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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2002

OR

For the transition period from         to    

Commission File Number 000-17157

NOVELLUS SYSTEMS, INC.

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

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

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value

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 [X]   NO [  ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES [X]  NO [  ]

As of June 28, 2002 the aggregate market value of voting and non-voting stock held by non-affiliates of the Registrant was approximately $5,064,390,563, based on the average of the high and low prices of the Common Stock as reported on the NASDAQ National Market on such date. Shares of Common Stock held by officers, directors and holders of more than 5% of the outstanding Common Stock have been excluded from this calculation because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares of the Registrant’s Common Stock outstanding on February 26, 2003 was 149,575,876.

Documents Incorporated by Reference: Part III of this Form 10-K incorporates information by reference from the Registrant’s Proxy Statement for its 2003 Annual Meeting of Shareholders.

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NOVELLUS SYSTEMS, INC.

2002 ANNUAL REPORT ON FORM 10-K

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K 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 Annual Report on Form 10-K, other than statements that are purely historical, are forward-looking statements. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions also identify forward-looking statements. Forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. Forward-looking statements in this Annual Report on Form 10-K include, without limitation:

•		Statements about the growth of the semiconductor industry; market size, share and demand; product performance; our expectations, objectives, anticipations, intentions and strategies regarding the future; expected operating results, revenues and earnings; and current and potential litigation, which statements are subject to various uncertainties, including, without limitation, those discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Factors”;
•		The statements under the heading “Item 1. Business” concerning (1) the semiconductor industry’s migration to the use of copper and low-k dielectrics and (2) the growing importance of the surface preparation and CMP manufacturing steps, which statements are subject to various risks and uncertainties, including, without limitation, the failure of our expectations regarding the future direction of the semiconductor industry and our failure to combine the recently-acquired product offerings of GaSonics International Corporation and SpeedFam-IPEC, Inc. with our offerings;
•		The statements under the heading “Item 1. Business – Industry Background” regarding our beliefs that (1) unit demand for semiconductor devices will continue to increase; (2) the next generation of chips will likely see line widths as small as 90 nanometer and below; (3) there will be a transition from aluminum to copper conductive material; (4) there will be a transition from silicon oxide films to low-k dielectric insulators; and (5) there is a trend toward larger wafer sizes, which statements are subject to various risks and uncertainties, including, without limitation, periodic downturns in the semiconductor industry, slowdowns in the rate of capital investment by semiconductor manufacturers, shifts in demand from expensive, high-performance products to lower priced, conventional products, and the failure of our expectations regarding the future direction of the semiconductor industry;
•		The statements under the heading “Item 1. Business – Strategy,” concerning (1) our objective to increase our market share in the interconnect manufacturing market and strengthen our position as a leading supplier of semiconductor processing equipment; (2) our emphasis on high-productivity systems; (3) our focus on reducing customer costs; (4) our service differentiation philosophy; (5) our goal to lead in our target markets; (6) our goal to broaden our interconnect offerings; (7) our focus on major semiconductor manufacturers; (8) our intention to expand our market presence in Asia; and (9) our intention to leverage our low manufacturing cost structure, which statements are subject to various risks and uncertainties, including, without limitation, shifts in demand from expensive, high-performance products to lower priced, conventional products, resulting in reduced profit for semiconductor manufacturers, the current and other periodic downturns in the semiconductor industry and the economy in general, slowdowns in the rate of capital investment by semiconductor manufacturers and future product developments, introductions by competitors, increased competition in the

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		semiconductor equipment industry and risks and uncertainties associated with international operations, including economic downturns, trade balance issues, political instability, banking issues, fluctuations in interest and foreign currency exchange rates and slower economic development in Asia;
•		The statements under the heading “Item 1. Business – Products” of our beliefs regarding our products, including (1) that Concept Two enables increased production throughput and system capability; (2) that Concept Three offers greater throughput in 300mm wafer-manufacturing applications; (3) that Concept Three SPEED offers minimal risk to our customers in making the transition from 200mm to 300mm volume chipmaking; (4) that Concept Two ALTUS is ideal for meeting the requirements of high-volume, automated 200mm wafer fabs producing semiconductor devices at 0.18 micron and below; (5) that the INOVA 200mm system will continue to gain market acceptance based on barrier seed step coverage performance; (6) that the 300 mm INOVA XT with Hollow Cathode Magnetron or HCM will continue to offer superior barrier performance; (7) that our Electrofill products are highly reliable and cost-effective; (8) the increasing importance of photoresist strip and clean processes; (9) that IRIDIA offers the highest productivity of any 200 mm dry-clean system currently on the market; (10) that SIERRA yields significantly higher capital productivity and significantly lower cost-of-ownership advantages than competing dry-clean systems; (11) that the opportunity to integrate and optimize the planarization, deposition and surface preparation steps gives us an important advantage in extending copper/low-k processes to advanced semiconductor devices; and (12) that MOMENTUM allows for maximum manufacturing flexibility, which statements are subject to various risks and uncertainties, including, among others, the inaccuracy of our assessment of the capabilities of our products, the greater financial, marketing, technical or other resources, broader product lines, greater customer service capabilities and larger and more established sales organizations and customer bases that some of our competitors possess, future competition from new market entrants, our competitors’ improvement of the design and performance of their products that may offer superior price or performance features over our products, and difficulties in selecting, developing, manufacturing and marketing our new products or enhancing our existing products;
•		The statements under the heading “Item 1. Business – Marketing, Sales and Service” of our beliefs that (1) our strategy of supporting our installed base through customer support and R&D groups has accelerated penetration of certain key accounts; (2) our marketing efforts are enhanced by the technical expertise of our R&D personnel; and (3) our customer service is enhanced by the design simplicity of our systems, which statements are subject to certain risks and uncertainties, including, without limitation, that during periods of rapid growth, we may not be able to hire, assimilate and retain a sufficient number of qualified people and our failure to design simple, streamlined systems;
•		The statement under the heading “Item 1. Business – Research and Development” regarding our expectation that research and development expenditures will continue to represent a substantial percentage of sales, which statement is subject to certain risks and uncertainties, including, among others, that we may be unable to allocate substantial resources to research and development;
•		The statements under the heading “Item 1. Business – Manufacturing” regarding (1) our belief that our outsourcing strategy enables us to minimize our fixed costs and capital expenditures while also

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		providing the flexibility to increase capacity as needed and allows us to focus on product differentiation through system design and quality control; (2) our belief that the use of manufacturing specialists for our subsystems incorporate the most advanced technologies in robotics, gas panels and microcomputers; (3) our goal to work with suppliers to achieve mutual cost reduction through joint design efforts; and (4) our goal of reduced dependence on limited suppliers for certain key parts, which statements are subject to various risks and uncertainties, including, without limitation, the possible occurrence of a disruption or termination of certain limited source suppliers, our prolonged inability to obtain certain components, our failure to work efficiently with suppliers, and our inability to establish relationships with alternative suppliers of key parts;
•		The statement under the heading “Item 1. Business – Competition” regarding our belief as to our favorable competitiveness in our market segments, which statement is subject to various risks and uncertainties, including, among others, the greater financial, marketing, technical or other resources, broader product lines, greater customer service capabilities and larger and more established sales organizations and customer bases that some of our competitors possess, future competition from new market entrants from overseas and domestic sources, our competitors’ improvement of the design and performance of their products that may offer superior price or performance features as compared to our products, and our success in selecting, developing, manufacturing and marketing our new products or enhancing our existing products;
•		The statements under the heading “Item 1. Business – Patents and Proprietary Rights” regarding our beliefs and intentions (1) to pursue the legal protection of our technology primarily through patent and trade secret protection; (2) to file additional patent applications; (3) to vigorously protect our intellectual property rights; (4) that the outcomes of current litigation will not have a material impact on our business; and (5) that in the future, litigation may be necessary to enforce patents issued to us, to protect trade secrets or know-how owned by us or to defend us against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of others, which statements are subject to various risks and uncertainties, including, without limitation, the absence of assurance that patents will be issued from any of our pending applications or that any claims allowed from existing or pending patents will be sufficiently broad to protect our technology, the fact that litigation could result in substantial cost and diversion of our effort and the fact that adverse litigation determinations could result in a loss of our proprietary rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties or prevent us from manufacturing or selling our products;
•		The statements under the heading “Item 1. Business – Employees” that our success depends upon (1) our ability to recruit and retain engineers and technicians, marketing, sales, service and other key personnel and (2) the retention of a limited number of key employees and other members of our senior management, which statements are subject to risks and uncertainties, including, among others, our inability to successfully retain or recruit key personnel and our inability to effectively manage growth;
•		The statement under the heading “Item 1. Business – Environmental Matters” that neither compliance with federal, state and local provisions regulating discharge of materials into the environment nor remedial agreements or other environmental actions is expected to have a material affect on our capital expenditures, financial condition, results of operations or competitive position, which statement is subject to various risks and uncertainties, including, among others, that we have inaccurately assessed the compliance requirements of environmental provisions;
•		The statement under the heading “Item 2. Properties” of our belief that our current properties will be sufficient to meet our requirements for the foreseeable future is subject to various risks and uncertainties, including, without limitation, growth in net sales placing unexpected strains on our resources and properties;
•		The statements under the headings “Item 3. Legal Proceedings” and “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 11. Litigation” of our beliefs (1) that there are meritorious defenses in the Applied Materials, Inc., Semitool, Inc., Plasma Physics Corporation, Solar Physics Corporation and Linear Technology Corporation litigation matters, and

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		(2)  regarding the impact and outcome of the Applied, Semitool, Plasma Physics, Solar Physics and Linear Technology litigation matters, which statements are subject to various uncertainties, including, without limitation, our inability to accurately predict the determination of complex issues of fact and law;
•		The statements under the heading “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations” regarding calculation of allowances, reserves, and other estimates that are based on historical experience, the judgment of management, and various other 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, our beliefs about critical accounting policies, and the significant judgments and estimates used in the preparation of our consolidated financial statements, which statements are subject to certain risks, including, among others, the inaccuracy of our beliefs regarding critical accounting policies and that actual product failure rates, material usage, installation costs, customer reserves or other estimates may be different from our estimates, requiring revisions to our estimated allowance for doubtful accounts, additional inventory write-downs, restructuring charges, litigation, warranty, and other reserves;
•		The statements under the heading “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations” of our strategies, beliefs, plans, expectations, anticipations and hopes with respect to Net Sales, Gross Profit, Selling, General and Administrative, Research and Development, Acquired In-Process Research and Development, Restructuring and Other Charges, Bad Debt (Recovery) Write-off, Other Income, net, Provision for Income Taxes, Deferred Tax Assets, Foreign Currency Accounting and Foreign Exchange Contracts including, without limitation, (1) our plan to continue our R&D commitment to improvement of new and existing technologies; (2) our belief that substantial investment in R&D is required to remain competitive; (3) management’s beliefs regarding the realization of deferred tax assets; and (4) the belief that our forward foreign exchange contracts do not subject us to speculative risk that would otherwise result from changes in currency exchange rates; and our strategies, beliefs, plans, expectations, anticipations and hopes with respect to Liquidity and Capital Resources set forth under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources,” including, without limitation, (1) our beliefs regarding the impact of the adoption of SFAS Nos. 143, 145 and 146; (2) our intention to continue our participation in synthetic leases in 2003; (3) our beliefs regarding our exposure in connection with the residual value guarantees related to our synthetic leases; (4) our belief that the fair market value of each of the properties subject to the synthetic leases exceeds the purchase option price for each property; (5) our beliefs regarding the impact to liquidity if we must purchase the properties subject to the synthetic leases; (6) our expectations regarding our actions if the lessor under the synthetic leases is deemed to be a voting interest entity versus a variable interest entity; (7) our belief that the additional taxes, losses and expenses associated with our maximum loss exposure on the synthetic leases would be immaterial; and (8) our belief that our current cash position, cash generated through operations and equity offerings, and available borrowings will be sufficient to meet our needs through at least the next twelve months, which statements are subject to numerous risks and uncertainties, including, without limitation, our inability to allocate substantial resources to R&D programs, the inaccuracy of our beliefs regarding taxes, foreign exchange contracts, the impact of certain accounting standards and our synthetic leases, that the semiconductor industry will continue to experience this or another periodic downturn, which could have a material adverse effect on the semiconductor industry’s demand for semiconductor processing equipment, including equipment we manufacture and market, and our success in selecting, developing, manufacturing and marketing our new products, or enhancing our existing products;
•		The statement under the heading “Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk” that we believe that an immediate change to interest rates to variable short-term borrowings will not have a material effect on our results is subject to the risk, among other risks, that we have inaccurately assessed our future borrowing needs; and

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•

The statement in “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 2. Significant Accounting Policies – Concentration of Credit and Other Risks” that we do not believe that there is a significant risk of nonperformance by counterparties on foreign exchange contracts is subject to the risk, among other risks, that we may fail to continuously monitor our positions and the credit ratings of counterparties.

The forward-looking statements in this Annual Report on Form 10-K are subject to additional risks and uncertainties further discussed under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Factors” 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 this Annual Report on Form 10-K. Readers should also consult the cautionary statements and risk factors listed from time to time in our Reports on Forms 10-Q, 8-K, 10-K and in our Annual Reports to Shareholders.

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PART I

ITEM 1. BUSINESS

Novellus Systems, Inc., a California corporation organized in 1984, develops, manufactures, sells and supports systems used in the fabrication of integrated circuits. The customers for these products are manufacturers of semiconductor integrated circuits, or chips, who either incorporate the chips they manufacture in their own products or sell them to other companies for use in electronic products.

Integrated circuits are generally built on a silicon wafer base and include a large number of different components, such as transistors, capacitors and other electronic devices that are connected by multiple layers of wiring or interconnects. To build an integrated circuit, transistors are first created on the surface of the silicon wafer. The wiring and insulating structures are then added as multiple thin-film layers through a series of processes. Typically, a first layer of dielectric, or insulating material is deposited on top of the formed transistors. That layer is then etched to create patterns that are subsequently filled with conductive metal (traditionally aluminum, but increasingly, copper is used). In copper dual damascene, a chemical mechanical planarization, or polishing, step follows to remove excess copper. The sequence is then repeated to create the multiple layers of wiring needed to connect the transistors and form the integrated circuit. Advanced chip designs require as many as 500 steps involving these and other manufacturing processes.

Novellus operates in a single industry segment for the manufacture, marketing and support of semiconductor fabrication equipment. Our product offerings are centered on the advanced systems used to deposit the films of conducting and insulating material, using chemical vapor deposition (CVD), physical vapor deposition (PVD) and electroplating or Electrofill^TM, commonly known in the industry as electrochemical deposition (ECD) processes, to form the layers of wiring and insulation, known as the “interconnect,” in semiconductor devices. Our High-Density Plasma CVD (HDP) and Plasma-Enhanced CVD (PECVD) systems employ a chemical plasma to deposit all of the dielectric or insulating layers and some of the metal or conductive layers on the surface of a semiconductor wafer. Our PVD systems use direct-current power to deposit conductive metal layers by sputtering metallic atoms from the surface of a target source. Our Electrofill systems are used for depositing conductive layers of copper on wafers in an electroplating or “damascene” process.

Building on our historical strength in deposition technologies, in 2001 we expanded into the area of wafer surface preparation by acquiring GaSonics International Corporation, a manufacturer of systems used to clean and prepare a wafer surface after the manufacturing steps that precede deposition. More recently, in December 2002 we completed the acquisition of SpeedFam-IPEC, Inc., a manufacturer of chemical mechanical planarization (CMP) products. As the semiconductor industry migrates to the use of copper and low-k (low-capacitance) dielectrics in semiconductors, the manufacturing steps for surface preparation and CMP are becoming increasingly important.

Our headquarters are located at 4000 North First Street, San Jose, California 95134. The telephone number is (408) 943-9700.

Additional information about Novellus is available on our web site at www.novellus.com. Novellus makes available free of charge on its web site its Annual Reports on Form 10-K, its Quarterly Reports on Form 10-Q, its Current Reports on Form 8-K and amendments to those Reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file them with or furnish them to the Securities and Exchange Commission, or the SEC. Information contained on our web site is not part of this Annual Report on Form 10-K or our other filings with the SEC.

Industry Background

Over the past twenty years, the semiconductor industry has grown rapidly as a result of increasing demand for personal computers, the expansion of the Internet and the telecommunications industry, and the emergence of new applications in consumer electronics. More recently, growth has slowed, and there are signs that the industry may be beginning to mature. While unit demand for semiconductor devices continues to rise, the average selling prices are declining. There is increasing pressure on chipmakers to reduce manufacturing costs while increasing the value of their products at the same time. The semiconductor industry has also been cyclical in nature over its history, with periods of rapid expansion followed by periods of over-capacity.

Several technological trends characterize semiconductor manufacturing. Perhaps the most prominent of these trends is increasing density. Moore’s Law, first postulated in the mid-1960s and still accurate almost 40 years later, states that the density of circuitry on an individual semiconductor chip doubles every 18 months. Today’s advanced devices are being manufactured with line widths as small as 0.13 micron and with up to eight layers of interconnect circuitry. By increasing circuit density, manufacturers can pack more electronic components on a chip and thereby provide higher performance and value. The next generation of chips will likely see line widths as small as 90 nanometer (0.09 micron) and below, requiring even more sophisticated interconnect wiring to keep pace.

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Another trend worth noting is the transition to copper wiring in place of aluminum as the primary conductive material in semiconductor devices. Copper has a lower electrical resistance value than aluminum, and this provides a number of performance advantages. Because of the superior properties of copper, a chip made with copper may need only half as many metal layers as one made with aluminum. This provides a significant reduction in manufacturing cost. In addition, copper wiring produces a significant improvement in device performance and a significant reduction in power requirements as compared to aluminum.

A similar transition is underway to low-k dielectric insulators, which are replacing traditional silicon oxide films. Low-k dielectrics are better at limiting the capacitance that occurs between metal lines in a device. This quality is important to the goal of smaller line widths and increasing component density. However, low-k materials are also less stable than silicon oxide, and this poses a host of new challenges to the semiconductor industry in pursuing its goals of increased circuit density and, at the same time, lower cost of manufacture and higher performance and value of the manufactured product.

Another important trend is the move to larger wafer sizes. Chipmakers are migrating to larger, 300mm wafers because of the potential manufacturing cost advantages these larger wafers provide (through the production of more integrated circuits on each individual wafer) compared to the 200mm wafers that have been the industry standard for approximately the past ten years.

These trends shape the equipment and process demands that our customers place on us. Our customers generally measure the cost and performance of their production equipment in terms of “cost per wafer,” a ratio determined by factoring in the costs for acquisition and installation of a system, operating costs, and net throughput rate. A system with higher net throughput allows a manufacturer to recover the purchase price over a greater number of wafers, thereby reducing the cost of ownership of the system on a per-wafer basis. Yield and film qualities are also significant factors in selecting processing equipment. The higher costs of larger and more complex semiconductor wafers have made high yields extremely important to our customers. To achieve higher yields and better film quality, systems must be able to repeat a process consistently and reliably. This characteristic, known as repeatability, is critical in achieving commercially acceptable yields. Systems that operate at desired throughput rates without approaching critical tolerance limits can achieve repeatability more easily.

Strategy

Our business objective at Novellus is to use our core expertise to increase our market share in the interconnect manufacturing arena and strengthen our position as a leading supplier of semiconductor processing equipment. The following are the key elements of our strategy:

Emphasize High-Productivity Systems – We established our current position in the industry by emphasizing high productivity as the principal benefit that our products and technologies deliver to customers. Our unique multi-chamber system for continuous PECVD processing illustrates our commitment to productivity. This multi-chamber design enables our PECVD systems to attain very high levels of wafer throughput, yield and film quality. The simple architecture of our systems also takes up less space in the fab and requires less downtime than other system designs. We intend to retain our historical focus on productivity by applying our multi-chamber and continuous processing architecture in product enhancements and new product offerings.

Focus on Reducing Customer Costs – Cost is an important component when measuring overall productivity. To that end, we strive to provide products and technologies that reduce our customers’ overall cost of ownership. We pursue these advantages by offering chipmakers a number of process improvements and process differentiators, as well as by providing highly reliable systems that require less servicing than competing alternatives in the market.

Differentiate our Service Philosophy – We do not view our customer service operations as a profit center and source of revenue generation. Our philosophy is to develop reliable products that do not break down as often or require as much servicing as competing alternatives. In addition, we strive to provide support that minimizes the downtime and service costs that our customers’ experience.

Lead in our Target Markets – Our goal is to command a leadership position in each of our target market areas. Historically, we have aimed to be the leader or the second or third largest provider in each of the subsets that comprise the served available market for our deposition products: HDP, CVD, PECVD, PVD and ECD. Due to our 2001 acquisition of GaSonics and subsequent internal product development efforts, we are one of the leading providers of surface preparation products. Our 2002 acquisition of SpeedFam-IPEC has enabled us to become one of the industry’s top suppliers of CMP products. We intend to aggressively pursue a leadership position in CMP similar to those we have achieved in other market segments.

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Broaden our Interconnect Offerings – As semiconductor manufacturing technology becomes more complex, the interconnect structures on a chip take on a greater importance in the manufacturing process. We believe that by expanding beyond our historical focus on deposition products we can add value in related interconnect manufacturing process steps. The acquisitions of GaSonics and SpeedFam-IPEC — which enabled Novellus to enter the surface preparation and CMP product arenas, respectively — are examples of this strategy in action.

Focus on Major Semiconductor Manufacturers – We have sold one or more systems to each of the 2002 world’s top 20 semiconductor manufacturing equipment capital spenders. Our sales objective is to work closely with our customers as they expand existing facilities, retrofit older manufacturing plants with new equipment, and build new fabrication facilities. We strive to build customer loyalty and achieve a high level of repeat business by offering high-reliability products, comprehensive field support, and a responsive parts replacement and service program.

Expand Market Presence in Asia – While we derive a significant percentage of net sales from Asia, we believe that substantial additional growth potential exists in the region over the long term. Japan, Taiwan and Korea continue to represent a disproportionate share of the world’s capacity for semiconductor manufacturing, and China is rapidly becoming a major manufacturing region for the industry. Our local presence in Asia includes sales and support offices throughout Japan. In addition, we maintain five offices in Korea, three in China, two each in Taiwan, Malaysia and Singapore, and one office in India. We plan to continue our efforts to better serve this region.

Leverage our Low Manufacturing Cost Structure – We do all system design, assembly and testing in-house, and outsource the manufacture of major subassemblies. This strategy allows us to minimize our fixed costs and capital expenditures and gives us the flexibility to increase capacity as needed. Outsourcing also allows us to focus on product differentiation through system design and quality control and helps to ensure that our subsystems incorporate the latest third-party technologies in robotics, gas panels and microcomputers. We work closely with our suppliers to achieve mutual cost reduction through joint design projects.

Products

Deposition Products

Our historical strength is rooted in deposition products, where we have consistently maintained a leadership position in the industry. We currently offer products that address the needs of manufacturers across a number of different deposition technologies — CVD, PVD and ECD.

Since the introduction of our Concept One dielectric platform in 1987, we have offered a range of processing systems for dielectric and metal deposition. In 1991, we introduced the Concept Two platform — a modular, integrated production system capable of depositing both dielectric and conductive metal layers by combining one or more processing chambers with a common, automated wafer handler. The Concept Two enables chipmakers to increase production throughput and system capability, as required in 200mm wafer manufacturing applications, by adding process modules without having to replace existing equipment. In 1997, we introduced the Concept Three platform, which builds on the foundation of its predecessor to offer greater throughput in 300mm wafer-manufacturing applications.

HDP CVD Products

In the CVD process, manufacturers place wafers in a reaction chamber, introduce a variety of pure and precisely metered gases into the chamber, and then add some form of energy to activate a chemical reaction that deposits a film on the wafer. The CVD process is the traditional method used to deposit dielectric (insulating) films on wafers. Manufacturers also use CVD to deposit conductive metal layers, particularly tungsten, as it is difficult to deposit such layers on devices with very small features using conventional PVD or other deposition technologies.

Concept Two SPEED^® – Introduced in 1996, Concept Two SPEED was the semiconductor industry’s first high-density plasma system capable of high-volume manufacturing, and today it is one of the top two leading systems in the HDP CVD marketplace. Concept Two SPEED is a single-wafer processing system for 200mm substrates. It is targeted for depositing dielectric material in aluminum interconnect manufacturing processes, as well as for deposition of pre-metal layers in copper manufacturing processes.

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Concept Three SPEED – The Concept Three SPEED is designed for applying dielectric material in 300mm wafer manufacturing processes. Because it is based on our production-proven Concept Two products, Concept Three SPEED offers minimal risk to our customers in making the transition from 200mm to 300mm wafer size in their high-volume integrated circuit manufacturing processes.

CVD Products

Concept Two ALTUS – In 1994, we introduced the Concept Two ALTUS, used to deposit the tungsten plugs and vias that connect aluminum interconnect lines in aluminum-based chips. The Concept Two ALTUS combines the modular architecture of the Concept Two with an advanced tungsten CVD dual-process chamber. The system is ideal for meeting the requirements of high-volume, automated 200mm wafer fabs producing semiconductor devices at 0.18 micron and below.

Concept Three ALTUS – The Concept Three ALTUS, introduced in 1997, brings the same advantages to 300mm wafer tungsten deposition as our Concept Two ALTUS predecessor provides for 200mm wafer applications.

PECVD Products

Concept Two SEQUEL Express^® – Introduced in 1999, the Concept Two SEQUEL Express is designed to deposit our CORAL^® family of low-k dielectric films, as well as other advanced films required for manufacturing 0.18 micron-and-smaller semiconductor devices. With a throughput in excess of 110 wafers per hour, Concept Two SEQUEL Express delivers up to 40 percent higher capital productivity and 40 percent lower cost of ownership than competing PECVD systems.

VECTOR^® – Introduced in 2000, VECTOR is a PECVD system for depositing dielectric films on 300mm wafers. VECTOR delivers a fully integrated low-k dielectric structure at 0.10-micron-and-smaller design rules. With approximately two-thirds the footprint of the nearest competitor, 40 percent fewer critical subassemblies and a throughput of 120 wafers per hour, VECTOR delivers higher capital productivity than any other PECVD system currently on the market.

PVD Products

PVD, also known as “sputtering,” is a process where ions of an inert gas such as argon are electrically accelerated in a high vacuum toward a target of pure metal, such as tantalum or copper. Upon impact, the argon ions sputter off the target material, which is then deposited as a thin film on the silicon wafer. PVD processes are used to create the barrier and seed layers in copper damascene interconnect applications. We entered the PVD marketplace with the acquisition of Varian Associates’ Thin Film Systems Division in 1998.

INOVA^® – The INOVA 200mm system was introduced in 1998 with a multi-chamber, single-wafer processing design. The Hollow Cathode Magnetron or HCM ionized PVD source continues to gain market acceptance based on barrier seed step coverage performance.

INOVA xT – In 2000, we introduced the 300mm INOVA xT with HCM technology. The product continues to offer superior barrier performance leading to low via resistance and improved device reliability.

Electrofill Products

Our Electrofill products are used to produce the primary copper conductive layers in advanced integrated circuits. Electrofill uses copper to fill a structure created within the circuit’s insulating layers, in a manufacturing process called copper damascene. Damascene manufacturing reverses the manufacturing process used with aluminum, where the metal is deposited first, then etched to create lines and vias, and finally filled with insulating layers between the metal lines. Our highly reliable and cost-effective Electrofill products employ liquid chemistries and electrolytic principles to deposit the copper wiring into the dielectric structure.

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SABRE – The SABRE copper Electrofill system, introduced in 1998, is one of the most reliable and technologically advanced copper ECD system available on the market. SABRE meets today’s technology requirements for copper metal layers all the way down to 90 nanometer (0.09 micron) line widths and beyond. It employs a proprietary electrofilling cell that eliminates contamination of the back of the wafer with copper. It features a unique plating cell design that improves the repeatability of the copper fill. The simplicity of SABRE’s design is the key to the system’s high reliability and manufacturing availability. Coupled with the INOVA PVD system, SABRE provides a complete system for depositing advanced copper interconnects.

SABRE xT – The second generation SABRE xT, introduced in 1999, is the industry’s leading ECD platform at both 200 mm and 300 mm wafer sizes. New features on the xT that were not found on the original SABRE include programmable electrical waveforms, advanced plating chemistries, an integrated anneal module and closed-loop chemical monitoring.

Surface Preparation Products

Photoresist strip and clean processes represent an area of semiconductor manufacturing that is becoming increasingly important with the industry’s migration to copper interconnects. Chipmakers use surface preparation products to remove photoresist and other potential contaminants from a wafer before proceeding with the next deposition step in the manufacturing process. We entered this application arena by acquiring GaSonics in 2001, and today we are one of the industry’s leading suppliers of dry-clean surface preparation products.

GAMMA^™ 2100 – The GAMMA 2100 200mm photoresist removal system uses a plasma source to strip photoresist. The GAMMA architecture features a multi-station sequential processing design with six strip stations, resulting in high wafer throughput with a minimal number of critical subsystems.

GAMMA 2130 – The GAMMA 2130 system is a front-end-of-line (FEOL) photoresist strip system for 300mm wafers. Our multi-station sequential processing architecture incorporates six stations within a single process chamber, enabling a 30 percent higher throughput rate when compared to that of the closest competitor.

PEP IRIDIA^® – The PEP IRIDIA is an advanced cleaning system designed for sub-0.18-micron 200mm wafer applications. The IRIDIA’s modular architecture allows manufacturers to configure the system for both front and back-end-of-line cleaning applications down to 90 nanometer device geometries. Targeted at critical steps in copper and low-k manufacturing processes, the IRIDIA offers the highest productivity of any 200mm dry-clean system currently on the market.

SIERRA^® – The SIERRA system is an advanced dry-clean system for 300mm wafer manufacturing processes. It delivers photoresist and residue removal for today’s most advanced applications. The SIERRA system is designed specifically to address the intricate cleaning challenges associated with the industry’s migration to copper metallization and low-k dielectrics. It yields significantly higher capital productivity and significantly lower cost-of-ownership advantages than competing dry-clean systems.

CMP Products

CMP systems polish the surface of a wafer after a deposition process to create a flat topography before moving on to subsequent manufacturing steps. Because copper is more difficult to polish and smooth than previous-generation aluminum interconnects, and because low-k dielectrics are much more porous than their predecessors, CMP has been elevated to the forefront of enabling technology required in a copper damascene manufacturing process. In recognition of this trend, in 2002, we completed the acquisition of SpeedFam-IPEC, a global supplier of CMP systems used in the fabrication of advanced copper interconnects. We believe that the opportunity to integrate the planarization, deposition and surface preparation steps and optimize them for overall performance gives us an important advantage in extending copper/low-k processes to advanced semiconductor devices.

MOMENTUM^™ – MOMENTUM is a high-throughput, dry-in/dry-out CMP system for all 200mm-wafer process applications. Designed with extendibility to accommodate future reductions in line widths, the MOMENTUM has four independent wafer-polishing platens that allow for maximum manufacturing flexibility. It also employs a patented orbital polishing motion that minimizes surface dishing and erosion and a slurry delivery system that results in more efficient consumption of polishing chemicals.

MOMENTUM 300 – Our MOMENTUM 300 is a highly flexible, dry-in/dry-out CMP system that provides a transition for manufacturers moving from 200mm to 300mm wafer processing. The system is unique in that it combines a number of advanced

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planarization and in-line inspection technologies to produce highly effective throughput, yield management, superior process capabilities and low cost of ownership.

Marketing, Sales and Service

We market products worldwide to manufacturers of semiconductor devices. In North America, we sell our products through a direct sales force that operates out of ten sales and support offices. In Europe, we sell our products predominantly through our sales and support facilities in France and Scotland. We also maintain sales and service support offices in the Netherlands, Germany, Ireland and Italy. In Asia, we sell our products directly in China, Japan, Korea, Malaysia, Singapore and Taiwan. Our Japanese operations, with headquarters near Tokyo, include ten sales offices throughout Japan.

The ability to provide prompt and effective field support is critical to our sales efforts, and we believe the support that we provide to our installed base has accelerated the penetration of certain key accounts. We also believe that our marketing efforts are enhanced by the technical expertise of our research and development personnel, who provide customer process applications support and participate in a number of industry forums such as conferences and technical symposia.

Equally significant, we believe that the design simplicity of our systems substantially enhances our ability to support our customers. In 1992, we became the first semiconductor equipment manufacturer to extend our warranty up to 24 months from shipment, and in 1993 we began to include the cost of consumable parts on some systems and preventative maintenance parts under warranty. We offer maintenance contracts as an additional service to customers.

For the year ended December 31, 2002, Samsung Electronics, Intel Corporation, Taiwan Semiconductor Manufacturing Company and International Business Machines Corporation accounted for 17%, 11%, 11% and 10% of our net sales, respectively. For the year ended December 31, 2001, Intel Corporation accounted for 16% of our net sales. For the year ended December 31, 2000, Intel Corporation and Taiwan Semiconductor Manufacturing Company accounted for 14% and 10% of our net sales, respectively. Historically, we have sold a significant proportion of systems in any particular period to a limited number of customers. Sales to our ten largest customers in 2002, 2001 and 2000 accounted for 79%, 61% and 71% of our net sales, respectively. We expect that sales of our products to relatively few customers — none of which has entered into a long-term agreement requiring it to purchase our products — will continue to account for a high percentage of our net sales in the foreseeable future.

Export sales — including sales by our Japanese subsidiary — for the year ended December 31, 2002 were approximately $513.6 million, or 61% of net sales. For the year ended December 31, 2001, export sales were $733.9 million, or 55% of net sales, while export sales for the year ended December 31, 2000 were approximately $834.5 million, or 63% of net sales.

Backlog

As of December 31, 2002, our backlog was $304.4 million, with no cancellations in the period subsequent to December 31, 2002 to the date of this Annual Report on Form 10-K, compared to a backlog of $266.5 million as of December 31, 2001, with approximately $81.8 million of cancellations subsequent to December 31, 2001. Our backlog includes only those customer orders for which we have accepted purchase orders and assigned shipment dates within twelve months. All orders are subject to cancellation or rescheduling by customers, with limited or no penalties. Some products are shipped in the same quarter in which the order was received. For this reason, and because of possible changes in delivery schedules, cancellations of orders and delays in shipments, our backlog as of any particular date is not necessarily a reliable indicator of actual sales for any succeeding period.

Research and Development

The highly cyclical semiconductor manufacturing industry is subject to rapid technological change and continual new product introductions and enhancements. Our ability to remain competitive depends in large part on our success in developing new and enhanced systems and introducing them at competitive prices on a timely basis. For this reason, we devote a significant portion of our personnel and financial resources to research and development programs.

Our current research and development efforts are directed at the development of new systems and processes and the improvement of the capabilities of existing systems. Research and development programs include advanced PVD systems, advanced gap fill technology, primary conductor metals, low-k dielectric materials, CMP systems, and additional advanced deposition and surface

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preparation technologies for the next generation of smaller-geometry fabrication lines. All new systems under development are capable of processing 300mm wafers.

Expenditures for research and development during 2002, 2001 and 2000 were $222.3 million, $272.0 million and $198.3 million, respectively. These investments represented approximately 26%, 20% and 15% of our net sales in 2002, 2001 and 2000, respectively. We believe that research and development expenditures will continue to represent a substantial percentage of our net sales in the future.

Manufacturing

Our manufacturing activities consist primarily of assembling and testing components and subassemblies that we acquire from third-party vendors and then integrate into a finished system. We utilize an outsourcing strategy for the manufacture of major subassemblies, and we perform all system design, assembly and testing in-house. Our outsourcing strategy enables us to minimize fixed costs and capital expenditures as well as provide the flexibility to increase production capacity. This strategy also allows us to focus on product differentiation through system design and quality control. We believe that our use of outsourced product specialists enables our subsystems to incorporate the latest and most advanced technologies in robotics, gas panels and microcomputers without the need for in-house expertise. We strive to work as closely as possible with all of our suppliers to achieve mutual cost reduction through joint design efforts.

Although we make reasonable efforts to ensure that such parts are available from multiple suppliers, certain key parts may only be obtained from a single or limited source. These suppliers are in some cases thinly capitalized, independent companies that generate significant portions of their business from us and/or a small group of other companies in the semiconductor industry. We seek to reduce our dependence on single or limited source suppliers. However, disruptions in parts delivery or termination of certain of these suppliers may occur. Such disruptions and terminations could have an adverse effect on our operations. A prolonged inability to obtain certain parts could have a material adverse effect on our business, financial condition or results of operations, and could result in our inability to meet customer demands on time.

We manufacture our systems in clean room environments similar to those used by semiconductor manufacturers for wafer fabrication. This helps to minimize the amount of particulates and other contaminants in the final assembled system, which in turn improves yields and reduces the level of contaminants for our customers. Following assembly, we package our completed systems in plastic shrink-wraps to maintain clean room standards during shipment.

Competition

Significant competitive factors in the semiconductor equipment market include system performance and flexibility, cost, the size of each manufacturer’s installed customer base, customer support capability and the breadth of a company’s product line. We believe that we compete favorably in all of the market segments we serve because of the fundamental advantages associated with our system performance and flexibility, low cost of ownership, high wafer yields and customer support. However, we face substantial competition from both established competitors and potential new entrants in each of these markets. Installing and integrating capital equipment into a semiconductor production line represents a substantial investment. For this reason, once a manufacturer chooses a particular vendor’s capital equipment, experience has shown that the manufacturer will generally rely upon that equipment for the useful life of the specific application. As a result, all of today’s semiconductor equipment makers typically have difficulty in selling a product to a particular customer to replace or substitute for a competitor’s product previously chosen or qualified by that customer.

In the CVD, PECVD and PVD markets, our principal competitor is Applied Materials, Inc., a major supplier of systems which has established a substantial base of installed equipment among today’s leading semiconductor manufacturers. In the ECD market, our principal competitors are Semitool, which has a large base of installed equipment, and Applied, which entered the market in 1999. Our principal competitors in the surface preparation product arena are Mattson Technologies and Axcelis Technologies. In the CMP market, which we entered at the end of 2002, our major competitors are Applied and Ebara.

Patents and Proprietary Rights

We intend to continue to pursue the legal protection of our technology primarily through patent and trade secret protection. We currently hold over 300 patents. We have many pending patent applications, and we intend to file additional patent applications as appropriate. There can be no assurance that patents will be issued from any of these pending applications or future filings, or that any

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claims allowed from existing patents or pending or future patent applications will be sufficiently broad to protect our technology. While we intend to vigorously protect our intellectual property rights, there can be no assurance that any patents we hold will not be challenged, invalidated or circumvented, or that the rights granted thereunder will provide competitive advantages to us. See Item 3. Legal Proceedings for further discussions.

We also rely on trade secrets and proprietary technology that we protect through confidentiality agreements with employees, consultants, and other parties. There can be no assurance that these parties will not breach these agreements, that we will have adequate remedies for any breach, or that our trade secrets will not otherwise become known to or independently developed by others.

There has been substantial litigation regarding patent and other intellectual property rights in semiconductor-related industries. We are currently involved in such litigation. Except as set forth in Item 3. Legal Proceedings, we are not aware of any significant claim of infringement by our products of any patent or proprietary rights of others; however, we could become involved in additional litigation in the future. Although we do not believe the outcome of the current litigation will have a material impact on our business, financial condition or results of operations, no assurances can be given that this litigation or future litigation will not have such an impact. For further discussion see Item 3. Legal Proceedings.

In addition to the current litigation, our operations—including the further commercialization of our products—could provoke additional claims of infringement from third parties. In the future, litigation may be necessary to enforce patents issued to us, to protect trade secrets or know-how that we own, to defend ourselves against claimed infringement of the rights of others, or to determine the scope and validity of the proprietary rights of others. Any such litigation could result in substantial cost and diversion of our effort and could have a material adverse effect on our financial condition or operating results. In addition, adverse determinations in such litigation could result in our loss of proprietary rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties, or prevent us from manufacturing or selling our products. Any of these occurrences could have a material adverse effect on our business, financial condition or results of operations.

Employees

On December 31, 2002, we had 3,228 full-time and temporary employees. None of our employees are represented by a labor union, and we have never experienced a work stoppage, slowdown or strike. We consider our employee relations to be good.

The success of our future operations depends in large part on our ability to recruit and retain senior management, engineers, technicians, marketing, sales and service professionals and other key personnel. Qualified people are in great demand across each of these industry disciplines, and there can be no assurance that we will be successful in retaining or recruiting key personnel.

Business Combinations

We acquired SpeedFam-IPEC on December 6, 2002 in a stock-for-stock acquisition whereby each share of SpeedFam-IPEC common stock and options outstanding as of the closing date were converted into 0.1818 of a share of Novellus common stock or options on a fixed exchange ratio basis.

We acquired GaSonics in a stock-for-stock acquisition on January 10, 2001, with all outstanding shares of GaSonics capital stock converted into approximately 9,240,000 shares of Novellus’ common stock. In addition, all outstanding options to purchase shares of GaSonics capital stock were automatically converted into options to purchase approximately 1,400,000 shares of Novellus’ common stock. For further discussion of business combinations, see Note 7 to the Consolidated Financial Statements.

Environmental Matters

Neither compliance with federal, state and local provisions regulating discharge of materials into the environment, nor remedial agreements or other actions relating to the environment, has had — or is expected to have — a material effect on our capital expenditures, financial condition, results of operations or competitive position.

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ITEM 2. PROPERTIES

Our operations are conducted primarily in 13 buildings with approximately 1,109,000 square feet of space. Eight buildings totaling approximately 559,000 square feet are located in the San Jose, California area, and four buildings totaling approximately 442,000 square feet are located in the Portland, Oregon area. In addition, we occupy one building of approximately 108,000 square feet in Chandler, Arizona, which served as the corporate headquarters of SpeedFam-IPEC prior to the December 2002 acquisition.

We lease buildings in San Jose under agreements that expire in 2006. These leases have options to extend for three one-year renewal periods with the lessor’s consent. These buildings house three manufacturing operations, a research and development facility, an applications demonstration lab, various administrative and customer support offices, and our headquarters.

Our properties in the Portland area consist of four buildings in the city of Tualatin. These buildings are located on 58 acres of owned land. Under a long-term ground lease, we lease a portion of the land consisting of 23 acres to the lessor of the buildings which have been constructed thereon. One building totaling approximately 65,000 square feet is owned by Novellus and provides manufacturing, research and development, and customer support for the SABRE, our Electrofill product. The remaining three buildings totaling approximately 377,000 square feet are leased under an agreement that expires in 2006 and contains an option to extend for three one-year renewal periods with the lessor’s consent. These buildings consist of manufacturing, research and development, engineering and training facilities.

Our Chandler facility consists of one building leased under an operating lease that expires in 2017. This building houses our CMP operations, including manufacturing, research and development and engineering.

We lease several field office sites domestically totaling approximately 94,000 square feet of space. In addition, we own one building totaling approximately 41,000 square feet in the Chicago, Illinois area, which we acquired in conjunction with the SpeedFam-IPEC acquisition in December 2002. We also sublease, or have available for sublease, approximately 778,000 square feet of space in and around the San Jose, California and Chandler, Arizona areas. We lease several sites outside of the United States which we use as sales and customer service centers. These sites total approximately 201,000 square feet of space.

Our European offices occupy approximately 38,000 square feet of space in various countries throughout Europe, including France, Germany, Italy, Ireland, the Netherlands and the United Kingdom. Our Asian offices occupy approximately 173,000 square feet of space in various countries throughout Asia, including China, India, Japan, Korea, Malaysia, Singapore and Taiwan.

We believe that our current facilities are sufficient to meet our requirements for the foreseeable future.

ITEM 3. LEGAL PROCEEDINGS

Applied Materials, Inc.

On June 13, 1997, we agreed to purchase the Thin Film Systems (“TFS”) business of Varian Associates, Inc. On the same day, Applied Materials, Inc. sued Varian in the United States District Court (the “Court”) for the Northern District of California for alleged infringement by TFS of several of Applied’s physical vapor deposition (PVD) patents (the “Applied Patents”).

On June 23, 1997, we sued Applied in the United States District Court for the Northern District of California, claiming infringement by Applied of several of our PVD patents acquired from Varian in the TFS purchase. Applied has filed counterclaims in this suit, alleging that we infringe Applied’s patents. We seek an injunction against future infringement by Applied, damages for past infringement and treble damages for willful infringement.

On July 7, 1997, Applied amended its complaint in its suit against Varian to add Novellus as a defendant. We have requested that the Court dismiss us as a defendant in this suit. The Court has not yet ruled on the request or required us to file an answer in this lawsuit.

The relief requested by Applied in both suits includes a permanent injunction against future infringement, damages for alleged past infringement and treble damages for alleged willful infringement.

We believe that we have meritorious claims against Applied. We also believe that there are meritorious defenses to Applied’s allegations, including the defense that our operations and products (including TFS products and systems) do not infringe the Applied Patents, and that the Applied Patents are invalid, unenforceable or both. As a result of court rulings adverse to Applied—and in light of

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certain indemnity obligations undertaken by Varian, which include reimbursement of certain legal expenses and a portion of any losses incurred from this litigation — we do not believe that Applied’s claims will have a material adverse effect on our business, financial condition or results of operations.

Semitool, Inc.

On August 10, 1998, Semitool, Inc. sued Novellus for patent infringement in the United States District Court for the Northern District of California. Semitool alleges patent infringement concerning several patents related to our SABRE and SABRE xT systems for depositing copper layers on semiconductor wafers. Semitool seeks an injunction against the manufacturing and sale of the SABRE and SABRE xT systems by Novellus, and damages for alleged past infringement. Semitool also seeks treble damages for alleged willful infringement.

On March 17, 2000, the District Court granted our motion for summary judgment and ruled that our SABRE and SABRE xT systems do not infringe Semitool’s patents. On May 15, 2000, Semitool appealed this ruling to the United States Court of Appeals for the Federal Circuit. On June 8, 2001, the Court of Appeals affirmed the judgment of non-infringement. On September 6, 2001, Semitool then filed a petition with the United States Supreme Court to review the judgment of the Court of Appeals. The Supreme Court vacated the opinion of the Court of Appeals and remanded the case to the Court of Appeals for further consideration. On July 23, 2002, the Court of Appeals again affirmed the District Court’s judgment of non-infringement.

On June 11, 2001, Semitool again sued Novellus for patent infringement in the United States District Court for the District of Oregon. In this second lawsuit, Semitool alleges that our SABRE and SABRE xT systems infringe one of Semitool’s patents. Semitool seeks an injunction against future infringement by Novellus, damages for alleged past infringement and treble damages for alleged willful infringement.

On November 13, 2001, we countersued Semitool for patent infringement in the United States District Court for the District of Oregon. We allege that Semitool infringes certain Novellus patents related to the SABRE and SABRE xT systems. We seek an injunction against Semitool, damages for past infringement, and treble damages for willful infringement by Semitool.

This litigation is in its early stages and therefore is inherently difficult to assess. We believe that we have meritorious claims against Semitool, and that this litigation will not have a material adverse impact on our business, financial condition or results of operations. However, the outcome of patent disputes is often affected by uncertainty in the resolution of complex issues of fact and law. If Semitool were to prevail against us, the adverse effect on our business, financial condition or results of operations could be material.

Plasma Physics Corporation and Solar Physics Corporation

On June 14, 2002, certain of our customers — including Agilent Technologies, Inc., Micron Technology, Inc., Agere Systems, Inc., National Semiconductor Corporation, Koninklijke Philips Electronics N.V., Texas Instruments, Inc., ST Microelectronics, Inc., LSI Logic Corporation, International Business Machines Corporation, Conexant Systems, Inc., Motorola, Inc., Advanced Micro Devices, Inc. and Analog Devices Inc. were sued for patent infringement by Plasma Physics Corporation and Solar Physics Corporation. We have not been sued by Plasma Physics, Solar Physics, or any other party in connection with any allegation of patent infringement by Plasma Physics or Solar Physics. Certain defendants in the case have notified us that they believe that we have indemnification obligations and liability relating to these lawsuits. We believe that this matter will not have a material adverse impact on our business, financial condition or results of operations. There can be no assurance, however, that we will not be sued in the future in connection with the allegations made by Plasma Physics and Solar Physics or that, if we are sued, we will prevail in any such lawsuit. If a party were to file such a lawsuit and prevail against us, the adverse impact on our business, financial condition or results of operations could be material.

Linear Technology Corporation

On March 12, 2002, Linear Technology Corporation filed a complaint against Novellus, among other parties, in the Superior Court of the State of California for the County of Santa Clara. The complaint seeks damages (including punitive damages) and injunctions for causes of actions involving alleged breach of contract, fraud, unfair competition, breach of warranty and declaratory relief. We filed a demurrer to Linear’s complaint.

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This litigation is in its early stages and is therefore inherently difficult to assess. We believe that this litigation will not have a material adverse impact on our business, financial condition or results of operations. However, the outcome of patent disputes is often affected by uncertainty in the resolution of complex issues of fact and law. If Linear were to prevail against us, the adverse effect on our business, financial condition or results of operations could be material.

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.

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

Not applicable.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Stock Information

Novellus’ common stock is traded on the NASDAQ Stock Market and is quoted on the NASDAQ National Market under the symbol “NVLS.” The following table sets forth the high and low prices of our common stock as reported by the NASDAQ National Market for the periods indicated:

We have not paid cash dividends on our common stock since inception, and our Board of Directors presently plans to reinvest our earnings in the business. Accordingly, it is anticipated that no cash dividends will be paid to holders of common stock in the foreseeable future. As of February 26, 2003, there were 1,179 holders of record of our common stock.

ITEM 6. SELECTED FINANCIAL DATA

Set forth below is a summary of certain consolidated financial information with respect to Novellus as of the dates and for the periods indicated. The consolidated statements of operations data set forth below for the fiscal years ended December 31, 2002, 2001, 2000, 1999 and 1998 and the consolidated balance sheet data as of December 31, 2002, 2001, 2000, 1999 and 1998 have been derived from our consolidated financial statements, which have been audited. We acquired GaSonics on January 10, 2001, in a transaction accounted for as a pooling-of-interests. The selected financial data includes the operating results and financial data of Novellus and GaSonics for all periods. We acquired SpeedFam-IPEC on December 6, 2002, in a transaction accounted for as a purchase business combination. The selected financial data includes the operating results and financial data of SpeedFam-IPEC from December 6, 2002.

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Selected Consolidated Financial Data
(in thousands, except per share data)

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(2)	We recorded pre-tax charges totaling $84.5 million for the year ended December 31, 2001 associated with restructuring and acquisition activities, other than temporary decline in value of an investment and write-off of a bad debt.
(3)	We adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” or SFAS No. 142, in the first quarter of 2002. As a result of its adoption, we no longer amortize goodwill, which resulted in an increase in net income of $3.6 million for the year ended December 31, 2002. Retroactive application of SFAS No. 142 would have resulted in an increase in net income for the year ended December 31, 2001 of $3.5 million, or $0.02 per diluted share. Amortization of goodwill was not material in all years shown prior to 2001.
(4)	We recorded pre-tax charges totaling $32.5 million for the year ended December 31, 2002 associated with restructuring and severance activities of $6.5 million, write-off of debt issuance costs of $17.0 million and acquired in-process research and development charge relating to the acquisition of SpeedFam-IPEC of $9.0 million. Additionally, we recorded a pre-tax benefit of $12.3 million for the year ended December 31, 2002 associated with the recovery of a receivable previously written off of $7.7 million and a gain on the sale of an equity investment of $4.6 million.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We are a supplier of semiconductor manufacturing equipment used in the fabrication of integrated circuits. Demand for our systems can vary significantly from period to period as a result of various factors, including, but not limited to, downturns in the semiconductor industry, supply and demand for semiconductor devices and substantial competition in the semiconductor industry among suppliers of similar products. For these and other reasons, our results of operations for fiscal 2002, 2001 and 2000 may not necessarily be indicative of future operating results.

As more fully described in Note 7 to the Consolidated Financial Statements, we acquired GaSonics, a developer and supplier of semiconductor equipment used for photoresist and residue removal, on January 10, 2001 in a pooling-of-interests transaction. The consolidated financial statements for fiscal 2000 have been restated to include the results of operations and cash flows of GaSonics. Because of differing year-end periods, financial information relating to Novellus’ fiscal year ended December 31, 2000 has been combined with financial information relating to GaSonics’ fiscal year ended September 30, 2000. GaSonics’ net income for the three months ended December 31, 2000 was not combined with our net income, but rather was included as an adjustment to shareholders’ equity. Revenue and net income of GaSonics for the three-month period ended December 31, 2000, which are excluded from the accompanying statements of operations, were $47.7 million and $0.9 million, respectively. There were no transactions between GaSonics and Novellus prior to the combination.

On December 6, 2002, we completed the acquisition of SpeedFam-IPEC, a global supplier of CMP systems used in the fabrication of advanced copper interconnects. Under the terms of the definitive agreement signed on August 12, 2002, we acquired all outstanding shares of SpeedFam-IPEC in a stock-for-stock acquisition whereby each share of SpeedFam-IPEC common stock outstanding as of the closing date was converted into 0.1818 of a share of Novellus common stock on a fixed exchange ratio basis. In addition, we assumed all $116.4 million of SpeedFam-IPEC’s 6.25% Convertible Subordinated Notes, originally due in 2004. The notes were subsequently paid off in full in January 2003. The acquisition was accounted for as a purchase business combination and qualifies as a tax-free reorganization under IRS regulations. The consolidated financial statements for fiscal 2002 include the financial position, results of operations and cash flows of SpeedFam-IPEC from December 6, 2002. For further discussion, see Note 7 to the Consolidated Financial Statements.

Critical Accounting Policies

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

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Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, or SAB 101, “Revenue Recognition in Financial Statements” and “SAB 101: Revenue Recognition in Financial Statements-Frequently Asked Questions and Answers” (“SAB 101 FAQ”). We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable and collectibility is reasonably assured.

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

Installation services are not essential to the functionality of the delivered equipment. We allocate revenue based on the residual method as a fair value has been established for installation services. However, since the final payment is not typically due until customer acceptance, we defer revenue for the final payment, which is in excess of the fair value of the installation services. All other equipment sales are recognized upon customer acceptance.

Revenue related to spare part sales is recognized upon shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Unearned maintenance and service contract revenue is not significant and is included in other accrued liabilities.

Inventory Valuation

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

Goodwill and Other Intangible Assets

Effective January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that goodwill and identifiable intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Furthermore, SFAS No. 142 includes provisions on the identification of intangible assets, reclassification of certain intangible assets from previously reported goodwill, and reassessment of the useful lives of existing intangible assets. Upon adoption, we reassessed the useful lives and residual values of all acquired identifiable intangible assets to identify any necessary amortization period adjustments and to determine whether other intangible assets should be reclassified from goodwill. Based on that assessment, no adjustments were made to the amortization period or residual values of identifiable intangible assets.

Deferred Tax Assets

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Our valuation allowance was recorded as an increase to goodwill in connection with acquired net operating loss carryforwards, which are not realizable until 2009 and beyond. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Should the existing deferred tax asset, which is currently offset by the valuation allowance, be realized, the benefit of such realization and the related reversal of the valuation allowance would result in a reduction of goodwill. If we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would decrease income in the period such determination was made.

Warranty Obligations

Our warranty policy generally states that we will provide warranty coverage for a predetermined amount of time on systems and modules for material and labor to repair and service the equipment. We record the estimated cost of warranty coverage to cost of sales

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upon system shipment. The estimated cost of warranty is determined by the warranty term, as well as the average historical labor and material costs for a specific product. Should actual product failure rates or material usage differ from our estimates, revisions to the estimated warranty liability may be required. These revisions could have a positive or negative impact on gross profit. We review the actual product failure rates and material usage rates on a quarterly basis and adjust our warranty liability as necessary.

Restructuring and Impairment Charges

We account for restructuring in accordance with Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring),” EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” and SAB No. 100, “Restructuring and Impairment Charges.” Accordingly, restructuring accruals are recorded when management initiates an exit plan that will cause us to incur costs that have no future economic benefit. Also under the terms of EITF 94-3, a liability for the restructuring charges is recognized in the period management approves the restructuring plan. Additionally, certain restructuring charges related to asset impairments are recorded in accordance with SFAS No. 144. The restructuring accrual related to vacated properties is calculated net of estimated sublease income we expect to receive once we sublet the properties that have been vacated. Sublease income is estimated based on current market quotes for similar properties. If we are unable to sublet these properties on a timely basis or if we are forced to sublet them at lower rates due to changes in market conditions, we would adjust the accrual accordingly.

Results of Operations
(dollars in thousands)

Net Sales

We operate our business in the semiconductor equipment industry, which is subject to cyclical conditions. These conditions have played a major role in the fluctuations in our net sales. The decrease in net sales of 37% from 2001 was primarily due to a substantial reduction in customer capital spending in response to weakened worldwide demand for semiconductor devices. The demand for semiconductor manufacturing equipment has historically fluctuated with changes in the supply of and demand for semiconductor devices and other factors, including rapid technological advances in the semiconductor manufacturing processes. The increase in net sales of 2% in 2001 from 2000 was attributable to an increase in sales of our Electrofill and 300mm product lines, partially offset by a decrease in sales of our 200mm products.

International sales were 61% of net sales in 2002, an increase from 55% in 2001. This increase was attributable to higher demand in the Asian region, primarily related to higher demand in China, Taiwan and Korea, and partially offset by lower demand in Southeast Asia and Japan. The Asian region accounted for 54% and 48% of total net sales in 2002 and 2001, respectively. International sales in 2001 were down from 63% of total net sales in 2000. The decrease in international sales as a percentage of net sales in 2001 was a result of lower demand in China, Taiwan, Southeast Asia and Korea, partially offset by higher demand in Japan.

Gross Profit

The decline in gross profit as a percentage of net sales in 2002 compared to 2001 and 2000 was primarily due to the reduced absorption of fixed overhead costs resulting from lower production and shipments. During 1999 and 2000, and through our acquisition of GaSonics in January 2001, we expanded our manufacturing facilities to accommodate the unprecedented growth in demand for

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semiconductor manufacturing equipment. As a result of the industry downturn and overall slowing economy that began in 2001 and continued through 2002, orders for our equipment were not sufficient to fully absorb the fixed overhead costs of these facilities in those periods. In 2001, we implemented a restructuring plan to consolidate some of our facilities. The 2001 gross profit was reduced by a $7.1 million charge associated with the write-off of inventory related to two products which we discontinued in connection with our restructuring plan. The gross profit was also impacted by a benefit of $4.4 million related to our decision not to pay our 2001 bonus and profit sharing because we did not meet the minimum performance guidelines required for bonus payment.

In addition, our gross profit is impacted by our treatment of certain product sales as multiple-element arrangements in accordance with SAB 101, for which we recognize all of a product’s cost upon shipment even though a portion of a product’s revenue may be deferred until final payment is due, which is typically upon customer acceptance.

Selling, General and Administrative

Selling, general and administrative, or SG&A, expenses include compensation and benefits for corporate, financial, marketing, and administrative personnel, travel, utilities, communications expenses and professional fees. Also included are expenses for rents, depreciation and amortization related to the assets utilized by the functions noted above. The increase in SG&A expenses as a percentage of net sales in 2002 over 2001 was primarily due to the substantial reduction in net sales. The decrease in the absolute dollar amount of these expenses reflects the impact of the cost reduction measures that we implemented in the second half of 2001. These cost reduction measures include executive and employee pay reductions and facilities consolidation. In addition, we had workforce reductions in the first and fourth quarter of 2002. The decrease in SG&A expense, both in absolute dollars and as a percentage of net sales in 2001 over 2000, reflects the impact of the cost reduction measures as well as our decision not to pay $13.1 million of bonus and profit sharing in 2001 as we did not meet the minimum performance guidelines required for bonus payment.

Research and Development

Our significant investments in research and development, or R&D, over the past three years reflect our strong commitment to the continuous improvement of our current product lines and the development of new products and technologies. We plan to continue to focus our R&D investment on the continuous improvement of our existing product lines as well as the development of new products and technologies such as advanced PVD and CMP systems, advanced gap fill technology, primary conductor metals, low-k dielectric materials, additional advanced deposition and surface preparation technologies for the next generation of smaller geometry fabrication lines and equipment to process 300mm wafers. R&D expenses include compensation and benefits for our research and development personnel, project materials, chemicals and other direct expenses incurred in product and technology development, repairs and maintenance, rent, depreciation and amortization expenses associated with patents and purchased technologies. The increase in R&D expenses as a percentage of net sales in 2002 over 2001 was primarily due to the substantial reduction in net sales. The 18% decrease in the absolute dollar amount of R&D expenses from 2001 to 2002 was due to the decision to lower our investment levels in R&D spending. The increase in R&D expenses from 2000 to 2001 resulted from our continued commitment to invest in new products and technologies. This increase was partially offset by our decision to cancel the payment of our 2001 bonus and profit sharing of $7.9 million as we did not meet the minimum performance guidelines required for bonus payment.

Fiscal 2002 R&D expense as a percentage of net sales increased from 2001 primarily because of the substantial reduction in net sales in 2002. This increase in R&D expenses as a percentage of net sales reflects our continued commitment to the development of new products and technologies to provide competitive cost advantages for our customers. Despite the downturn in the industry and weakened demand for semiconductor equipment, we continue to believe that substantial investments in R&D are critical to remaining competitive and positioning ourselves to meet current and projected requirements of semiconductor fabrication processes.

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Acquired In-Process Research and Development

In connection with the acquisition of SpeedFam-IPEC in December 2002, we recorded a $9.0 million charge to write-off certain acquired in-process research and development, or IPR&D. Projects which qualify as IPR&D have not yet reached technological feasibility and have no alternative future use. Technological feasibility is defined as being equivalent to completion of a beta-phase working prototype in which there is no significant remaining risk relating to the development.

The value assigned to IPR&D was determined by considering the importance of each project to the overall development plan, estimating costs to develop the acquired IPR&D into commercially viable products, estimating the resulting net cash flows from the projects when completed and discounting the net cash flows to their present value. The revenue estimates used to value the purchased IPR&D were based on estimates of relevant market sizes and growth factors, expected trends in technology and the nature and expected timing of new product introductions by SpeedFam-IPEC and its competitors.

The rates utilized to discount the net cash flows to their present value were based on a weighted-average cost of capital determined by examining market information for several comparable companies. The weighted-average cost of capital was adjusted to reflect the difficulties and uncertainties in completing each project and thereby achieving technological feasibility, the percentage of completion of each project, anticipated market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. Based on these factors, a discount rate of 25% was deemed appropriate for valuing the IPR&D. The estimates used in valuing IPR&D were based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. As a result, actual results may differ from estimates.

In fiscal 2000, GaSonics recorded a charge of $6.0 million for the write-off of acquired in-process research and development associated with the acquisition of Gamma Precision Technologies, Inc., or GPT, because certain of GPT’s ongoing research and development projects had not reached technological feasibility and had no alternative future use. This included development, engineering and testing activities associated with the introduction of GPT’s new products and technologies.

Restructuring and Other Charges

Restructuring and other charges in 2002 consisted of $1.5 million related to vacated facilities and $5.0 million of severance benefits for workforce reductions. In 2001, we implemented a restructuring plan and recorded restructuring and asset impairment charges of $47.9 million and acquisition costs of $13.2 million related to the acquisition of GaSonics. The restructuring and asset impairment charges included $33.8 million related to vacated facilities, $9.5 million related to abandoned assets associated with the discontinuation of certain projects and $4.6 million related to a write-off of abandoned purchased technology. The discontinuation of two products resulted in a $7.1 million inventory write-down in 2001, which is included in cost of sales for that year.

The charge for vacated facilities relates to rent obligations after the abandonment of certain facilities currently under long-term operating lease agreements. When applicable, anticipated future sublease income related to the vacated buildings has been offset against the charge for the remaining lease payments. Additionally, certain fixed assets, including leasehold improvements, associated with the abandoned facilities that had no future economic benefit have been written off. Except for the future rent obligations and the sublease of the vacated facilities, substantially all actions under the 2001 restructuring plan had been achieved as of December 31, 2001. Under the 2001 restructuring plan, $18.5 million remains for future rent obligations, which are to be paid in cash over the next four years. For further discussion, see Note 8 to the Consolidated Financial Statements.

The restructuring saved us approximately $38.8 million of expenses in fiscal 2002. Of the $38.8 million in savings, $9.8 million relates to savings from vacated facilities and $29.0 million relates to savings from workforce reductions.

The acquisition costs related to the acquisition of GaSonics included $9.4 million of professional fees and financial printing and $3.8 million of other related costs. The acquisition costs also included charges related to the cancellation of various contracts and the write-off of certain redundant assets. All expenses related to this acquisition have been paid.

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Bad Debt (Recovery) Write-off

     In September 2001, we determined that an outstanding accounts receivable balance was at risk for collection because the customer was facing financial difficulties, payment was overdue and overall industry conditions continued to deteriorate. Accordingly, we recorded a write-off of $7.7 million. However, in the first quarter of 2002, all amounts owed under this accounts receivable balance were collected, resulting in a benefit to operations of $7.7 million.

Other Income, net

Other income, net, includes interest income, interest expense and other non-operating income and expenses. The decrease in other income, net, from 2001 to 2002 reflects a decrease in interest income primarily due to a continued decline in interest rates and a decrease in interest-bearing investments after we used $880.0 million of restricted investments to retire substantially all of our Liquid Yield Option^TM Notes, or LYONs, in the third quarter of 2002. Additionally, we recorded a non-cash charge of $17.0 million for the unamortized issuance costs related to the retirement of the LYONs in the third quarter of 2002. The decrease in other income in 2002 was partially offset by a $4.6 million gain on the sale of an equity investment.

The increase in other income, net from 2000 to 2001 is attributable to higher cash and short-term investment balances in the second half of the year as a result of the $880.0 million cash obtained from the LYONs, partially offset by an $8.6 million write-down of an equity investment due to an other-than-temporary decline in fair value.

Provision for Income Taxes

The provision for income taxes reflects an effective tax rate of zero in 2002, 31.0% in 2001 and 31.7% in 2000. The decrease in the effective tax rate compared with the prior years is due primarily to the relative benefit of tax credits being higher due to decreased profitability in 2002.

Deferred Tax Assets

As of December 31, 2002, we had approximately $100.1 million of deferred tax assets, net of a valuation allowance, related principally to acquired net operating loss carryforwards and items that are not currently deductible. Management believes the deferred tax assets will be realized due to anticipated future income and potentially refundable taxes in available carryback periods. We have a valuation allowance of $57.0 million principally related to acquired net operating loss carryforwards, which are not realizable until 2009 and beyond.

Foreign Currency Accounting

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

Foreign Exchange Contracts

We conduct our business in various foreign currencies. Forward foreign exchange contracts are used to hedge against the short-term impact of foreign currency fluctuations on intercompany accounts payable denominated in U.S. dollars recorded by our Japanese

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subsidiary. We also enter into forward foreign exchange contracts to buy and sell foreign currencies to hedge our intercompany balances denominated in a currency other than the U.S. dollar. In 2002 and 2001, these hedging contracts were denominated primarily in the Japanese yen and the Taiwanese dollar. The forward foreign exchange contracts we use are generally short-term in nature. The effect of exchange rate changes on forward foreign exchange contracts is expected to offset the effect of exchange rate changes on the underlying hedged items. We believe these financial instruments do not subject us to speculative risk that would otherwise result from changes in currency exchange rates. Net foreign currency gains and losses have not been material to the results of operations.

Related Parties

We lease an aircraft from NVLS I, LLC, a third-party entity wholly owned by Richard S. Hill, our Chairman and Chief Executive Officer. Under the aircraft lease agreement, we incurred lease expense of approximately $0.2 million through December 31, 2002. The Board of Directors authorized us to commission an accounting firm to conduct a study of lease rates for similar aircraft. The results of this study confirmed that rates charged by NVLS I, LLC are comparable to amounts charged by third-party commercial charter companies for similar aircraft.

A member of our Board of Directors, D. James Guzy, is also a member of the Board of Directors of Intel Corporation, which is one of our significant customers. Intel Corporation represented approximately 11%, 16% and 14% of net sales for the years ended December 31, 2002, 2001 and 2000, respectively. Intel Corporation also accounted for 18% and 14% of our accounts receivable as of December 31, 2002 and 2001, respectively.

From time to time we have made secured relocation loans to our executive officers, vice presidents and key personnel. As of December 31, 2002, we do not have any outstanding loans to our executive officers as defined by the Securities and Exchange Commission. However, we do have outstanding loans to certain non-executive vice-presidents and key personnel. As of December 31, 2002, the total outstanding balance of loans to non-executive vice presidents and key personnel was approximately $5.7 million, of which $5.5 million are secured by collateral and $0.2 million are unsecured. All loans except relocation loans bear interest.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board, or FASB, issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. We do not expect that the adoption of SFAS No. 143 will have a material effect on our financial condition or results of operations.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” For most companies, SFAS No. 145 will require gains and losses on extinguishments of debt to be classified as income or loss from continuing operations, rather than as extraordinary items, as previously required under SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt, an amendment of APB Opinion No. 30.” Extraordinary treatment will be required for certain extinguishments, as provided in APB Opinion No. 30, “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” The statement also amended SFAS No. 13, “Accounting for Leases,” for certain sale-leaseback transactions and sublease accounting. We are required to adopt the provisions of SFAS No. 145 effective January 1, 2003. We do not expect the adoption of SFAS No. 145 to have a material effect on our financial condition or results of operations.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, and must be applied beginning on January 1, 2003. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than when the exit or disposal plan is approved. We do not expect the adoption of SFAS No. 146 to have a material effect on our financial condition or results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. SFAS No. 148 is effective for financial statements for fiscal years ending after December 15, 2002. The adoption of SFAS No. 148 has not had a material effect on our financial condition or results of operations.

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In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” or FIN 45. FIN 45 will significantly change current practice in the accounting for, and disclosure of, guarantees. FIN 45 requires certain guarantees to be recorded at fair value, which is different from the current practice of recording a liability only when a loss is probable and reasonably estimable, as those terms are defined in SFAS No. 5, “Accounting for Contingencies.” FIN 45 also requires a guarantor to make significant new disclosures, even when the likelihood of making any payments under the guarantee is remote, which is another change from the current practice. FIN 45 disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002, while the initial recognition and initial measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. We are currently evaluating the impact of the adoption of FIN 45 on our results of operations or financial condition.

In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We are currently evaluating our synthetic leases and seeking additional information from the lessor and its advisors with regard to whether the lessor should be characterized as a variable interest entity. Consequently, we have not yet concluded whether it is reasonably possible that we would be required to record the specific assets and liabilities associated with our synthetic leases in our financial statements for our third fiscal quarter beginning on June 29, 2003. In the event the leasing structures used in our synthetic leases qualify as variable interest entities, we would seek to refinance with entities with whom we would not be required to consolidate or purchase the properties by exercising our purchase option. For further discussion, see Note 10 to the Consolidated Financial Statements.

Liquidity and Capital Resources

We have historically financed our operating and capital resource requirements through cash flows from operations, sales of equity securities and borrowings. Our primary source of funds as of December 31, 2002 consisted of $1,019.7 million of cash, cash equivalents and short-term investments. This amount represents an increase of $97.9 million from the December 31, 2001 balance of $921.8 million. The increase is primarily due to net cash provided by operating activities, which is attributable to net income, as adjusted to exclude non-cash charges and benefits and changes in working capital. The increase is partially offset by our decision to participate in the synthetic leases. Our participation in the synthetic lease transactions is further discussed below.

Net cash provided by operating activities for the year ended December 31, 2002 was $214.9 million. The primary sources of cash from operating activities were net income, as adjusted to exclude non-cash charges and benefits and changes in working capital requirements, including notable decreases in accounts receivable, inventories and prepaid and other current assets. The decrease in accounts receivable is attributable to the decrease in net sales and improved cash collections. The decrease in inventories, as adjusted to exclude inventories acquired from SpeedFam-IPEC, is due to a lower inventory level as a result of certain inventory management programs initiated in 2002. The decrease in prepaid and other current assets is primarily due to a $69.0 million income tax refund received during the year.

Net cash provided by investing activities was $777.2 million for the year ended December 31, 2002. The cash inflows from investing activities consist primarily of $3.0 billion in proceeds from sales and maturities of available-for-sale securities and restricted investments, partially offset by purchases of new investments of $2.0 billion. Additionally, we acquired $43.5 million of net cash upon the closing of the acquisition of SpeedFam-IPEC on December 6, 2002. The cash inflows were partially offset by $26.8 million of capital expenditures and $177.5 million of cash used for collateral in synthetic lease transactions.

We did not have any significant property and equipment purchase commitments as of December 31, 2002.

For the year ended December 31, 2002, net cash used in financing activities was $926.9 million, which was attributable to the $880.0 million retirement of the LYONs, $78.2 million for repurchases of common stock, and $23.4 million for repayment of borrowings under lines of credit. The cash used in financing activities is partially offset by proceeds of $54.4 million from the issuance of common stock under our employee stock option and stock purchase plans.

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The following is a table summarizing our significant commitments as of December 31, 2002, consisting of future minimum lease payments under all non-cancelable operating leases, including synthetic leases, with initial or remaining terms in excess of one year and debt payments related to the convertible debentures assumed as part of our acquisition of SpeedFam-IPEC. These convertible debentures were redeemed in January 2003. Amounts payable under synthetic leases exclude any payments under residual value guarantees and relate only to the net lease financing amounts. In addition, payments under synthetic leases are subject to changes in the London Interbank Offer Rate (LIBOR) and have been included using interest rates on December 31, 2002 (in thousands):

We lease nearly all of our facilities under operating leases, including synthetic leases, which expire at various dates through 2017. A synthetic lease is a form of operating lease wherein a third party lessor funds 100% of the acquisition and construction costs relating to one or more properties to be leased to a lessee. The lessor is the owner of the leased property and must provide at least 3% of the required funds in the form of at-risk equity. The lessor generally borrows the balance of the funds necessary to fund the acquisition and construction. Under our synthetic lease agreements, we are obligated to lend approximately 87% of the cost of the leased asset to the lessor upon completion of construction. The leases with this requirement are known as defeased or self-funded transactions. Additionally, our synthetic leases require us to maintain collateral for the benefit of the lessor.

The San Jose lease agreement covers 13 properties located in and around San Jose, California, including manufacturing, research and development, and administrative facilities, as well as our corporate headquarters. The lease has a term of five years beginning in September 2001 and covers properties with original values of approximately $293.2 million. The lease agreement requires the lessor to provide 3.5% of at-risk equity throughout the term of the lease. The remaining 96.5% of the lessor’s financing was in the form of debt, including $257.0 million loaned to the lessor which is classified as notes receivable on our balance sheet. We have also provided the lessor with $36.2 million in collateral, which is classified within other assets on our balance sheet.

Under the lease agreement, we have the right to purchase the properties at any time prior to the expiration date of the lease for an amount that equals the total lease financing amount of $293.2 million plus any current rent due and payable. At the end of the lease term, we may renew the lease for up to three additional years with the lessor’s consent, refinance the lease, purchase the properties under a purchase option or arrange to sell the properties to a third party. If we choose the sale option we will be obligated to the lessor up to the amount of the residual value guarantee if the sale price falls below the lease financing amount. The aggregate residual value guarantee related to the San Jose properties is approximately $258.2 million as of December 31, 2002, and represents an off-balance sheet contingent liability for which we do not believe that we have any significant exposures as discussed below.

Rent payments under the San Jose lease agreement are based on the net outstanding lease balance, which includes the cost of the leased properties, less the amount defeased by us, multiplied by either a fixed rate or LIBOR plus an applicable margin. As of December 31, 2002, the net outstanding lease balance and the amount we have defeased were $293.2 million, and $257.0 million, respectively. Rent expense and interest income on the lease balance includes $8.0 million of imputed amounts at rates of 2% to 4% for the year ended December 31, 2002. Imputed amounts result from the application of a deemed market rate of interest on loan balances, including the lease receivable from the lessor, which is non-interest bearing, and a portion of the collateral, which is interest bearing at lower than the deemed market rate of interest. Our lease receivable from the lessor is repayable in full only if we choose the sale option at the end of the lease term and successfully sell the properties for amounts in excess of the cost. Our collateral is available to the lessor upon default, with certain exceptions.

On April 18, 2001, we entered into a synthetic lease agreement for the development of a manufacturing, research and development and administrative facility to be constructed on 23 acres of land we own in Tualatin, Oregon. We have leased the land to the lessor under a long-term ground lease. Construction was completed at the Tualatin site in May 2002. The construction costs totaled $163.2 million and were fully financed by the lessor. The lease agreement requires the lessor to maintain 3% of at-risk equity throughout the term of

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the lease. The lessor financed the balance of the construction costs with debt. Upon completion of construction, we defeased $140.4 million of the lessor’s debt financing in the form of a non-interest bearing loan to the lessor, which is included in notes receivable on our balance sheet at December 31, 2002. We have also provided $22.8 million in collateral held by the lessor to cover the remainder of the lease financing, which is classified as other assets on our balance sheet.

We have the right to purchase the property at any time prior to the expiration date of the lease for an amount that equals the total lease financing amount of $163.2 million, plus any current rent due and payable. At the end of the five-year lease term, we may renew the lease for up to three additional years with the lessor’s consent, purchase the property under the purchase option for an amount equal to the total lease financing amount or arrange to sell the property to a third party. If we choose the sale option, we will be obligated to the lessor up to the amount of the residual value guarantee if the sale price falls below the lease financing amount. The residual value guarantee related to the Tualatin property is approximately $140.4 million as of December 31, 2002 and represents an off-balance sheet contingent liability for which we do not believe that we have any significant exposure as discussed below.

Rent payments under the Tualatin lease agreement are based on the net outstanding lease balance, which includes the cost of the leased properties, less the amount defeased by us, multiplied by either a fixed rate or LIBOR, plus an applicable margin. As of December 31, 2002, the net outstanding lease balance and the amount we have defeased were $163.2 million and $140.4 million, respectively. Rent expense and interest income on the lease balance includes $2.9 million of imputed amounts at rates of 2% to 4% for the year ended December 31, 2002. Imputed amounts result from the application of a deemed market rate of interest on loan balances, including the lease receivable from the lessor, which is non-interest bearing, and a portion of the collateral, which is interest bearing at lower than the deemed market rate of interest. Our lease receivable from the lessor is repayable in full only if we choose the sale option at the end of the lease term and successfully sell the property for an amount in excess of the cost. Our collateral is available to the lessor upon default, with certain exceptions.

If we purchase the San Jose and Tualatin properties at the end of their respective lease terms or earlier, the transactions would increase property and equipment by the lower of the purchase option price or the then fair value of the purchased properties. As of December 31, 2002, we believe that the fair market value for each property exceeds the purchase option price for each property. We estimate the cumulative fair value of all properties to be approximately $456.4 million as of December 31, 2002. Upon purchase of the properties, our note receivable and collateral would be returned to us as cash or used to offset the purchase price of the properties. As a result of the purchase, depreciation expense would increase by approximately $30.0 million to $35.0 million per year, and rent expense and interest income would each decrease by approximately $12.6 million per year, based on current interest rates. If we purchased the properties at the end of their respective lease terms or earlier, we believe there would be no material impact on our liquidity, as the cash paid to purchase the properties would be offset by the note receivable and collateral associated with our participation in these leases.

The synthetic lease agreements contain certain restrictive covenants, which include quick ratio and tangible net worth tests. We were in compliance with these covenants as of December 31, 2002. If we had not complied with these covenants, the lessor could have terminated the leases, resulting in an acceleration of our purchase obligation, in which case, our residual value guarantee would have equaled 100% of the lease balances.

Our intention with respect to the properties we lease under synthetic leases is dependent upon the treatment of our lessor under FIN 46. If the lessor is deemed to be a voting interest entity, we would expect to continue the synthetic lease arrangements and exercise our three one-year renewals subject to obtaining the lessor’s consent. If our lessor is deemed to be a variable interest entity and we are deemed to be the primary beneficiary, we would seek to refinance with entities with whom we would not be required to consolidated or purchase the properties by exercising our purchase option.

The maximum exposure to loss on our synthetic leases includes (i) residual value guarantee payments as described above, (ii) certain tax indemnifications in the event third parties are obligated for certain federal, state or local taxes as a result of their participation in the transaction, and (iii) indemnification for various losses, costs and expenses incurred by third-party participants as a result of their ownership of the leased property or participation in the transaction, and as a result of the environmental condition of the property. The additional taxes, losses and expenses as described in (ii) and (iii) are contingent upon the existence of certain conditions that may arise in the future and, therefore, are not quantifiable at this time. However, we do not expect these additional taxes, losses and expenses to be material. In addition, as noted above, we have funded advances to the lessor in the aggregate amounts of $257.0 million for the San Jose facilities and $140.4 million for the Tualatin facilities, and have deposited with the lessor investment collateral in the amount of $36.2 million for the San Jose facilities and $22.8 million for the Tualatin facilities as a source of payment for our obligations for the residual value guarantee payments and other amounts owed under the leases.

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As of December 31, 2002, our subsidiaries had no outstanding obligation under lines of credit with banks. The available lines of credit with these banks total $36.7 million. These credit facilities bear interest at various rates, expire on various dates through December 2003 and are used for general corporate purposes. As of December 31, 2001, amounts outstanding under these lines of credit were $26.2 million at an annual weighted-average interest rate of 0.62%. There were no balances outstanding under these lines of credit as of December 31, 2002.

On December 6, 2002, in connection with the acquisition of SpeedFam-IPEC, we assumed SpeedFam-IPEC’s $115.0 million Convertible Subordinated Notes due in 2004. The notes accrue interest at a rate of 6.25%, which is payable semi-annually in March and September and were adjusted to their fair value of $116.4 million as of the acquisition date. The notes were subordinated to all existing and future senior indebtedness and could be converted into 3.3096 shares of Novellus’ common stock at a conversion price of $302.15 per $1,000 principal amount. We had the right to redeem the Notes at various prices, subject to specified conditions as set forth in the indenture.

We called the Notes on January 8, 2003 at a redemption price of $117.1 million, which represents 101.786% of par value. We recognized approximately $0.6 million in expense in January 2003 as a result of the redemption of the Notes. The $0.6 million expense represents the difference between the carrying value and the redemption price of the Notes.

On July 26, 2001, we issued $880.0 million of Liquid Yield Option™ Notes (“LYONs”) due July 26, 2031. The net proceeds after issuance costs (which were being amortized over 30 years) from the LYONs offering were $862.4 million. The LYONs are zero coupon, zero-yield subordinated debentures convertible into shares of our common stock or redeemable for cash by the security holder, subject to specified conditions as set forth in the indenture.

On July 26, 2002, the holders of the LYONs exercised their option to require us to repurchase the LYONs for $1,000 in cash each on such date, or approximately $880.0 million for substantially all of the outstanding LYONs. We used restricted short-term investments, which had matured to $880.0 million, to repurchase the LYONs. We recorded a charge of approximately $17.0 million in other expenses for the remaining unamortized issuance costs related to the LYONs.

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

Risk Factors

Set forth below and elsewhere in this Annual Report on Form 10-K, including in Item 7. Management’s Discussion and Analysis, and in other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report.

Cyclical Downturns in the Semiconductor Industry

Our business depends predominantly on the capital expenditures of semiconductor manufacturers, which in turn depend on current and anticipated market demand for integrated circuits and the products that use them. The semiconductor industry has historically been very cyclical and has experienced periodic downturns that have had a material adverse effect on the demand for semiconductor processing equipment, including equipment that we manufacture and market. During periods of reduced and declining demand, we must be able to quickly and effectively align our costs with prevailing market conditions, as well as motivate and retain key employees. In particular, our inventory levels during periods of reduced demand have at times reached and are now at higher-than-necessary levels relative to the current levels of production demand. We cannot provide any assurance that we may not be required to make inventory valuation adjustments in future periods. During periods of rapid growth, we must be able to acquire and/or develop sufficient manufacturing capacity to meet customer demand, and hire and assimilate a sufficient number of qualified people. We cannot give assurances that our net sales and operating results will not be adversely affected if the current downturn in the semiconductor industry continues, or if other downturns or slowdowns in the rate of capital investment in the semiconductor industry occur in the future.

The Semiconductor Industry is Intensely Competitive and Capital-Intensive

We face substantial competition in the industry, both from potential new entrants into the market and established competitors. Some of these companies may have greater financial, marketing, technical or other resources than we do, as well as broader product lines, greater customer service capabilities, or larger and more established sales organizations and customer bases. Remaining competitive in the market depends in part upon our ability to develop new and enhanced systems, and to introduce them at competitive prices on a timely basis.

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Our customers must incur substantial expenditures to install and integrate capital equipment into their semiconductor production lines. Once a manufacturer has selected another vendor’s capital equipment, the manufacturer is generally reliant upon that equipment vendor for the specific production line application in question. Accordingly, we may experience difficulty in selling a product to a particular customer for a significant period of time when that customer has selected a competitor’s product. In addition, sales of our systems depend in significant part upon a prospective customer’s decision to increase manufacturing capacity or expand current manufacturing capacity—both of which typically involve a significant capital commitment. From time to time, we have experienced delays in finalizing system sales following initial system qualification. Due to these and other factors, our systems typically have a lengthy sales cycle, during which we may expend substantial funds and management effort.

Rapidly Changing Technology

We devote a significant portion of our personnel and financial resources to research and development programs, and we seek to maintain close relationships with our customers in order to remain responsive to their product needs. As is typical in the semiconductor capital equipment market, we have experienced delays from time to time in the introduction of and certain technical and manufacturing difficulties with certain of our products and product enhancements. In addition, we may experience delays and technical and manufacturing difficulties in future introductions or volume production of our new systems or enhancements.

Our success in developing, introducing and selling new and enhanced systems depends upon a variety of factors. These include product selection, timely and efficient completion of product design and development, timely and efficient implementation of manufacturing and assembly processes, product performance in the field, and effective sales and marketing. There can be no assurance that we will be successful in selecting, developing, manufacturing and marketing new products, or in enhancing our existing products. In addition, we could incur substantial unanticipated costs to ensure the functionality and reliability of our future product introductions early in their product life cycles. If new products have reliability or quality problems, reduced orders, or higher manufacturing costs, then delays in collecting accounts receivable and additional service and warranty expenses may result. Any of these events could materially adversely affect our business, financial condition or results of operations.

International Operations

Export sales currently account for a significant portion of our net sales. This trend is expected to continue in the foreseeable future. As a result, a significant portion of our sales is subject to certain risks, including, but not limited to:

•		Tariffs and other trade barriers;
•		Challenges in staffing and managing foreign subsidiary operations;
•		Difficulties in managing foreign distributors;
•		Potentially adverse tax consequences;
•		Imposition of legislation and regulations relating to the import or export of semiconductor products, either by the United States or other countries;
•		Periodic economic downturns;
•		Political instability; and
•		Fluctuations in interest and foreign currency exchange rates, creating the need to enter into forward foreign exchange contracts to hedge against the short-term impact of foreign currency fluctuations, specifically yen-denominated transactions.

There can be no assurance that any of these factors or the adoption of restrictive policies will not have a material adverse effect on our business, financial condition or results of operations. In addition, each region in the global semiconductor equipment market exhibits unique market characteristics that can cause capital equipment investment patterns to vary significantly from period to period. We derive a substantial portion of our revenues from customers in Asian countries. Any negative economic developments in these countries could result in the cancellation or delay by Asian customers of orders for our products, which could adversely affect our business, financial condition or results of operations.

Variability of Quarterly Operating Results

We have experienced and expect to continue experiencing significant fluctuations in our quarterly operating results. These fluctuations are due to a number of factors that include, but are not limited to:

•		Building our systems according to forecast, and not using limited backlog information, which hinders our ability to plan production and inventory levels;
•		Failure to receive anticipated orders in time to permit shipment during that quarter;
•		Customers rescheduling or canceling shipments;
•		Manufacturing difficulties;
•		Customers deferring orders of our existing products due to new product announcements by us and/or our competitors; and

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•

Overall business conditions in the semiconductor equipment industry.

Variations in quarterly operating results or changes in analysts’ earnings estimates may subject the price of our common stock to wide fluctuations and possible rapid increases or declines in a short time period.

Acquisitions

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

•		Difficulties in integrating the operations, technologies, products and personnel of acquired companies;
•		Lack of synergies or the inability to realize expected synergies;
•		Difficulties in managing geographically dispersed operations;
•		The potential loss of key employees, customers and strategic partners of acquired companies;
•		Diversion of management’s attention from normal daily operations of the business; and
•		The impairment of acquired intangible assets as a result of technological advancements, or worse-than-expected performance of acquired companies.

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

A Large Portion of Net Sales is Derived from Sales to a Few Customers

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

Intellectual Property

We intend to continue pursuing the legal protection of our proprietary technology primarily through patent and trade secret protection. There can be no assurance that patents will be issued from any of these pending applications, or that any claims allowed from existing or pending patents will be sufficiently broad to protect our proprietary technology. There is also no guarantee that any patents we hold will not be challenged, invalidated or circumvented, or that the rights granted thereunder will provide competitive advantages to us. We also cannot provide assurance that the confidentiality agreements we enter into with employees, consultants and other parties will not be breached.

We are currently involved in a number of legal disputes regarding patent and other intellectual property rights. Except as set forth in Item 3. Legal Proceedings in this document, we are not aware of any significant claim of infringement by our products of any patent or proprietary rights of others. Adverse outcomes in current or future legal disputes could result in our loss of proprietary rights, subject the company to significant liabilities to third parties, require us to seek licenses from third parties, or prevent us from manufacturing or selling our products. Any of these circumstances could have a material adverse effect on our business, financial condition or results of operations.

Supply Shortages

We use numerous suppliers to obtain parts, components and sub-assemblies for the manufacture and support of our products. Although we make reasonable efforts to ensure that such parts are available from multiple suppliers, certain key parts may only be obtained from a single or limited source. These suppliers are in some cases thinly capitalized, independent companies that generate significant portions of their business from us and/or a small group of other companies in the semiconductor industry. We seek to reduce our dependence on this limited group of sources. However, disruption or termination of certain of these suppliers may occur. Such disruptions could have an adverse effect on our operations. A prolonged inability to obtain certain parts could have a material adverse effect on our business, financial condition or results of operations, and could result in our inability to meet customer demands on time.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and short-term debt obligations. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer.

We mitigate default risk by investing in only the safest and highest credit quality securities and by monitoring the credit rating of investment issuers. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. We have no material cash flow exposure due to rate changes for cash equivalents and short-term investments.

The majority of our short-term obligations have fixed interest rates, including the convertible bonds assumed in connection with the SpeedFam-IPEC acquisition, all of which were subsequently redeemed in January 2003. Therefore, our results are only affected by the interest rate changes to variable rate short-term borrowings. Due to the short-term nature of these borrowings, an immediate change to interest rates is not expected to have a material effect on our results.

The table below presents principal amounts and related weighted interest rates by year of maturity for our investment portfolio and debt obligations and the fair value of each as of December 31, 2002 and 2001. All of our available-for-sale investments and debt securities mature within two years from the original purchase or issuance date.

We have operating lease agreements on several properties. The agreements are for five years with interest rates that approximate the London Interbank Offer Rate (LIBOR). Rent expense was approximately $17.8 million, $16.9 million and $20.1 million for the years ended December 31, 2002, 2001 and 2000, respectively, net of sublease income of $7.4 million, $7.2 million and $8.1 million, respectively. Rent expense may increase significantly with changes in prevailing interest rates.

Excluded from the 2002 table above is $456.4 million of collateralized investments recorded within other assets and as a note receivable, related to our participation in the synthetic leases. Of this amount, $15.2 million is subject to interest rate risk since amounts payable as rent expense are based on LIBOR. The remaining balance of rent expense is either paid using a fixed rate of interest or is non-

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interest bearing. Imputed amounts result from the application of a deemed market rate of interest on loan balances, including the lease receivable from the lessor, which is non-interest bearing, and a portion of the collateral, which is interest bearing at lower than the deemed market rate of interest. Since interest is imputed for financial reporting and disclosure purposes only, market risk is not associated with these instruments. For further discussion, see Note 10 to the Consolidated Financial Statements.

Foreign Currency Risk

We transact business in various foreign countries. Our primary foreign currency cash flows are in Asia and Europe. During 2002 and 2001, we utilized foreign currency forward exchange contracts to hedge foreign currency denominated balance sheet positions. Under this program, increases or decreases in currency commitments and balance sheet positions, as translated into U.S. dollars, were primarily offset by realized gains and losses on the hedging instruments. The goal of the hedging program is to minimize the impact of foreign currency fluctuations on our results of operations. We do not use foreign currency forward exchange contracts for speculative or trading purposes.

All of our unsettled foreign currency contracts are marked-to-market, with unrealized gains and losses included as a component of other income and expense. The following table provides information as of December 31, 2002 and 2001 about our derivative financial instruments, which are comprised of foreign currency forward exchange contracts. The information is provided in U.S. dollar equivalent amounts, as presented in our consolidated financial statements. The table below presents the notional amounts (at the contract exchange rates), the weighted-average contractual foreign currency exchange rates, and the estimated fair value of those contracts.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

NOVELLUS SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)