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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended June 28, 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 August 11, 2003, 151,392,498 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 JUNE 28, 2003

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PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

See accompanying notes to condensed consolidated financial statements.

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NOVELLUS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)

*

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

See accompanying notes to condensed consolidated financial statements.

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NOVELLUS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 and six months ended June 28, 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 three and six months ended June 28, 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 other assumptions that are believed to be reasonable under the current circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our intent is to accurately state our assets given facts known at the time of valuation. Our assumptions may prove incorrect as facts change in the future. Actual results may differ from these estimates under different assumptions or conditions.

The accompanying condensed consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries after the elimination of all significant intercompany account balances and transactions. Certain 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 sheet date, inventories consisted of the following (in thousands):

3.

NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of common shares

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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 approximately 9.3 million and 2.1 million shares of common stock at weighted-average exercise prices of $43.02 and $52.21 per share were outstanding as of June 28, 2003 and June 29, 2002, respectively, but were not included in the computation of diluted net income per common share because the respective exercise prices of these options were greater than the average respective market prices of the common shares and, therefore, the effect would be anti-dilutive.

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 lease that is treated as an operating lease for book purposes, but as a financing lease for tax purposes. Under our synthetic lease agreements, 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. 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. The collateral is classified within other assets on the accompanying condensed consolidated balance sheets.

Summary information about our synthetic lease arrangements is as follows as of June 28, 2003 (square feet and dollar amounts in thousands):

In January 2003, the Financial Accounting Standards Board, or FASB, issued Financial Interpretation No. 46,

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“Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” or FIN 46. FIN 46 requires variable interest entities to be consolidated by the primary beneficiary of the entity. An entity is considered a variable interest 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.

After evaluating our synthetic leases, we have concluded that the lessor is a variable interest entity and that we are the primary beneficiary of the variable interest entity. As such, we are required to consolidate the variable interest lessor beginning on June 29, 2003. Additionally, since each of the other lessees involved with this lessor has a variable interest in specified assets and liabilities of the variable interest lessor, we will only be required to consolidate in our financial statements the specific assets, liabilities, and operating results associated with our synthetic leases. As a result of the adoption of FIN 46 and the expected exercise of our purchase options, property and equipment will increase on a net basis by approximately $360.0 million and notes receivable and other non-current assets will decrease by $456.4 million. In addition, as a result of the adoption of FIN 46, we expect to record a non-cash net of tax charge of approximately $63.5 million in the third quarter of fiscal 2003 as a cumulative effect of a change in accounting principle in accordance with Accounting Principles Board Opinion No. 20, “Accounting Changes.” The gross charge represents approximately $97.0 million of pre-tax depreciation that would have been recorded had we owned these assets from inception of the leases. On a prospective basis, our quarterly depreciation expense will increase by approximately $8.4 million, rent expenses and interest income will each decrease by approximately $3.0 million, and our quarterly earnings per share will be decreased by approximately $0.04. The adoption of FIN 46 and exercise of our options to purchase the properties will have no impact on our liquidity.

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 NOTES

In connection with the acquisition of SpeedFam-IPEC, Inc., we assumed $115.0 million of 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

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between the carrying value as of the acquisition date and the redemption price.

6.

RESTRUCTURING AND OTHER CHARGES

The following table summarizes restructuring activity for the first two quarters of 2003 related to the restructuring charges we recorded in 2001 and 2002 (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 third quarter of 2001. 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

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

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

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 June 28, 2003, there were a total of 8.9 million options available for grant and 24.1 million options outstanding under all stock option plans with an average

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exercise price of $31.27 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. As of June 28, 2003, approximately 844,000 shares were reserved for future issuance under the Purchase Plan.

We account for stock-based employee compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and have adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosures.” Accordingly, no expense has been recognized for options granted to employees at fair value. 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 expense recorded 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 123, we would have reported pro forma net loss and net loss per share 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 three and six months ended June 28, 2003 and June 29, 2002:

The weighted-average fair value of stock options granted during the period was $14.39 and $24.85 for the three and six months ended June 28, 2003 and $15.74 and $24.73 for the three and six months ended June 29, 2002. The effects of applying SFAS 123 on net income to determine the pro forma disclosures are not likely to be representative of the effects on pro forma disclosures for 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 three and six months ended June 28, 2003 and June 29, 2002:

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The weighted-average fair value of purchase rights granted during the period was $6.82 and $8.71 for the three and six months ended June 28, 2003, respectively and $14.27 and $13.52 for the three and six months ended June 29, 2002, respectively.

10.

RELATED PARTY TRANSACTIONS

In the second quarter of 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 leasing agreement, we incurred rental expense of approximately $240,000 and $379,000 for the three and six months ended June 28, 2003, respectively, and $58,000 for both the three and six months ended June 29, 2002.

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. Sales to Intel represented approximately 14% of our net sales for both the three and six months ended June 28, 2003 and 12% and 16% for the three and months ended June 29, 2002, respectively. Intel also accounted for 7% and 14% of our accounts receivable as of June 28, 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 June 28, 2003, we do not have any outstanding loans to our executive officers as defined by the Securities and Exchange Commission. However, we have outstanding loans to non-executive officers and key personnel. As of June 28, 2003 and December 31, 2002, the total outstanding balances of loans to non-executive officers and key personnel were approximately $6.6 million and $6.0 million, respectively. Of the total amount outstanding at June 28, 2003, $6.1 million was secured by collateral.

11.

RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, The Emerging Issues Task Force reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” or EITF 00-21. EITF 00-21 provides guidance on accounting for arrangements that involve the delivery of performance of multiple products, services and/or rights to use assets. We are in the process of assessing the effect of EITF 00-21 and do not expect the adoption of EITF 00-21, which will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003, to have a material effect on our financial condition or results of operations.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” or SFAS 149. This statement amends SFAS 133 to clarify the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. SFAS 149 will be effective for all contracts entered into or modified after June 30, 2003. We do not anticipate that the adoption of SFAS 149 will have a material effect on our financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” or SFAS 150. SFAS 150 establishes standards for the classification and measurement of three types of financial instruments with characteristics of both liabilities and equity. SFAS 150 will become effective for financial instruments entered into or modified after May 31, 2003. The adoption of SFAS 150 does not have a material impact on our results of operations or financial condition.

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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 expectations regarding the effect on our financial results of the consolidation of the variable interest lessor under our synthetic leases; our expectation that we will exercise our options to purchase the synthetic lease properties in the third quarter; our expectation that the implementation of FIN 46 will have no impact on our liquidity; our continued belief that significant investment in R&D is required to remain competitive; our intent to continue to invest in our existing products and new products and technologies; our expectations regarding the effect of the adoption of SFAS 149, SFAS 150 and EITF 00-21 on our financial condition or results of operations; 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: our failure to accurately predict the effect of our adoption of certain accounting pronouncements; our inability to exercise our purchase options for properties subject to synthetic leases; our inability to allocate substantial resources to R&D; 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 set forth below in this Item 2 of Part I, and are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of 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

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judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements,” or SAB 101, 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

We account for goodwill and other intangible assets under the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” or SFAS 142. SFAS 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 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 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Furthermore, SFAS 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 of SFAS 142 in January 2002, 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

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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

We account for restructuring charges under the provision of SFAS No. 146, “Accounting for Cost Associated with Exit or Disposal Activities,” or SFAS 146. SFAS 146 nullifies EITF Issue No. 94-3 effective January 1, 2003 and requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred, rather than when the exit or disposal plan is approved.

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 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 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.

Results of Operations
(dollars in thousands)

Net Sales

The semiconductor equipment industry is subject to cyclical conditions that have played a major role in the fluctuations in our net sales. The increase in net sales for the three and six month periods ended June 28, 2003 from the respective prior year periods is primarily due to improved market conditions during the first half of 2003 and is also partially attributable to first half revenues resulting from our December 2002 acquisition of SpeedFam-IPEC, Inc. The decline in demand for semiconductor equipment began in early 2001 and continued through the early part of 2002. While we have experienced a modest increase in demand from the first half of 2002, it has remained weak through the first half of 2003.

The decrease in international net sales as a percentage of net sales for the three months ended June 28, 2003 over the respective prior year period is primarily a result of lower net sales in the Asia region (consisting primarily of Korea, Japan and Taiwan). The decrease for the six months ended June 28, 2003 is primarily due to a proportionally lower increase in net sales in the Asia region compared to net sales in North America. The increase from the immediately preceding quarter is due to higher net sales in the Asia region. The Asia region accounted for 53% of total net sales for the quarter ended June 28, 2003, compared to 47% in the immediately preceding quarter.

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Gross Profit

The prolonged decline in demand for semiconductor devices has continued to affect our gross profit margin as we have not been able to fully absorb fixed overhead costs. The decrease in gross margin as a percentage of net sales from the second quarter of 2002 and the first quarter of 2003 is primarily due to the change in product mix, higher product upgrades and a lower overhead absorption rate.

Selling, General and Administrative (SG&A)