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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended March 29, 2003

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)

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES     X           NO

As of May 9, 2003, 149,910,708 shares of the Registrant’s common stock, no par value, were issued and outstanding.

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NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED MARCH 29, 2003

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PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOVELLUS SYSTEMS, INC.

See accompanying notes to the condensed consolidated financial statements.

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NOVELLUS SYSTEMS, INC.

*

Amounts as of December 31, 2002 are derived from the December 31, 2002 audited financial statements.

See accompanying notes to the condensed consolidated financial statements.

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NOVELLUS SYSTEMS, INC.

See accompanying notes to the condensed consolidated financial statements.

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NOVELLUS SYSTEMS, INC.

1. BASIS OF PRESENTATION

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. The interim financial information is unaudited and does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 29, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2002.

On December 6, 2002, we acquired SpeedFam-IPEC, Inc., a global supplier of chemical mechanical planarization (CMP) systems used in the fabrication of advanced copper interconnects. The acquisition was accounted for as a purchase business combination and qualifies as a tax-free reorganization under IRS regulations. Our condensed consolidated financial statements for the first quarter of 2003 include the financial position, results of operations and cash flows of SpeedFam-IPEC, Inc.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures of contingent assets and liabilities. We evaluate our estimates on an ongoing basis, including those related to revenue recognition, allowance for doubtful accounts, inventory valuation, deferred tax assets, property and equipment, goodwill and other intangible assets, warranty obligations, restructuring and impairment charges, contingencies and litigation and stock-based compensation. We base our estimates on historical experience and on 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. Our intent is to accurately state our assets given facts known at the time of valuation. Our assumptions may prove incorrect as facts change in the future. Actual results may differ from these estimates under different assumptions or conditions.

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

2. INVENTORIES

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

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3. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. For purposes of computing basic net income per share, the weighted-average number of outstanding shares of common stock excludes shares of restricted stock subject to repurchase.

Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding, including shares of restricted common stock subject to repurchase and, when dilutive, potential shares from stock options to purchase common stock using the treasury stock method and from convertible securities on an as-if-converted basis.

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

Options to purchase 12,697,000 and 1,818,000 shares of common stock at weighted-average exercise prices of $40.03 and $52.66 per share were outstanding as of March 29, 2003 and March 30, 2002, respectively, but were not included in the computation of diluted net income per common share because the respective exercise price of these options was greater than the average respective market price of the common shares and, therefore, the effect would be anti-dilutive.

4. COMMITMENTS AND GUARANTEES

Operating Leases

We lease nearly all of our facilities under operating leases, including synthetic leases, which expire at various dates through 2017. Our synthetic leases are primarily for properties in San Jose, California and Tualatin, Oregon. 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. In addition, our synthetic leases require us to maintain collateral for the benefit of the lessor.

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Summary information about our synthetic lease arrangements is as follows as of March 29, 2003 (square feet and dollar amounts in thousands):

In January 2003, the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” or FIN 46. 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 as to whether the lessor should be characterized as a variable interest entity. Our preliminary conclusion is that the lessor is a variable interest entity and that we are the primary beneficiary of the variable interest entity. As such, to the extent we do not exercise our purchase options or renew the leases with a voting interest lessor or a variable interest lessor where we are not the primary beneficiary, we expect to be required to consolidate the variable interest lessor in the third quarter of 2003. Additionally, since each of the other lessees involved with this lessor has a variable interest in specified assets of the variable interest lessor, we would only be required to record the specific assets and liabilities associated with our synthetic leases in our financial statements for the third quarter of 2003 beginning on June 29, 2003. We are currently researching our options for refinancing our synthetic leases with a voting interest lessor or a variable interest lessor where we are not the primary beneficiary. Upon completion of this research we will decide to either refinance with an entity with which we would not be required to consolidate, consolidate our portion of the variable interest entity or purchase the properties by exercising our purchase options.

If we consolidate our portion of the variable interest entity, we would record a non-cash charge of approximately $90 million to $120 million as a cumulative effect of a change in accounting principle, which would represent depreciation that would have been recorded had we owned these assets from inception. In addition, our annual depreciation expense would increase by approximately $30.0 million to $35.0 million beginning in the third quarter of 2003, and rent expense and interest income would each decrease by approximately $13.4 million per year, based on current interest rates.

If we exercise options to purchase the San Jose and Tualatin properties, the transactions would increase our property and equipment by the lower of the purchase price or the then fair market value of the properties. As of March 29, 2003, we believe that the fair market value for each property is equal to or greater than the purchase option price for each property. We estimate the cumulative fair market value of all properties to be approximately $456.4 million as of March 29, 2003. If we were to purchase the properties, our notes receivable and collateral in a total amount of $456.4 million would be returned to us as cash or used to offset the purchase price of the properties. As a result of the purchase, annual depreciation expense would increase by approximately $30.0 million to $35.0 million beginning in the third quarter of 2003, and rent expense and interest income would each decrease by approximately $13.4

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million per year, based on current interest rates. If we purchased the properties at the end of their respective lease terms or earlier, there would be no material impact on our liquidity, as the cash paid to purchase the properties would be offset by the notes receivable and collateral associated with our participation in these synthetic leases.

Product Warranty

We record the estimated cost of warranty as a component of cost of sales upon system shipment. The estimated cost is determined by the warranty term as well as the average historical labor and material costs for a specific product. Should actual product failure rates or material usage differ from our estimate, revisions to the estimated warranty liability may be required. We review the actual product failure rates and material usage on a quarterly basis and adjust our warranty liability as necessary. Effective December 31, 2002, we adopted the provisions of FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Indebtedness of Others,” which requires changes to the accounting and disclosure of guarantees, including product warranty. Changes in our accrued warranty liability were as follows (in thousands):

5. CONVERTIBLE SUBORDINATED DEBENTURES

In connection with the acquisition of SpeedFam-IPEC, we assumed SpeedFam-IPEC’s $115.0 million Convertible Subordinated Notes due in 2004. The notes were adjusted to their fair value of $116.4 million as of the acquisition date. The notes accrued interest at a rate of 6.25%, which was payable semi-annually in March and September. The notes were subordinated to all existing and future senior Novellus indebtedness and could have been converted into 3.3096 shares of Novellus’ common stock at a conversion price of $302.15 per $1,000 principal amount. We exercised our right to redeem the notes on January 8, 2003 at a redemption price of $117.1 million. The redemption price represented 101.786% of par value. As a result, we recognized approximately $616,000 in expense for the difference between the carrying value as of the acquisition date and the redemption price.

6. RESTRUCTURING AND OTHER CHARGES

In September 2001, we implemented a restructuring plan in response to a decline in sales orders due to the contraction of the semiconductor capital equipment market. The plan addressed the need to improve our cost structure by consolidating excess facilities. We recorded restructuring and asset impairment charges totaling $55.0 million in the third quarter of 2001, of which $47.9 million is included in operating expense and $7.1 million is included in cost of sales. The restructuring charges consisted of $33.8 million related to the vacated facilities, $14.1 million of asset impairment charges and $7.1 million of discontinued inventory write-downs. Of the $14.1 million asset impairment charge, $9.5 million related to abandoned assets associated with the discontinuation of certain projects and $4.6 million related to the write-off of purchased technology.

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In connection with the acquisition of SpeedFam-IPEC, we recorded a restructuring liability of $28.5 million in the fourth quarter of 2002 for certain activities of SpeedFam-IPEC which we planned to exit as a result of the purchase business combination. This amount consisted primarily of facility-related charges of $27.0 million, severance-related charges of $251,000 and other costs associated with exiting activities of SpeedFam-IPEC of $1.2 million.

The following table summarizes restructuring activity for the first quarter of 2003 (in thousands):

7. BAD DEBT RECOVERY

In September 2001, we determined that, due to the financial difficulties facing one of our customers, an outstanding account receivable balance was at risk for collection. Accordingly, we recorded a write-off of $7.7 million. In the first quarter of 2002, all amounts under this account receivable balance were paid, resulting in a recovery of $7.7 million.

8. COMPREHENSIVE INCOME (LOSS)

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

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

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9. STOCK-BASED COMPENSATION

Employee Stock Option Plans

We grant options to employees under several stock option plans. Our stock option plans provide that stock options expire ten years after the date of grant and generally vest ratably over a four-year period on the anniversary of the date of grant or as determined by the Board of Directors. We also award restricted stock to our employees under our 1992 Stock Option Plan and our 2001 Stock Incentive Plan. As of March 29, 2003, there were a total of 8.9 million options available for grant and 25.6 million options outstanding under all stock option plans with an average exercise price of $31.09 per share.

Employee Stock Purchase Plans

In May 1992, we adopted a qualified Employee Stock Purchase Plan, referred to herein as the Purchase Plan, under Sections 421 and 423 of the Internal Revenue Code. Under the Purchase Plan, qualified employees are entitled to purchase shares at 85% of fair market value on specified dates. There were approximately 211,000 and 178,000 shares issued under the Purchase Plan in the quarters ended March 29, 2003 and March 30, 2002, respectively. As of March 29, 2003, approximately 1.1 million shares were reserved for future issuance under the Purchase Plan.

We account for stock-based employee compensation using the intrinsic value method under APB Opinion No. 25 and have adopted the disclosure-only provisions of SFAS No. 123, as amended by SFAS No. 148. Accordingly, no expense has been recognized for options granted to employees under the Plans. We amortize deferred stock-based compensation on the graded vesting method over the vesting periods of the applicable stock purchase rights and stock options, generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in greater vesting in earlier years than the straight-line method. Had compensation expense been determined based on the fair value at the grant date for awards, consistent with the provisions of SFAS No. 123, our pro forma net loss and net loss per share would be as follows (in thousands, except per share data):

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions for grants made in the quarters ended March 29, 2003 and March 30, 2002:

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The weighted-average fair value of stock options granted during the period was $17.31 and $23.42 for the quarters ended March 29, 2003 and March 30, 2002, respectively. The effects of applying SFAS No. 123 on net income to determine the pro forma disclosures are not likely to be representative of the effects on pro forma disclosures of future years.

The pro forma net loss and net loss per share data listed above include expense related to the Purchase Plan. The fair value of issuances under the Purchase Plan is estimated on the date of issuance using the Black-Scholes option-pricing model, with the following weighted-average assumptions for issuances made in the quarters ended March 29, 2003 and March 30, 2002:

The weighted-average fair value of purchase rights granted during the period was $11.40 and $21.16 for the quarters ended March 29, 2003 and March 30, 2002, respectively.

10. RELATED PARTY TRANSACTIONS

In March 2002, we began leasing 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 $139,000 during the first quarter of 2003.

A member of our Board of Directors, D. James Guzy, is also a member of the Board of Directors of Intel Corporation, one of our significant customers. Intel Corporation represented approximately 14% and 18% of net sales for the quarters ended March 29, 2003 and March 30, 2002, respectively. Intel also accounted for 10% and 18% of our accounts receivable as of March 29, 2003 and December 31, 2002, respectively.

From time to time we have made secured relocation loans to our executive officers, vice presidents and key personnel. As of March 29, 2003, we do not have any outstanding loans to our executive officers as defined by the Securities and Exchange Commission. However, we do have outstanding loans to non-executive vice presidents and key personnel. As of March 29, 2003 and December 31, 2002, the total outstanding balance of loans to certain non-executive vice presidents and key personnel was approximately $6.8 million and $5.7 million, respectively. Of the total loans outstanding at March 29, 2003, $6.4 million was secured by collateral.

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11. RECENT ACCOUNTING PRONOUNCEMENTS

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 Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” SFAS No. 145 also amended SFAS No. 13, “Accounting for Leases” for certain sale-leaseback transactions and sublease accounting. The adoption of SFAS No. 145 does not 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 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. SFAS No. 146 nullifies EITF Issue No. 94-3, and must be applied beginning January 1, 2003. The adoption of SFAS No. 146 does not have a material effect on our financial condition or results of operations.

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. The adoption of FIN 45 does not have a material impact on our results of operations and financial condition.

12. LITIGATION

For a discussion of legal matters, see Part II: Other Information, Item 1: Legal Proceedings.

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

This Quarterly Report on Form 10-Q contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included in this Quarterly Report, 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 in this Quarterly Report include, without limitation: our expectation that we may be required to consolidate a variable interest lessor in the third quarter of 2003; our continued R&D investment focus on improvement of our existing products and development of new products and technologies; our expectations regarding the effect of the adoption of SFAS 145 and 146 on our financial condition or results of operations; our belief that we would seek to refinance or exercise our purchase options for our properties subject to synthetic leases

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in the event the leasing structures used in these synthetic leases qualify as variable interest entities; our belief that the fair market value for each of the properties subject to the synthetic leases equals or exceeds the purchase option price for the property; 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 the next twelve months; our intent to continue pursuing the legal defense of our proprietary technology primarily through patent and trade secret protection; our belief that the ultimate outcome of the Applied Materials, Inc., Semitool, Inc., Plasma Physics Corporation, Solar Physics Corporation and Linear Technology Corporation litigation matters and various other litigations that have arisen in the normal course of business will not have a material adverse effect on our business, financial condition or results of operations; and our belief that we have meritorious claims and/or defenses in the Applied Materials and Semitool litigation matters.

Our expectations, beliefs, objectives, anticipations, intentions and strategies regarding the future, including, without limitation, those concerning expected operating results, revenues and earnings and current and potential litigation are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from results contemplated by the forward-looking statements including, but not limited to: the inaccuracy of our assumptions regarding the characterization of a lessor as a variable interest entity; our inability to allocate substantial resources to R&D; our failure to accurately predict the effect of our adoption of certain accounting pronouncements; our inability to refinance or exercise our purchase options for properties subject to synthetic leases; our failure to properly measure the fair market value of the properties subject to synthetic leases; our unanticipated need for additional liquid assets in the next twelve months; our potential inability to enforce our patents and protect our trade secrets; our failure to accurately predict the effect of the ultimate outcome of current litigation on our business, financial condition or results of operations; and inherent uncertainty in the outcome of litigation matters.

The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties further discussed under Part I: Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations. Risk Factors beginning on page 22 of this Quarterly Report on Form 10-K 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 Quarterly Report on Form 10-Q. Readers should also consult the cautionary statements and risk factors listed in our Annual Report on Form 10-K for the year ended December 31, 2002 and in our other filings with the Securities and Exchange Commission (SEC), including our Forms 10-Q and 8-K and our Annual Reports to Shareholders.

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,” or 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 inventories, including raw materials, work-in-process, finished goods and spare parts to determine whether adjustments for impairment are required. Inventory that is obsolete or in excess of our forecasted usage is written down to its estimated 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,” or SFAS No. 142. 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.

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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 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

Effective January 1, 2003, we adopted SFAS No. 146, “Accounting for Cost 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. 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. The adoption of SFAS No. 146 does not have a material effect on our financial condition or results of operations.

Additionally, we account for business combination restructurings under the provisions of EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” and SAB 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. Additionally, certain restructuring charges related to asset impairments are recorded in accordance with SFAS No. 144. The restructuring accrual related to the vacated facilities is calculated net of estimated sublease income. 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.

Our critical accounting policies are also discussed in our Annual Report on Form 10-K for the year ended December 31, 2002, in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 1 to our Consolidated Financial Statements.

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Results of Operations
(dollars in thousands)

Net Sales

We operate our business in the semiconductor equipment industry, which is subject to cyclical conditions that have played a major role in the fluctuations in our net sales. The increase in total net sales over the prior year period is primarily due to improved market conditions during the first quarter of 2003. Although the demand for semiconductor equipment remains sluggish, market conditions have somewhat improved from the first quarter of 2002. The decline in demand for semiconductor equipment began in early 2001 and continued through the early part of 2002. While we experienced a modest increase in the second half of 2002, demand has remained relatively flat through the first quarter of 2003. The increase in net sales over the fourth quarter of 2002 is primarily due to the combined effect of the increase in shipments and net sales from the operations of SpeedFam-IPEC, Inc., which we acquired in December 2002.

The increase in international net sales as a percentage of total net sales from the fourth quarter of 2002 results from higher net sales in the Asia region (consisting primarily of Korea, Japan and Taiwan). The Asia region accounted for 47% of total net sales for the quarter ended March 29, 2003, compared to 42% and 40% for the quarters ended March 30, 2002 and December 31, 2002, respectively.

Gross Profit

The overall reduction in customer capital spending in response to weakened worldwide demand for semiconductor devices has continued to affect our gross profit margin as we are not able to fully absorb fixed overhead costs. The increases in gross profit as a percentage of net sales from the first quarter of 2002 and fourth quarter of 2002 are primarily due to improved absorption of fixed overhead costs resulting from the increase in shipments.

Selling, General and Administrative (SG&A)

SG&A expense includes compensation and benefits, travel, utilities, communications costs and professional fees for our corporate, financial, marketing and administrative functions. Also included are expenses for rents, depreciation and amortization related to the assets utilized by the functions noted above. The decrease in SG&A expense as a percentage of net sales versus the first quarter of 2002 is primarily due to the increase in net sales. The increases in SG&A expense in absolute dollars from the first and fourth quarter of 2002 are primarily due to a full quarter of SpeedFam-IPEC operations being included in our results for the first quarter of 2003, an increase in selling expenses and expense savings

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resulting from our holiday shutdown in the fourth quarter of 2002, which did not recur in the first quarter of 2003. The increase in selling expenses is due to the increase in volume and change in product mix.

Research and Development (R&D)

R&D expense includes compensation and benefits, project materials, repairs and maintenance, rent, depreciation and amortization expenses associated with patents and purchased technologies for our R&D functions. The decrease in R&D expense as a percentage of net sales compared to the first quarter of 2002 is primarily due to the increase in net sales. The increases in R&D expense in absolute dollars over the first and fourth quarter of 2002 reflect our commitment to the continuous improvement of our current product lines and the development of new products and technologies. We plan to continue focusing on our R&D expenditures.

Restructuring and Other Charges

The $3.3 million restructuring charge in the first quarter of 2002 consisted primarily of severance compensation related to a workforce reduction, which was carried out in response to the downturn in market conditions. The $3.2 million charge in the fourth quarter of 2002 consisted of a $1.7 million charge for severance compensation related to a workforce reduction and a $1.5 million restructuring charge related to previously vacated facilities.

Bad Debt Recovery

In September 2001, we determined that an outstanding account 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 in the third quarter of 2001. However, in the first quarter of 2002, the amount owed under this account was paid in full, resulting in a benefit to operations of $7.7 million.

Other Income, Net

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Other income, net, includes interest income, interest expense and other non-operating items. The decrease in other income, net from the first quarter of 2002 is primarily due to lower balances of interest-bearing cash and short-term investments and lower interest rates in the first quarter of 2003. The decline in the investment balance is primarily due to the repayment of the $880.0 million Liquid Yield Option™ Notes (LYONs) in the third quarter of 2002. Additionally, we had a $4.6 million gain from the sale of an equity investment in the first quarter of 2002.

The decrease in other income, net from the fourth quarter of 2002 is primarily due to lower balances of interest-bearing cash and short-term investments as we used approximately $119.3 million for repayment of the SpeedFam-IPEC convertible debt and accrued interest. Additionally, we recorded a loss on extinguishment of the SpeedFam-IPEC debt of $616,000, which contributed to the reduction of other income, net, during the first quarter of 2003.

Provision for Income Taxes

Our estimated effective tax rate is 25% for the first quarter of 2003, compared to 21% for the respective prior year period and 0% in the immediately preceding quarter. The increases in the effective tax rate compared to the respective prior year period and immediately preceding quarter are primarily due to higher pre-tax income projected for the current fiscal year and reduced benefit from R&D tax credits.

Related Party Transactions

In March 2002, we began leasing 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 $139,000 for the first quarter of 2003.

A member of our Board of Directors, D. James Guzy, is also a member of the Board of Directors of Intel Corporation, one of our significant customers. Intel Corporation represented approximately 14% and 18% of net sales for the quarters ended March 29, 2003 and March 30, 2002, respectively. Intel also accounted for 10% and 18% of our accounts receivable as of March 29, 2003 and December 31, 2002, respectively.

From time to time we have made secured relocation loans to our executive officers, vice presidents and key personnel. As of March 29, 2003, we do not have any outstanding loans to our executive officers as defined by the Securities and Exchange Commission. However, we do have outstanding loans to non-executive vice presidents and key personnel. As of March 29, 2003 and December 31, 2002, the total outstanding balance of loans to non-executive vice presidents and key personnel was approximately $6.8 million and $5.7 million, respectively. Of the total loans outstanding at March 29, 2003, $6.4 million was secured by collateral.

Recent Accounting Pronouncements

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,

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“Reporting the Results of Operations – Reporting the Effects of Disposal of a segment of Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” SFAS No. 145 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. The adoption of SFAS No. 145 does not have a material effect on our financial condition or results of operations.

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. The adoption of FIN 45 does not have a material impact on our results of operations and financial condition.

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 at March 29, 2003 consisted of $929.8 million of cash, cash equivalents and short-term investments. This amount represents a decrease of $90.2 million from the December 31, 2002 balance of $1.02 billion. The decrease was due primarily to the repayment of SpeedFam-IPEC’s convertible debt at a redemption price of $117.1 million and accrued interest of $2.2 million, offset by positive cash generated from operations, which included $18.5 million from an income tax refund.

Net cash provided by operating activities during the first quarter of 2003 was $16.5 million. This amount consisted primarily of net income, the effect of non-cash charges and changes in working capital accounts, which include a decrease in prepaid and other current assets of $25.1 million, an increase in accounts receivable of $10.8 million and a combined effect of decreases in accounts payable, accrued payroll, income tax payable and other accrued liabilities of $33.7 million. The decrease in prepaid and other current assets was primarily a result of an $18.5 million income tax refund received in the first quarter of 2003.

Net cash used in investing activities during the first quarter of 2003 was $12.4 million, which consisted primarily of capital expenditures of $8.2 million and net purchases of short-term investments of $9.2 million, offset by a decrease in other assets of $5.0 million. As of March 29, 2003, we do not have any significant commitments to purchase property and equipment.

Net cash used in financing activities during the first quarter of 2003 was $102.8 million, which is primarily due to the repayment of SpeedFam-IPEC’s convertible debt at a redemption price of $117.1 million, partially offset by proceeds from employee stock compensation plans of $14.3 million.

We lease nearly all of our facilities under operating leases, including synthetic leases, which expire at various dates through 2017. Our synthetic leases are primarily for properties in San Jose, California and Tualatin, Oregon. 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

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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. In addition, our synthetic leases require us to maintain collateral for the benefit of the lessor.

Summary information about our synthetic lease arrangements is as follows as of March 29, 2003 (square feet and dollar amounts in thousands):