As of June 28, 2008, $2.3 million of current obligations were outstanding at an interest rate of 5.0%, $29.2 million was pledged against outstanding letters of credit and the remaining $66.7 million was unutilized.

Current debt obligations also include a credit arrangement denominated in Euros used to fund the acquisition of Peter Wolters AG in 2004 and for general corporate purposes. As of June 28, 2008 borrowings under this credit arrangement were $150.3 million at an interest rate of 4.6% and are secured by deposits in money market funds, which are included within restricted cash and cash equivalents, current on our Condensed Consolidated Balance Sheet. Borrowings under this credit arrangement are due and payable on or before June 25, 2009. This credit arrangement includes certain financial covenants, with which we were in compliance as of June 28, 2008.

We also have long-term credit facilities with various institutions totaling $151.4 million, of which $150.0 million was unutilized as of June 28, 2008. As of June 28, 2008 we had $1.4 million in long-term debt outstanding under these credit arrangements at an interest rate of 4.0%, expiring in December 2037. The unutilized amount relates to a senior unsecured five-year revolving credit agreement (the Agreement) expiring in 2011 with an aggregate committed amount of $150.0 million and an option to increase the total line by up to an additional $100.0 million under certain circumstances. We expect to use the proceeds, if any, for working capital and other general corporate purposes, including the repurchase of our own common shares. The Agreement contains customary affirmative and negative covenants, financial covenants, representations and warranties and events of default, which are subject to various exceptions and qualifications. We were in compliance with these covenants as of June 28, 2008. No amounts were outstanding under the Agreement as of June 28, 2008.

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

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For quantitative and qualitative disclosures about market risk affecting Novellus, see Item 7A: “Quantitative and Qualitative Disclosures about Market Risk” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. Our exposure related to market risk has not changed materially since December 31, 2007.

ITEM 4: CONTROLS AND PROCEDURES

Quarterly Evaluation of Our Disclosure Controls and Internal Controls

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

CEO and PFO Certifications

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

Disclosure Controls and Internal Controls for Financial Reporting

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

Limitations on the Effectiveness of Controls

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

Scope of the Controls Evaluation

The evaluation of our disclosure controls and our internal controls for financial reporting by our Chief Executive Officer and our Principal 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 Principal 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 Principal Financial Officer have concluded that our disclosure controls are effective to ensure that information required to be disclosed is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that material information relating to the Company is made known to management, including the Chief Executive Officer and the Principal Financial Officer, particularly during the period when our periodic reports are being prepared, and that our internal controls for financial reporting are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with U.S. GAAP.

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PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

There have been no material developments in litigation matters during the quarter ended June 28, 2008 from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007.

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

ITEM 1A: RISK FACTORS

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

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

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

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

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

Changes in tax rates, tax assets or liabilities have negatively impacted our results and could further negatively impact our future results.

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We are subject to taxation in the United States and other countries. Our tax rate has fluctuated in the past and may fluctuate in the future. For example, our effective tax rate for the six months ended June 28, 2008 is higher compared to the same period in 2007 as a result of lower profitability for 2008, non-deductible expenses related to stock-based compensation and certain nonrecurring items.

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

• Changes in the regulatory environment;

• Changes in accounting and tax standards or practices; and

• Overall business conditions in the equipment industry.

Our financial results have fallen short and may continue to fall short of anticipated levels; forecasting net sales and profitability is complex and our forecasts may be inaccurate.

Our financial results in the first quarter of 2008 fell short of previously announced guidance for the quarter. This was the result of higher than anticipated manufacturing costs, higher write-downs of evaluation systems and a higher than anticipated effective tax rate. Management typically provides quarterly financial forecasts. These forecasts when made are based on assumptions believed to be reasonable at the time. However, actual results may vary from forecasted results for a variety of reasons as evidenced by the first quarter 2008 results. Our lengthy sales cycle, coupled with customers’ competing capital budget considerations, makes the timing of customer orders and product acceptances difficult to predict. In addition, our backlog at the beginning of a quarter typically does not include all orders required to achieve our sales objectives for that quarter and is not a reliable indicator of our future sales. As a result, our revenues and operating results for a quarter depend on our shipping orders as scheduled during that quarter, receiving customer acceptance of shipped products during the quarter, and obtaining new orders for products to be shipped in that same quarter. Any delay in, or cancellation of, scheduled shipments and customer acceptances or in shipments from new orders could materially and adversely affect our financial results. These factors have caused and may continue to cause our financial results to differ materially from prior periods and from financial forecasts we have previously provided.

Although we believe that these forecasts provide investors and analysts with a better understanding of management’s expectations for the future and are useful to our stockholders and potential stockholders, such forecasts are comprised of forward-looking statements subject to the risks and uncertainties described in this report and in our other public filings and public statements. If our operating or financial results for a particular period differ from our forecasts or the expectations of investment analysts, or if we change our forecasts for future periods, the market price of our common stock could decline.

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

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

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beginning in the fourth quarter of 2006 and continuing through the third quarter of 2007. In the fourth quarter of 2007 our bookings increased over the third quarter of 2007, however we experienced a decrease in bookings in both the first and second quarters of 2008. We could continue to experience decreases in bookings in the future, and as a result, our net sales and operating results may be adversely affected.

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

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

Our liquidity can be affected by unanticipated events in the debt markets.

As of June 28, 2008, we held approximately $112.1 million of tax-exempt auction-rate securities, $2.0 million of which was classified as short-term investments with the remainder classified as non-current assets, whose underlying assets are generally student loans, substantially backed by the federal government, or closed-end municipal funds. Beginning in February 2008, many of these auction-rate securities became illiquid because their scheduled auctions failed to settle. An auction failure occurs when the parties wishing to sell securities at auction cannot. As a result, we may have limited or no opportunities to liquidate these investments and fully recover their stated value in the near term. When an auction fails the affected securities begin to pay interest under their default interest rate terms. As a result of the illiquidity caused by the lack of an active market, $110.1 million of these investments were classified as non-current and a temporary unrealized loss of $7.1 million has been recorded as of June 28, 2008. We utilized a cash-flow-based valuation method in determining the fair value of these securities, which used significant unobservable inputs at June 28, 2008.

We believe the impairment of these securities is temporary because they have either been guaranteed by the federal government or in the case of closed-end funds they are backed by more than 200% collateral. Substantially all of our auction-rate securities are currently rated AAA, the highest rating by a rating agency. We believe we will ultimately be able to liquidate these investments without significant loss through successful auctions, redemptions of securities by the issuers, or upon maturity. However, it could take until the final maturity of the underlying notes (up to 49 years) to realize the investments’ full value. If current market conditions do not improve, an other-than-temporary impairment charge could occur in future periods which would negatively impact our results of operations. Based on our expected operating cash flows, and our other sources of cash, we do not anticipate that the current illiquidity of these investments will adversely affect our operations.

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

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

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

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

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

We face risks related to concentration of net sales.

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

We are exposed to the risks of global operations.

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

• Tariffs and other trade barriers;

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

• Difficulties in managing foreign distributors;

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

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

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

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

• Adverse conditions in credit markets;

• Global or regional economic downturns; and

• Political instability, natural disasters, acts of war or terrorism.

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

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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 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, legal or regulatory changes, terrorism in Asia or geo-political instability in Asia, including the possible outbreak of hostilities or epidemics involving Singapore, China, Taiwan, Korea or Japan, could result in the cancellation or delay by certain significant customers of orders for our products, which could adversely affect our business, financial condition or results of operations. Our continuing expansion in Asia renders us increasingly vulnerable to these risks.

From time to time we may enhance, modify or upgrade our enterprise resource planning and other key software applications, which could cause unexpected problems to occur and could cause disruption to the management of our business.

From time to time, we may enhance, modify or upgrade our enterprise resource planning (ERP) system used for our worldwide operations, as well as other key software applications used in our operations. Our ERP system is integral to our ability to accurately and efficiently maintain our books and records, record our transactions, provide critical information to our management and prepare our financial statements.

Enhancements may eventually become more costly, difficult and time-consuming to purchase and implement than we currently anticipate. We may encounter unexpected difficulties or costs or other challenges, any of which may disrupt our business or cause delays in the reporting of our financial results. Our existing systems, procedures or controls may not be adequate to support our operations and require us to change our internal business practices. Corrections and improvements may be required as we enhance, modify or upgrade our systems, procedures and controls, and could cause us to incur additional costs and require additional management attention, placing burdens on our internal resources. If we fail to manage these changes effectively, it could adversely affect our ability to manage our business and our operating results.

We face risks related to intellectual property.

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

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

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

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

Intellectual Property Litigation

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

Other Litigation

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

We are exposed to risks associated with our diversification strategy.

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

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

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

We face risks associated with acquisitions, divestitures, and other transactions.

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;

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• 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.

When we make a decision to sell assets or a business, we may encounter difficulty completing the transaction as a result of a range of possible factors such as new or changed demands from the buyer. These circumstances may cause us to incur additional time or expense or to accept less favorable terms, which may adversely affect the overall benefits of the transaction.

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

Our quarterly operating results and stock price are unpredictable.

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

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

• Economic conditions in the electronics and semiconductor industry generally and the equipment industry specifically;

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

• Emergence of new industry standards;

• Competitive pricing pressures;

• 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;

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

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

• Foreign currency exchange rate fluctuations;

• Fluctuation in warranty costs;

• Variability in manufacturing yields; and

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• Ability to fund capital requirements.

Compliance with current and future environmental regulations may be costly.

We may be subject to environmental and other regulations in certain states and countries where we produce or sell our products. We also face increasing complexity in our product design and procurement operations as we adjust to new and prospective requirements relating to the materials composition of our products, including the restrictions on lead and certain other substances in electronics that apply to specified electronics products put on the market in the European Union (EU). The EU also makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. Other countries, such as the United States, China and Japan, have enacted or may enact similar laws or regulations similar to the EU. These and other future environmental regulations could require us to reengineer certain of our existing products.

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

Repurchase of Company Securities

Period	Total Number of Shares Purchased	Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Approximate Dollar Value of Shares that May yet be Purchased Under the Plans or Programs
March 30, 2008 through April 3, 2008	—		—	—	$	884.7 million
April 4, 2008 through May 3, 2008	—		—	—	$	884.7 million
May 4, 2008 through June 28, 2008	455,200	$	21.97	455,200	$	874.7 million
Total	455,200	$	21.97	455,200	$	874.7 million

All shares were purchased pursuant to publicly announced plans. On February 24, 2004 we announced that our Board of Directors approved a stock repurchase plan that authorized the repurchase of up to $500.0 million of our outstanding common stock through February 13, 2007. On September 20, 2004 we announced that our Board of Directors authorized an additional $1.0 billion for repurchase of our outstanding common stock through September 14, 2009. On October 26, 2007 we announced that our Board of Directors authorized an additional $1.0 billion for repurchase of our outstanding common stock through October 26, 2011.

In addition to shares repurchased above, we withheld 2,367 shares through net share settlements during the three months ended June  28, 2008 upon the vesting of restricted stock awards to cover tax withholding obligations.

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

At Novellus’ Annual Meeting of Shareholders, held on May 13, 2008, the following proposals were voted on by the Shareholders as noted below:

1. Election of Directors.

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Name of Nominee	Voted For	Voted Against
Richard S. Hill	73,106,707	848,852
Neil R. Bonke	73,116,962	838,597
Youssef A. El-Mansy	73,116,786	838,773
J. David Litster	73,116,962	838,597
Yoshio Nishi	73,116,786	838,773
Glen G. Possley	73,106,701	848,858
Ann D. Rhoads	73,116,786	838,773
William R. Spivey	73,116,956	838,603
Delbert A. Whitaker	73,116,962	838,597

2. Ratification of the appointment of Ernst & Young LLP as the independent registered public accounting firm for Novellus for the fiscal year ending December 31, 2008.

Voted For	Voted Against	Abstain
72,569,368	645,360	740,831

ITEM 6: EXHIBITS

(a) Exhibits

*10.19	Amended and Restated Employment Agreement between Novellus and Richard S. Hill dated July 24, 2008.
31.1	Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc. dated August 5, 2008 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 Jeffrey C. Benzing, Executive Vice President and Chief Administrative Officer of Novellus Systems, Inc. dated August 5, 2008 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 August 5, 2008 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 Jeffrey C. Benzing, Executive Vice President and Chief Administrative Officer of Novellus Systems, Inc. dated August 5, 2008 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* Management contracts or compensatory plans or arrangements.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

NOVELLUS SYSTEMS, INC.
By:	/s/ Jeffrey C. Benzing
	Jeffrey C. Benzing
	Executive Vice President and Chief Administrative Officer
	(Principal Financial Officer)

August 5, 2008

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EXHIBIT INDEX

*10.19	Amended and Restated Employment Agreement between Novellus and Richard S. Hill dated July 24, 2008.
31.1	Certification of Richard S. Hill, Chairman of the Board of Directors and Chief Executive Officer of Novellus Systems, Inc. dated August 5, 2008 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 Jeffrey C. Benzing, Executive Vice President and Chief Administrative Officer of Novellus Systems, Inc. dated August 5, 2008 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 August 5, 2008 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 Jeffrey C. Benzing, Executive Vice President and Chief Administrative Officer of Novellus Systems, Inc. dated August 5, 2008 in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* Management contracts or compensatory plans or arrangements.

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