Novellus Systems (NVLS)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

ANNUAL REPORT
PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

Commission file number 000-17157

Novellus Systems, Inc.

(Exact name of Registrant as specified in its charter)

 

 

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

 

 

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

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

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

 

Indicate by check mark 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.  þ

 

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

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

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

 

As of July 1, 2006 the aggregate market value of voting and non-voting stock held by non-affiliates of the Registrant was $3,061,932,456 based on the average of the high and low price 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 21, 2007 was 125,751,401.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III of this Annual Report on Form 10-K incorporates information by reference from the Registrant’s Proxy Statement for its 2007 Annual Meeting of Shareholders. Except as expressly incorporated by reference, the Registrant’s Proxy Statement shall not be deemed to be a part of this Annual Report on Form 10-K.

 

 

NOVELLUS SYSTEMS, INC.

 

2006 ANNUAL REPORT ON FORM 10-K

 

TABLE OF CONTENTS

 

PART I

 

The following information should be read in conjunction with the Consolidated Financial Statements and notes thereto included in this Annual Report on Form 10-K.

 

The Company

 

Novellus Systems, Inc. is a California corporation organized in 1984. Novellus develops, manufactures, sells and supports equipment used in the fabrication of integrated circuits, which are commonly called chips or semiconductors. Customers manufacture chips for sale or for incorporation in their own products, or provide chip-manufacturing services to third parties.

 

Integrated circuits are generally built on a silicon wafer substrate and include a large number of different components, such as transistors, capacitors and other electronic devices. These components are connected on the silicon wafer by multiple layers of wiring, also called interconnects. To build an integrated circuit, transistors are first fabricated on the surface of the silicon wafer. Wiring and insulating structures are then added as alternating thin-film layers in a series of manufacturing process steps. Typically, a first layer of dielectric (insulating) material is deposited on top of the transistors. If the conductive material used is aluminum, subsequent metal layers are deposited on top of this base layer, etched to create the conductive lines that carry the electricity, and then covered with dielectric material to create the necessary insulation between the lines. When copper wires are being constructed, the manufacturing process is a mirror image of that described for aluminum: the insulator is etched, and the copper wiring is deposited within the etched insulator using a high-technology combination of PVD deposition and an electrochemical deposition process. Building either copper or aluminum wiring requires these manufacturing steps to be repeated many times: advanced chip designs may require more than 500 process steps.

 

Novellus provides products that are used in a number of different manufacturing process steps. The current advanced deposition systems use chemical vapor deposition (CVD), physical vapor deposition (PVD), and electrochemical deposition (ECD) processes to form the interconnects in an integrated circuit. Our High-Density Plasma CVD (HDP-CVD) and Plasma-Enhanced CVD (PECVD) systems employ a chemical plasma to deposit dielectric material within the gaps formed by the etching of aluminum or as a blanket which can then be etched with patterns so conductive materials can be deposited into the etched dielectric. Our CVD Tungsten systems are used to deposit tiny tungsten plugs between layers of metal. Our PVD systems use direct-current electrical power to deposit conductive metal layers by sputtering metal atoms from the surface of a target source. Our Electrofill^tm ECD systems are used for depositing copper on wafers which form the conductive wiring on the integrated circuit. Beginning in 2001, Novellus expanded beyond deposition technologies with a series of business acquisitions. In 2001 we acquired GaSonics International Corporation, a manufacturer of systems used to clean and prepare a wafer surface. In 2002 we acquired SpeedFam-IPEC, Inc., a manufacturer of chemical mechanical planarization (CMP) products. In 2004 we further diversified by acquiring Peter Wolters AG, a 200-year-old German company specializing in lapping and polishing equipment. These systems are sold into a broad range of industrial applications. With the acquisition of Peter Wolters, Novellus entered into market sectors beyond semiconductor manufacturing for the first time. In November 2005 we acquired Voumard Machine Co. SA (Voumard) a privately-held manufacturer of high-precision machine manufacturing tools based in Neuchatel, Switzerland. This acquisition further expanded Peter Wolter’s product offering to include specialized, high-precision grinding equipment. In December 2004, the Board of Directors approved the creation of Novellus Development Company LLC, with funding of up to $10 million, for investment in private companies at various stages of development.

 

The headquarters of Novellus Systems, Inc. is located at 4000 North First Street, San Jose, California 95134. The main telephone number is (408) 943-9700.

 

Additional information about Novellus is available on our web site at www.novellus.com. Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, as well as amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as

amended (Exchange Act) are available on the web site free of charge. These reports are available as soon as reasonably practicable after we electronically file them with the Securities and Exchange Commission (SEC). Information contained on the web site is not part of this Annual Report on Form 10-K or of other filings with the SEC.

 

Semiconductor Industry Background

 

Over the past twenty years or more, 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 high technology products for the consumer. In recent years, growth has moderated, and there are signs that the industry is beginning to mature. While unit demand for chips continues to rise, their average selling prices continue to decline. There is growing pressure on chip manufacturers to reduce manufacturing costs while increasing the performance of their products. The semiconductor equipment industry is a major factor in the cost structure in the semiconductor industry. The semiconductor industry has also been historically cyclical, with periods of rapid expansion followed by periods of over-capacity.

 

Several technological trends characterize integrated circuit manufacturing. Perhaps the most prominent of these trends is the increasing density of the integrated circuit. Moore’s Law, first postulated in the mid-1960s and still substantially accurate some 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 45 nanometers, and with up to eleven layers of interconnect circuitry. By increasing circuit density, manufacturers can pack more electronic components per silicon area and thereby provide higher performance at substantially the same cost.

 

Another trend worth noting is the transition to copper from aluminum wiring as the primary conductive material in semiconductor devices. Copper has a lower electrical resistance value than aluminum and provides a number of performance advantages. Because of the superior properties of copper, a device made with copper will need fewer metal layers than one made with aluminum. This provides a considerable reduction in manufacturing cost. Copper wiring allows a substantial improvement in device speed and a significant reduction in power compared to aluminum.

 

A similar transition is under way from traditional insulating films made of silicon oxide to insulators with a low dielectric constant, or “low-k.” Low-k dielectrics reduce the capacitance between metal lines in a device. This improves the speed and lowers power consumption in the device. However, low-k materials are more fragile than silicon oxide, and this poses a host of new challenges to the industry in integrating the new materials into existing manufacturing processes.

 

Another trend in the industry is to continue to increase the wafer size. Semiconductor device manufacturers have migrated to larger, 300mm wafers because of the potential manufacturing cost advantages of these larger wafers compared to 200mm. The 300mm wafers provide in excess of 2.25 times the number of chips per wafer and may provide significant economies of scale in the manufacturing process. More than 75% of all wafer fabrication equipment sold during 2006 was for 300mm wafer manufacturing.

 

These trends shape the equipment and process demands of our device-manufacturing customers. These 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, its operating costs, and net throughput rate. In a fixed period of time, 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 increased cost of larger and more complex semiconductor wafers has made high yields extremely important to customers. To achieve higher yields, systems must be able to deposit high quality films repeatably, consistently and reliably. This characteristic is critical in achieving commercially acceptable yields. Systems that operate at desired throughput rates with wide process windows can achieve repeatability more easily than those with narrow process windows.

 

Semiconductor Business Strategy

 

Our business objective is to increase our market share in semiconductor manufacturing process equipment sold to the semiconductor industry. 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-station sequential architecture, which is incorporated in many of our products, is an example of our commitment to productivity. We intend to retain our historical focus on productivity by applying our multi-station sequential architecture in product enhancements and new product offerings.

 

Be Recognized for our Technology in our Served Available Markets — In the new era of nanoelectronics manufacturing, technology becomes critically important, given the difficulties in manufacturing chips at ever smaller line widths. It is our strategy to anticipate the technologies the customers need and design innovative products which will enhance their manufacturing capabilities.

 

Focus on Reducing Customer Costs — Cost is an important component when measuring overall productivity. Recognizing that, we strive to provide products and technologies that reduce the customer’s overall cost of ownership by continuing to increase our systems throughput, improving our deposition quality and improving the reliability of our products.

 

Broaden our Interconnect Offerings — As semiconductor manufacturing technology becomes more complex, the interconnect structures on a device become more critical to overall performance. We have expanded beyond deposition technology with the acquisitions of Gasonics and SpeedFam-IPEC, which give us expertise in dry photoresist removal and chemical-mechanical polish. In addition, in 2005 we introduced our internally developed ultraviolet thermal processing (UVTP) system for post deposition treatment of films to control stress and improve mechanical integrity. Other areas may offer opportunity for future product portfolio expansion.

 

Differentiate our Service — A vital element of success in the systems business is the service and repair of those systems. Service is critical to the support of our mission, but service is not the ultimate goal of our mission.

 

Expand Operational and Customer Support Presence in Asia — In the fourth quarter of 2006, we announced the establishment of Novellus International Systems, BV, in Singapore, our new international headquarters for systems sales that more closely aligns our operational structure with our customer base. The semiconductor industry is steadily moving to Asia. We have offices in the key locations necessary to compete and are actively increasing our worldwide sourcing of materials to this region as well.

 

Leverage our Low-Cost Manufacturing Structure — We perform all system design, assembly and testing in-house, and outsource the manufacture of most subassemblies. This manufacturing strategy allows us to minimize our overhead costs and capital expenditures and gives us 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 panel designs and power supplies. We work closely with our suppliers to achieve cost reduction through joint development projects.

 

Semiconductor Manufacturing Products

 

Deposition Technologies

 

Our historical strength is rooted in deposition products. 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 enabled semiconductor device manufacturers to increase production throughput and system capability by adding process modules without having to replace existing equipment. In 1997, we introduced the Concept Three^® platform, which built on the foundation of Concept Two to offer greater throughput in 300mm wafer manufacturing applications.

 

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 a form of energy to activate a chemical reaction that deposits a film on the wafers. The CVD process is the traditional method used to deposit dielectric 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 when using conventional PVD or other deposition technologies.

 

HDP CVD Products

 

Concept Two SPEED^® — Introduced in 1996, Concept Two SPEED was the semiconductor industry’s first high-density plasma system capable of high-volume manufacturing. Concept Two SPEED is a single-wafer processing system for 200mm substrates, and was originally designed to deposit dielectric materials in an aluminum interconnect manufacturing process. Today, Concept Two SPEED is primarily used to deposit shallow trend isolation (STI) films as part of the transistor formation as well as to deposit pre-metal layer dielectrics (PMD) in both aluminum and copper based devices.

 

Concept Three SPEED — Introduced in 1997, the Concept Three SPEED is designed to deposit dielectric material on the 300mm wafer. It is based on our production-proven Concept Two product.

 

SPEED NExT — Introduced in 2004, the SPEED NExT system for 300mm wafers is designed specifically to address the challenges of dielectric gap fill at 65 nanometers and beyond.

 

W-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.

 

Concept Three ALTUS — The Concept Three ALTUS, introduced in 1997, provides the same capabilities to 300mm wafer tungsten deposition as its Concept Two ALTUS predecessor delivers for 200mm wafer applications.

 

ALTUS DirectFill^tm — Introduced in 2004, the ALTUS DirectFill tungsten nitride/tungsten deposition system is designed for advanced contact and via-fill applications at 65 nanometers and below. ALTUS DirectFill simplifies the tungsten deposition process by replacing the standard multi-tool approach with a single three-module system.

 

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.

 

VECTOR^® — Introduced in 2000, VECTOR is a PECVD system for depositing dielectric films on 300mm wafers. VECTOR delivers dielectric films required for a low-k device at 90 nanometer-and-smaller design rules.

 

SOLA^® — Introduced in 2005, SOLA is a UVTP system used for the low-temperature, post-deposition treatment of dielectric films. SOLA is designed for advanced materials such as high stress nitrides and porous

low-k dielectrics that are used to deliver increased device speeds and lower power consumption in sub-90 nanometer chips.

 

PVD Products

 

PVD, also known as “sputtering,” is a process in which 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 1997.

 

INOVA^® — The INOVA 200mm system was originally developed by the Thin Films Systems Division of Varian Associates. Novellus reintroduced the product in 1998 with the addition of a patented Hollow Cathode Magnetron (HCM)^® ionized PVD source that was designed specifically for the deposition of copper barrier and seed films.

 

INOVA^® xT — In 2000, we introduced the 300mm INOVA xT, which features HCM technology.

 

INOVA^® NExT^tm — In 2005, we introduced the INOVA NExT, a 300mm metallization system designed to deposit highly conformal copper barrier-seed films at 45 nanometers and beyond. On the INOVA NExT, the single target HCM technology has been extended to the 45 nanometer node; the system also features an integrated ion-induced atomic layer deposition (iALD) module to deposit tantalum nitride (TaN) barrier films below 45 nanometers.

 

ECD Products

 

Our Electrofill products are used to build the copper primary conduction layers in advanced integrated circuits. Electrofill uses a copper electrolytic solution to create lines and vias in a dielectric layer which has been etched with the pattern of the circuitry, in a process called copper damascene.

 

SABRE^® — The SABRE copper Electrofill system was introduced in 1998. The SABRE employs a proprietary electrofill cell. When 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 an ECD platform for both 200mm and 300mm wafers. New features on the SABRE xT that were not found on the original SABRE include advanced plating chemistries, an integrated anneal module and closed-loop chemical monitoring.

 

SABRE NExT^tm — Introduced in 2003, the SABRE NExT builds on the SABRE xT’s production track record, offering a proprietary chemistry, a new anode cell design and other hardware refinements to tackle the complex process requirements of 90 nanometer, 65 nanometer and 45 nanometer interconnect structures.

 

SABRE Extreme^tm — In July 2006 we introduced the SABRE Extreme, an advanced Electrofill system that has been qualified at 45 nanometers and has demonstrated fill at 32 nanometers. The SABRE Extreme incorporates a number of technological innovations for advanced manufacturing applications, including advanced wafer entry control for thin seed layers (< 200A), tunable profile control for improved uniformities, and the capability to plate on non-copper seed materials.

 

Surface Preparation Technologies

 

Chip manufacturers use surface preparation products to remove photoresist from a wafer before proceeding with the next deposition step in the manufacturing process. We entered the market for this manufacturing process step in 2001.

 

GAMMA^tm 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.

 

GAMMA^® 2130 — The GAMMA 2130 system is our photoresist strip system for 300mm wafers. Our multi-station sequential processing architecture incorporates six stations within a single process chamber.

 

GAMMA^® Express — The GAMMA Express, introduced in 2006, is a high productivity resist strip system designed to meet the technology requirements for 45 nanometer manufacturing. GAMMA Express performs high dose implant strip (HDIS) and incorporates non-oxidizing processes for advanced silicides and low-k dielectric films. The redesigned GAMMA Express platform offers a new direct-drive wafer handling subsystem, as well as a new high ash rate source.

 

CMP Technologies

 

CMP systems polish the surface of a wafer after a deposition step to create a planar surface before moving on to subsequent manufacturing steps. Since copper films are more difficult to polish than the tungsten and oxide films used in previous-generation aluminum interconnects and since low-k dielectrics are much more porous than their predecessors, CMP has been elevated to the forefront of the enabling technologies required in a copper damascene manufacturing process. In recognition of this trend, in 2002 we acquired SpeedFam-IPEC, a global supplier of CMP systems used in the fabrication of advanced copper interconnects. We believe that the opportunity to understand the interactions between planarization, deposition and surface preparation steps and to optimize them for overall performance gives us an important advantage in extending copper and low-k processes to advanced semiconductor devices.

 

MOMENTUM^tm — 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. MOMENTUM also employs an orbital polishing motion and features a through-the-pad slurry delivery system.

 

XCEDA^tm — Introduced in 2004, the XCEDA copper CMP system is an advanced 300mm platform designed to exceed both the technical and economic requirements of CMP at 65 nanometers and beyond. The XCEDA has four polishing modules and a through-the-pad slurry delivery system.

 

Industrial Applications Group

 

We acquired Peter Wolters AG in June 2004, the same year in which it celebrated its 200th anniversary, and in 2005 further expanded our Industrial Applications Group with the acquisition of Voumard Machine Co. SA. Our Industrial Applications Group supplies high-precision machines for grinding, deburring, lapping, honing and polishing the outer surfaces of parts made of metal, glass, ceramic, plastic, silicon or similar materials. Our customers for these machines are manufacturers in sectors such as vehicles, aircraft and electronic products, parts and components. Other customers are in the glass and ceramics industries as well as manufacturers of products such as pumps, transmissions, compressors and bearings. In all of these areas, the demand for close tolerances for finish quality, thickness, flatness and parallelism is high. Our products include single-side machines, double-side machines, thru-feed grinding machines that feature the continuous feed of parts to be processed, and deburring systems.

 

Marketing, Sales and Service

 

We rely on a direct sales force to sell our chip manufacturing products in all geographic regions in the world where semiconductors are manufactured, which are Europe, the United States, Korea, Japan, China, Taiwan, and Southeast Asia. Our Industrial Applications products are also sold through a combination of a direct sales force and manufacturer’s representatives.

 

The ability to provide prompt and effective field service 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, conferences and technical symposia.

 

Customers

 

For the year ended December 31, 2006, Samsung, Intel Corporation, and Hynix accounted for 16%, 11% and 10% of our net system sales, respectively. For the year ended December 31, 2005, Samsung and Intel Corporation accounted for 20% and 13% of our net system sales, respectively. For the year ended December 31, 2004, Taiwan Semiconductor Manufacturing Company, Ltd., UMC (United Microelectronics Corporation) and Samsung accounted for 12%, 12% and 11% of our net system sales, respectively. System sales to our ten largest customers in 2006, 2005, and 2004 accounted for 72%, 71%, and 69% of our system sales, respectively. We expect that sales of our products to relatively few customers, none of which have entered into long-term agreements requiring them to purchase our products, will continue to account for a high percentage of our net sales in the foreseeable future.

 

Export sales outside of the United States for the year ended December 31, 2006 were $1.2 billion, or 72% of net sales. For the year ended December 31, 2005, export sales were $1.0 billion, or 73% of net sales. For the year ended December 31, 2004, export sales were $1.0 billion, or 77% of net sales.

 

Backlog

 

As of December 31, 2006, our backlog was $566.0 million of which $17.3 million was cancelled in the period from December 31, 2006 to February 26, 2007. As of December 31, 2005, our backlog was $382.2 million, with no cancellations in the period from December 31, 2005 to March 15, 2006. Our backlog includes transactions 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 shipments 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 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 developing new systems and processes and improving 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 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, excluding charges for acquired in-process research and development, during 2006, 2005, and 2004 were $244.2 million, $247.3 million, and $252.1 million, respectively. These expenditures represented approximately 15%, 18%, and 19% of our net sales in 2006, 2005, and 2004, 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 most subassemblies, and we perform all system design, assembly and testing in-house. Our outsourcing strategy enables us to minimize fixed costs and capital expenditures, and provides us with 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

panel designs and power supplies 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 development 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 source or limited sources. These suppliers are, in some cases, thinly capitalized, independent companies that generate significant portions of their business from us or from a small group of 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 suppliers may occur, and 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 semiconductor device fabrication, which helps to minimize the amount of particulates and other contaminants in the final assembled system and to improve product yields for our customers. Following assembly, we package our completed systems in vacuum packaging to maintain clean-room standards of particulates and other contaminants 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, HDP and PVD markets, our principal competitor is Applied Materials, Inc. (Applied), a major supplier of systems that has established a substantial base of installed equipment among today’s semiconductor manufacturers. In the PECVD market, we also compete against ASM International. In the ECD market, our principal competitors are Applied and Semitool, Inc. Our principal competitors in the surface preparation product arena are Mattson Technologies, Inc. and Axcelis Technologies, Inc. In the CMP market, our major competitors are Applied and Ebara Corporation.

 

Patents and Proprietary Rights

 

We intend to continue to pursue patent and trade secret protection for our technology. We currently hold 594 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 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 patent rights granted will provide competitive advantages to us. See Part I, Item 3. “Legal Proceedings,” for further discussion.

 

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 those 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 current litigation will have a material impact on our business, financial condition or results of operations, no assurances can be given that current or future litigation will not have such an impact. For further discussion, see Part I, Item 3. “Legal Proceedings.”

 

In addition to 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 efforts and could have a material adverse effect on our financial condition or operating results. In addition, adverse determinations in such litigation could result in 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. Any of these occurrences could have a material adverse effect on our business, financial condition or results of operations.

 

Employees

 

On December 31, 2006, we had 3,725 full-time and temporary employees. Certain employees outside of the United States are represented by labor unions. 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, 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.

 

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.

 

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

 

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

 

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

changing market conditions or customer requirements, or remain focused on research and development efforts that will translate into greater revenues, our business could be seriously harmed.

 

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

 

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

 

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

 

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

 

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

 

We face substantial competition in the industry, from both potential new market entrants and established competitors. Competitors may have greater financial, marketing, technical or other resources, and greater ability to respond to pricing pressures, than we do. They may also have broader product lines, greater customer service capabilities, or larger and more established sales organizations and customer bases. To

maintain or capture a position in the market, we must develop new and enhanced systems and introduce them at competitive prices on a timely basis, while managing our research and development and warranty costs. Semiconductor equipment manufacturers incur substantial costs to install and integrate capital equipment into their production lines. This increases the likelihood of continuing relationships with chosen equipment vendors, including our competitors, and the difficulty of penetrating new customer accounts. In addition, sales of our systems depend in significant part upon a prospective customer’s decision to increase or expand manufacturing capacity — which typically involves a significant capital commitment. From time to time, we have experienced delays in finalizing system sales following initial system qualification. Due to these and other factors, our systems typically have a lengthy sales cycle, during which we may expend substantial funds and management effort. Heightened competition may also force price reductions that could adversely affect our results of operations.

 

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

 

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

 

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

 

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

 

Our employees are extremely important to our success and our key management, engineering and other employees are difficult to replace. The expansion of high technology companies has increased demand and competition for qualified personnel. If we are unable to retain key personnel, or if we are not able to attract, assimilate and retain additional highly qualified employees to meet our needs in the future, our business and operations could be harmed.

 

We face risks related to concentration of net sales.

 

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

 

We are exposed to the risks of global operations.

 

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

 

 

There can be no assurance that any of these factors will not have a material adverse effect on our business, financial condition or results of operations. In addition, each region in the global semiconductor equipment market exhibits unique market characteristics that can cause capital equipment investment patterns to vary significantly from period to period. We derive a substantial portion of our revenues from customers in Asia. Any negative economic developments or geo-political instability in Asia, including the possible outbreak of hostilities or epidemics involving China, Taiwan, Korea or Japan, could result in the cancellation or delay by certain significant customers of orders for our products, which could adversely affect our business, financial condition or results of operations. Our continuing expansion in Asia renders us increasingly vulnerable to these risks.

 

We face risks related to intellectual property.

 

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

 

Adverse outcomes in current or future legal disputes regarding patent and intellectual property rights could result in the loss of our intellectual property rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties on terms that may not be reasonable or favorable to us, prevent us from manufacturing or selling our products, or compel us to redesign our products to avoid incorporating third parties’ intellectual property. As a result, our product offerings may be delayed, and we may be unable to

meet customers’ requirements in a timely way. Regardless of the merit of any legal disputes, we incur and may be required to incur in the future substantial costs to prosecute or defend our intellectual property rights. Even if there were no infringement by our products of third parties’ intellectual property rights, we have in the past and may in the future elect to seek licenses or enter into settlements to avoid the costs of protracted litigation and diversion of resources and management attention. However, if the terms of settlements entered into with certain of our competitors are not observed or enforced, we may suffer further costs. Any of these circumstances could have a material adverse effect on our business, financial condition or results of operations during any reported fiscal period.

 

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

 

Changes in tax rates or liabilities could negatively impact our future results.

 

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

 

 

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

 

Intellectual Property Litigation

 

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

 

Derivative Litigation

 

We and certain of our current and former officers and directors have been named as defendants in two derivative lawsuits claiming violations of the Securities and Exchange Act of 1934, as amended, in connection with our stock option administration practices. See Part I, Item 3 “Legal Proceedings” for a description of the claims brought against us. The outcome of legal proceedings of this kind is difficult to predict. Moreover, the

complaints filed against us do not specify the amount of damages that the plaintiffs seek, and we are therefore unable to estimate the possible range of loss that we might incur should these lawsuits ultimately be resolved against us. We believe that the claims are without merit and that our stock option administrative practices do not require any material financial statement adjustment. Nevertheless, these lawsuits, if ultimately resolved against us, could seriously harm our business, financial condition and operating results. These matters, and any other derivative litigation in which we may become involved, could result in substantial costs to us and a diversion of our resources and the efforts of our management personnel, and this could materially and adversely affect our business, financial condition and operating results.

 

Other Litigation

 

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

 

We are exposed to risks associated with our diversification strategy.

 

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

 

We are exposed to risks associated with our investment activities.

 

Our ability to compete in the semiconductor manufacturing industry depends on our success in developing new and enhanced technologies that advance the productivity and innovation advantages of our products. To further these goals, we have formed the Novellus Development Company, a venture fund that enables us to invest in emerging technologies and strengthen our technology portfolio for both existing and potentially new market opportunities. Although the fund intends to make inquiries reasonably necessary to make an informed decision as to the companies and technologies in which it will invest, we cannot provide any assurance as to any future return on investment or ability to bring new technologies to market. There are risks inherent in investing in start-up companies, which may lack a stable management team, operating history or adequate cash flow. The securities in which the fund may invest may not be registered under the Securities Act of 1933, as amended, or any applicable state securities laws, and may be subject to restrictions on marketability or transferability. Given the nature of the investments that may be contemplated by the fund, there is a significant risk that it will be unable to realize its investment objectives by sale or other disposition, or will otherwise be unable to identify or develop any commercially viable technology. In particular, these risks could arise from changes in the financial condition or prospects, management inexperience and lack of research and development resources of the companies in which investments are made, and evolving technological standards. Investments contemplated by the fund may divert management time and attention, as well as capital, away from our core operating business. Any future losses on investments attributable to the fund may materially and adversely impact our business, financial condition and operating results.

 

Corporate governance and financial reporting requirements have led and may continue to lead to increased costs and may make it more difficult to attract qualified executive officers and directors.

 

To comply with the requirements of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), as well as new rules subsequently implemented by the SEC and adopted by The Nasdaq Stock Market in response to Sarbanes-Oxley, we have made changes to our financial reporting, securities disclosure and corporate governance practices. In 2006 and 2005, we incurred increased legal and financial compliance costs due to these new and evolving rules, regulations, and listing requirements, and management time and resources were re-directed to ensure current and implement future compliance initiatives. These rules may make it more difficult for us to attract and retain qualified executive officers and members of our Board of Directors, particularly to serve on our audit committee.

 

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

 

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

 

We face risks related to changes in accounting standards for stock option plans.

 

Beginning in the first fiscal quarter of 2006, we adopted Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), which requires us to recognize compensation expense in our statement of operations for the fair value of stock options granted to our employees over the related vesting periods of the stock options. The requirement to expense stock options granted to employees reduces their attractiveness as a compensation vehicle because the expense associated with these grants results in compensation charges. In addition, the expenses recorded may not accurately reflect the value of our stock options because the option pricing models commonly used under SFAS 123R were not developed for use in valuing employee stock options and are based on highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Alternative compensation arrangements that can replace stock option programs may also negatively impact profitability. Stock options remain an important employee recruitment and retention tool, and we may not be able to attract and retain key personnel if we reduce the scope of our employee stock option programs. Our employees are critical to our ability to develop and design systems that advance our productivity and technology goals, increase our sales goals and provide support to customers. Accordingly, as a result of the requirements of SFAS 123R, our profitability has and can be expected to continue to be reduced compared to periods prior to adoption of the new standard.

 

If our outside audit firm does not maintain its independence, we may be unable to meet our regulatory reporting obligations.

 

Our independent registered public accounting firm communicates with us at least annually regarding any relationships between the firm and Novellus that, in the firm’s professional judgment, might have a bearing on the firm’s independence with respect to Novellus. If our independent registered public accounting firm finds that it cannot confirm that it is independent of Novellus based on existing securities laws and registered public accounting firm independence standards, we could experience delays or otherwise fail to meet our regulatory reporting obligations.

 

We face risks associated with 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:

 

 

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.

 

Our quarterly operating results and stock price are unpredictable.

 

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

 

 

Compliance with current and future environmental regulations may be costly.

 

We may be subject to environmental and other regulations in certain states and countries where we produce or sell our products. We also face increasing complexity in our product design and procurement operations as we

adjust to new and prospective requirements relating to the materials composition of our products, including the restrictions on lead and certain other substances in electronics that apply to specified electronics products put on the market in the European Union after July 1, 2006 (Restriction of Hazardous Substances in Electrical and Electronic Equipment Directive (EU RoHS)). The European Union has also finalized the Waste Electrical and Electronic Equipment Directive (WEEE), which makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for enacting and implementing this directive by individual European Union governments was August 13, 2004, although extensions were granted in some countries. Producers became financially responsible under the national WEEE legislation beginning in August 2005. Other countries, such as the United States, China and Japan, have enacted or may enact laws or regulations similar to the EU RoHS or the WEEE Directive. These and other future environmental regulations could require us to reengineer certain of our existing products.

 

Not applicable.

 

Information regarding our principal properties at December 31, 2006 is as follows:

 

 

In our Semiconductor Group, we also lease several domestic field offices totaling approximately 26,000 square feet of space and several sites outside the United States totaling approximately 213,000 square feet of space that we use as sales and customer service centers. Our facilities in Europe include approximately 29,000 square feet of leased space in various countries including France, Germany, Italy, and Ireland. Our facilities in Asia include approximately 184,000 square feet of leased space in various countries including China, India, Japan, Korea, Malaysia, Singapore, Taiwan and Vietnam.

 

We have properties for sale of approximately 231,000 square feet in San Jose, California that are not included in the table above.

 

In our Industrial Applications Group, we also lease five field offices totaling approximately 41,000 square feet in Germany, Switzerland, China and Japan. We also sublease approximately 39,000 square feet of space in Mettmann, Germany.

 

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

 

Linear Technology Corporation

 

In March 2002, Linear Technology Corporation (Linear) filed a complaint against Novellus, among other parties, in the Superior Court of the State of California for the County of Santa Clara. The complaint seeks damages (including punitive damages) and injunctions for causes of actions involving alleged breach of contract, fraud, unfair competition, breach of warranty and declaratory relief. On September 3, 2004, Novellus filed a demurrer to all causes of action in the complaint, which the Court granted without leave to amend on October 5, 2004. On January 11, 2005, Linear filed a notice of appeal of the court’s order and the appeal is now fully briefed. The Court of Appeal has not yet set a date for oral argument. Although we prevailed on these claims in the Superior Court, it is possible that the Court of Appeal will reverse the ruling of the Superior Court, in which case Novellus could face potential liability on these claims. We cannot predict how the Court of Appeal will rule on this issue or, if it does rule against Novellus, estimate a range of potential loss, if any. However, we currently believe that the ultimate disposition of these matters will not have a material adverse effect on our business, financial condition or operating results.

 

Derivative Litigation

 

On May 31, 2006, a complaint titled “Joshua Teitelbaum, in the right of and for the benefit of Novellus Systems, Inc., v. Richard S. Hill, Jeffrey C. Benzing, D. James Guzy, Tom Long, Robert H. Smith, Neil R. Bonke, Youssef A. El-Mansy, J. David Litster, Yoshio Nishi, Glen G. Possley, Ann D. Rhoads, William R. Spivey and Delbert A. Whitaker, as defendants, and the Company as a Nominal Defendant” was filed in the United States District Court for the Northern District of California. The complaint alleges that our practices in connection with certain stock option grants to executives caused a diversion of assets from Novellus to the executives and caused us to make false and misleading statements to the SEC. The complaint also alleges,

among other things, violations of sections 10(b) and 14(a) of the Exchange Act, a breach of fiduciary duty, abuse of control, gross mismanagement, corporate waste, and unjust enrichment. The complaint seeks unspecified monetary damages and other relief against the defendants. On June 21, 2006, a separate complaint titled “Alaska Electrical Pension Fund, on behalf of Novellus Systems, Inc., v. Richard S. Hill, Jeffrey C. Benzing, William H. Kurtz, Neil R. Bonke, Youssef A. El-Mansy, J. David Litster, Yoshio Nishi, Glen G. Possley, Ann D. Rhoads, William R. Spivey and Delbert Whitaker, as defendants, and the Company as a Nominal Defendant” was filed in the United States District Court for the Northern District of California with similar allegations. The complaints seek unspecified monetary damages and other relief against the defendants. We have, through outside counsel, conducted an inquiry into each of the option grants referenced in the complaints. As a result of this inquiry, Novellus and its Board of Directors believe the claims of both complaints to be without merit. However, we cannot predict the outcome of this case or if the outcome is unfavorable, estimate a range of potential loss, if any. However, we currently believe that the ultimate disposition of these matters will not have a material adverse effect on our business, financial condition or operating results.

 

The two complaints were consolidated on September 8, 2006. The plaintiffs filed an amended, consolidated complaint on December 8, 2006. Novellus and the individual defendants filed motions to dismiss on January 19, 2007. Briefing on these motions will be complete by March 9, 2007. The Court will hear argument on the motions on March 23, 2007.

 

Other Litigation

 

During the year ended December 31, 2006, we reached an agreement to settle a customer indemnity claim, and the $3.3 million cost of this settlement was included in our results of operations.

 

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

 

Not applicable.

PART II

 

Stock Information

 

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

 

 

 

As of February 26, 2007, there were 1,051 holders of record of our common stock. We have not paid cash dividends on our common stock since inception, and our Board of Directors presently plans to use the cash generated from operations to reinvest in the business and to repurchase common shares. Accordingly, it is anticipated that no cash dividends will be paid to holders of common stock in the foreseeable future.

 

On February 24, 2004 we announced that our Board of Directors had approved a stock repurchase plan that authorized the repurchase of up to $500.0 million of our outstanding common stock through February 13, 2007. On September 20, 2004 we announced that our Board of Directors had authorized an additional $1.0 billion for repurchase of our outstanding common stock through September 14, 2009. We may repurchase shares from time to time in the open market, through block trades or otherwise. The repurchases may be commenced or suspended at any time or from time to time without prior notice depending on prevailing market conditions and other factors.

 

We did not repurchase any of our shares during the quarter ended December 31, 2006. As of December 31, 2006, we had approximately $613.3 million of remaining authorized funds for the repurchase of shares of our common stock.

 

The following graph compares the cumulative 5-year total return attained by shareholders on our common stock relative to the cumulative total returns of the S & P 500 index and the RDG Technology Composite index. The graph tracks the performance of a $100 investment in our common stock and in each of the indices (with the reinvestment of all dividends) from December 31, 2001 to December 31, 2006.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Novellus Systems, Inc., The S & P 500 Index
And The RDG Technology Composite Index

 

 

 

Copyright^© 2007, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. www.researchdatagroup.com/S&P.htm

 

 

This graph is not “soliciting material,” is not deemed filed with the SEC and is not to be incorporated by reference in any filing by us under the Securities Act of 1933, as amended (the “Securities Act”), or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

 

The stock price performance included in this graph is not necessarily indicative of future stock price performance.

 

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 each of the five years in the period ended December 31, 2006 and the Consolidated Balance Sheet data at each respective year end have been derived from our Consolidated Financial Statements, which have been audited. We acquired Voumard Machine Co. SA (Voumard) on November 18, 2005, Peter Wolters AG on June 28, 2004 and SpeedFam-IPEC, Inc. on December 6, 2002. These transactions were accounted for as purchase business combinations and the Selected Consolidated Financial Data includes the operating results and financial information of these companies from their respective dates of acquisition.

 

Selected Consolidated Financial Data

 

The following selected consolidated financial data has been derived from our historical Consolidated Financial Statements and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes for the corresponding fiscal years:

 

 

 

 

 

Cautionary Note 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 contained in this Annual Report on Form 10-K, other than statements that are purely historical, are forward-looking statements and are based upon management’s present expectations, objectives, anticipations, plans, hopes, beliefs, intentions or strategies regarding the future. As such, forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated. We do not undertake, and expressly disclaim, any obligation to update this forward-looking information, except as required under applicable law.

 

The following information should be read in conjunction with “Part I, Item 1. Business,” “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II, Item 8. Consolidated Financial Statements” and the notes thereto. Forward-looking statements in this Annual Report on Form 10-K may be identified by words such as “anticipates,” “estimates,” “expects,” “projects,” “intends,” “plans,” “believes” or similar expressions, and include, without limitation:

 

 

 

 

 

Introduction

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide readers with an understanding of Novellus. Our MD&A addresses the following topics:

 

 

 

Overview of Our Business and Industry

 

Novellus Systems, Inc. is a California corporation organized in 1984. At Novellus, we develop, manufacture, sell and support equipment used in the fabrication of integrated circuits, which are commonly called chips or semiconductors. The customers for our products manufacture chips for sale or for incorporation in their own products, or provide chip-manufacturing services to third parties.

 

Beginning in 2001, Novellus has expanded beyond deposition technologies with a series of business acquisitions. In 2001, we acquired GaSonics International Corporation, a manufacturer of systems used to clean and prepare a semiconductor silicon wafer surface. In 2002, we acquired SpeedFam-IPEC, Inc., a manufacturer of chemical mechanical planarization (CMP) products. In 2004, we further diversified by acquiring Peter Wolters AG, a 200-year-old German company specializing in lapping and polishing equipment for a number of industries. With the acquisition of Peter Wolters AG, Novellus entered into market sectors beyond semiconductor manufacturing for the first time. In November 2005 we acquired Voumard, a privately-held manufacturer of high-precision machine manufacturing tools based in Neuchatel, Switzerland.

 

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

 

We focus on certain key quarterly financial data to manage our business. Net sales, gross profit, net income (loss) and net income (loss) per share are the primary measures we use to monitor performance, although we also use certain non-GAAP measures such as net orders to assess business trends and performance. Net orders are also used to forecast and plan future operations. Net orders consist of current period orders less current period cancellations. The following table sets forth certain quarterly and annual financial information for the periods indicated (in thousands, except per share data):

 

 

The semiconductor equipment industry is subject to cyclical conditions, which play a major role in demand, as defined by net orders. These fluctuations, in turn, affected our net sales over the past three years. In 2006, we experienced a significant increase in demand for our products. Net orders increased by $537.5 million or 43% from 2005 to 2006. The increase began in the fourth quarter of 2005 and continued through the first three quarters of 2006 with a 19% increase in the first quarter, a 10% increase in the second quarter, and a 3% increase in the third quarter. Net orders decreased by 6% in the fourth quarter. Increased 2006 orders reflect a recovery in the semiconductor and semiconductor related industries and the global economy as end-user demand for electronic products drove increased customer requirements for advanced silicon products.

 

In 2005, we experienced a moderate decrease in demand for our products. Net orders decreased by $249.7 million or 17% from 2004 to 2005. The decrease in demand began in the fourth quarter of 2004, when net orders decreased 22% sequentially, and continued into 2005. Net orders during the first three quarters of 2005 were mostly lower sequentially with a 9% decrease in the first quarter, a 3% increase in the second quarter, and a 7% decrease in the third quarter. The net order decline in 2005 was driven primarily by our customers’ assimilation of significant production capacity increases undertaken during 2004. In the fourth

quarter of 2005, demand grew significantly in large part due to an increase in the utilization of our customer’s production capacity as evidenced by our 22% increase in net orders over the prior quarter.

 

In 2004, we experienced a significant increase in demand for our products. Net orders increased by $561.9 million or 60% from 2003 to 2004. The increase in demand began in the fourth quarter of 2003, when net orders increased 25% sequentially, and continued into 2004. In the first three quarters of 2004, we experienced sequential increases in net orders of 26%, 15%, and 6%, respectively. The net order growth in 2004 was driven primarily by strengthening demand for corporate and consumer electronic devices, which resulted in an increase in our customers’ production capacity utilization. We also experienced increased demand as a result of our customers’ transition to 300mm fabrication equipment. In the fourth quarter of 2004, demand began to slow and we experienced a 22% sequential decrease in net orders.

 

The receipt of net orders in a particular quarter affects revenue in subsequent quarters. Net orders result in revenue either at shipment and transfer of title or upon customer acceptance of the equipment. Our revenue recognition policy addresses the distinction between the revenue recognized upon shipment and transfer of title and the revenue recognized upon customer acceptance. Equipment generally ships within two to six months of receiving the related order and if applicable, customer acceptance is typically received one to six months after shipment. These time lines are general estimates and actual times may vary depending on specific customer circumstances. We do not report orders for systems with delivery dates greater than twelve months after receipt of the order.

 

Demand for our systems can vary significantly from period to period as a result of several factors, including, but not limited to, downturns in the economy and semiconductor industry, supply of and demand for semiconductor devices, and competition in the semiconductor industry among suppliers of similar products. For these and other reasons, our results of operations for fiscal years 2006, 2005 and 2004 may not necessarily be indicative of future operating results.

 

Results of Operations

 

Net Sales

 

 

Net sales related to our Semiconductor Group increased $311.0 million from 2005 to 2006, while sales related to our Industrial Applications Group remained relatively unchanged increasing by $7.0 million from 2005 to 2006. The increase in net sales of our Semiconductor Group is primarily due to increased sales volume and a change in the mix of products sold.

 

Net sales decreased from 2004 to 2005 primarily due to decreased volume and a decrease in average selling price. The decrease in 2005 net sales was partially offset by a full year of operations in 2005 for Peter Wolters AG, which we acquired in June 2004, compared to a partial year of operations in 2004. Net sales provided by Peter Wolters AG were $88.6 million in 2005, compared to $41.0 million in 2004. Geographical net sales as a percentage of total net sales were as follows (based on the location of the customers’ facilities):

 

 

We continue to rely on international customers, particularly those in Asia, for a significant portion of our net sales. We consider the Asia region to consist principally of Korea, Japan, Singapore, China and Taiwan. A substantial portion of the world’s semiconductor manufacturing capacity is located there. We plan to continue

to focus on expanding our market presence in Asia, as we believe that significant additional growth potential exists in this region over the long term.

 

Gross Profit

 

 

The increase in gross profit as a percentage of net sales in 2006 compared to 2005 is due primarily to a reduction in installation and warranty costs, a change in the mix of products sold and efficiencies in operations. Gross margin also increased by $2.5 million from 2005 to 2006 due to the adoption of SFAS 151 and decreased by $0.7 million due to the adoption of SFAS 123R (see Recent Accounting Pronouncements within this Item 7).

 

The decrease in gross profit as a percentage of net sales in 2005 compared to 2004 is due primarily to increased warranty costs associated with 300mm tools, a $5.3 million write-down of obsolete inventory resulting from a restructuring, and a decline in average selling price. Additional warranty charges relating to pre-existing warranties were about $13.9 million in 2005. Sales of inventory previously written down resulted in a decrease in cost of sales of approximately $15.1 million for the year ended December 31, 2005.

 

Our gross profit from period to period is affected by the treatment of certain product sales in accordance with SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition,” (SAB 104) which superseded the earlier related guidance in SAB No. 101, “Revenue Recognition in Financial Statements.” For these sales, we recognize all of a product’s cost upon shipment even though a portion of a product’s revenue may be deferred until final payment is due, typically upon customer acceptance.

 

Selling, General and Administrative (SG&A)

 

 

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

 

The increase in SG&A expense in 2006 over the prior year, in absolute dollars and as a percentage of sales, is primarily due to an increase in stock compensation expense of $20.2 million due primarily to the adoption of SFAS 123R, the acquisition of Voumard, an increase in headcount to support sales volume and increases in commissions and profit sharing due to increased sales and improved financial performance in 2006.

 

The increase in SG&A expense in 2005 over the prior year, in absolute dollars and as a percentage of sales, is primarily due to a reduction in SG&A of $8.1 million in 2004 from the reversal of previously accrued royalty payments in connection with our legal settlement with Applied Materials, Inc., as well as a full year of operations in 2005 for Peter Wolters AG, which we acquired in June 2004, compared to a partial year of operations in 2004. Partially offsetting these increases is a net reduction in SG&A of $7.3 million during 2005 due to a reduction in our allowance for doubtful accounts.

 

Research and Development (R&D)

 

 

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

 

The decrease in R&D expense in 2006 and 2005 in absolute dollars results from lower R&D program spending and lower depreciation and related facility costs due to restructuring. The decrease in R&D expense in 2006 is partially offset by an increase of $9.9 million of stock-based compensation included in R&D primarily as a result of the adoption of SFAS 123R. As a percentage of sales R&D has decreased due to higher sales and relatively fixed R&D spending. The 2005 reduction from 2004 levels was partially offset by a full year of operations in 2005 for Peter Wolters AG, which we acquired in June 2004, compared to a partial year of operations in 2004.

 

Acquired In-Process Research and Development (IPR&D)

 

 

During 2004, we incurred a $6.1 million charge for acquired in-process research and development (IPR&D) in connection with the acquisition of Angstron Systems, Inc. We incurred no such charges during 2006 and 2005.

 

Legal Settlement

 

 

In 2006, we incurred a charge of $3.3 million to settle a customer indemnity claim. During 2004, we incurred a charge of $2.9 million related to the Semitool litigation and a charge of $2.5 million related to the settlement of a class action lawsuit by field service engineers relating to overtime compensation. No such legal charges were incurred during the year ended December 31, 2005.

 

Restructuring and Other Charges

 

 

During 2006, we implemented a restructuring plan to dispose of certain owned facilities located in San Jose, California. We recorded an impairment charge of $8.9 million to write down certain of those facilities to their

estimated fair value and reclassified certain of those assets to assets held for sale in our Consolidated Balance Sheet as of December 31, 2006 as we expect to sell them within one year. In 2006, we also recorded restructuring charges of $6.0 million related to future lease payments, $1.3 million related to accelerated depreciation of leasehold improvements and $0.2 million related to other charges, all in connection with a restructuring plan we implemented in 2005 to relocate certain operations from Chandler, Arizona to San Jose, California and Tualatin, Oregon.

 

During 2005, we incurred a severance charge of $0.8 million and asset impairments of $14.2 million. These charges were offset by the reversal of a previously recorded restructuring accrual of $5.8 million due to a change in future estimated sublease income.

 

During 2004, we incurred a severance charge of $1.2 million and asset impairments of $1.2 million. These charges were offset by the reversal of a previously recorded restructuring accrual of $0.9 million due to a change in future estimated sublease income related to vacated facilities.

 

The charges 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 property and equipment, including leasehold improvements, associated with the abandoned facilities that had no future economic benefit have been written off.

 

As a result of the 2006 restructuring plan we expect to decrease net expenses in 2007 by approximately $2.5 million, which considers decreased depreciation expense related to asset write offs and sublease income. In addition we experienced cash flow savings of $1.3 million in 2006 and expect savings of $1.8 million in 2007, due primarily to sublease income. See Note 7 to Consolidated Financial Statements for further disclosure of our restructuring activities.

 

Interest and Other Income, net

 

 

Interest and other income, net, includes interest income, interest expense and other non-operating items. The increase in interest and other income, net, in absolute dollars for 2006 compared to 2005 is primarily due to an increase in interest income of approximately $7.0 million, due to higher balances of interest-bearing cash and short-term investments along with higher interest rates during 2006 and a gain of $2.8 million related to our acquisition of Voumard.

 

The increase in interest and other income, net, in absolute dollars for 2005 compared to 2004 is primarily due to an increase in interest income of approximately $9.2 million, due to higher balances of interest-bearing cash and short-term investments along with an increase in foreign currency-related gains of $6.5 million. Higher cash and investment balances resulted mainly from positive cash flow from operations during the year ended December 31, 2005. In 2004, interest and other income, net, included the cash receipt of $8.0 million in connection with the settlement of the Applied Materials, Inc. litigation.

 

Income Taxes

 

Our effective tax rate was 44%, 31% and 30% in 2006, 2005 and 2004, respectively. Our effective tax rate in 2006 differs from 2005 primarily because of the implementation of a new global business structure, the conclusion of certain tax examinations, increased benefit from federal manufacturing and export sales incentives, reduced state taxes, and reduced incremental benefit from tax-exempt interest income. Our new global business structure is being implemented to align our operations with the business needs of our non-U.S. customers. We expect to achieve a lower tax rate in the future as well as business efficiencies, as a result of the global structure. In 2006, a tax expense of approximately $46.1 million due to foreign losses with

no current tax benefit associated with the global structure was partially offset by an $8.0 million benefit from the adjustment of tax reserves as a result of the conclusion of tax examinations. Our effective tax rate in 2005 differs from 2004 because of decreased benefit from export sale incentives and less benefit from a valuation allowance reduction. The effective tax rate in 2006 also reflects research and development credits, and foreign income taxes on foreign source earnings taxed at less than the U.S. statutory rate.

 

Our future effective income tax rate depends on various factors, such as profits (losses) before taxes, tax legislation, the geographic composition of pre-tax income and non-deductible expenses incurred in connection with acquisitions.

 

We remain subject to examination by federal and state tax authorities. In addition, certain of our foreign subsidiaries are subject to examination by foreign taxing authorities. The timing of the settlement of these examinations is uncertain. We believe that adequate accruals have been provided for any potential adjustments that may result from these examinations.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our assumptions and estimates, including those related to revenue recognition, inventory valuation, goodwill and other intangible assets, deferred tax assets, warranty obligations, restructuring and impairment charges 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. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our Consolidated Financial Statements.

 

Revenue Recognition

 

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

 

Our equipment sales generally have two elements: 1) the equipment and 2) installation of that equipment. If we have met defined customer acceptance experience levels with both the customer and the specific type of equipment, we recognize revenue for the equipment element upon shipment and transfer of title. The installation element is recognized upon customer acceptance. Installation services are not essential to the functionality of the delivered equipment. As provided for in EITF 00-21, “Revenue Arrangements with Multiple Deliverables,” we allocate revenue based on the residual method when fair value has been established for installation services. For many of our sales contracts, the final payment is not billable until customer acceptance and typically exceeds the fair value of the installation services. Under these arrangements, we defer revenue for the final payment until customer acceptance. In the short-term, this practice creates variability in our gross margin, as revenue related to customer acceptance is recognized with little or no associated costs, which may not be indicative of our future operating performance.

 

We also enter into revenue arrangements that involve the sale of multiple pieces of equipment under a single arrangement. Revenue under these arrangements is allocated among the separate elements based on their relative fair values, provided the elements have value on a stand alone basis and there is objective and reliable evidence of fair value. Our sales arrangements do not include a general right of return. In cases where there is objective and reliable evidence of the fair value of the undelivered item(s) in an arrangement but no such evidence for the delivered item(s), the residual method is used to allocate the arrangement consideration.

 

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

 

Inventory Valuation

 

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

 

Goodwill and Other Intangible Assets

 

We account for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (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” (SFAS 144).

 

We review our long-lived assets, including goodwill and other intangible assets, for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In accordance with our policy, we completed the goodwill impairment test in the fourth quarter of 2006. The first step of the test identifies when impairment may have occurred, while the second step of the test measures the amount of the impairment, if any. The results of our impairment tests did not indicate impairment.

 

Deferred Tax Assets

 

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. As of December 31, 2006, we had approximately $130.0 million of deferred tax assets, net of a valuation allowance of approximately $3.8 million principally related to acquired net operating loss carryforwards that are not realizable until 2017 and beyond. Management believes the majority of deferred tax assets will be realized due to anticipated future income. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. If in the future we determine that we would not be able to realize all or part of our net deferred tax assets, an increase to the valuation allowance for deferred tax assets would decrease income in the period in which such determination is made.

 

Warranty Obligations

 

Our warranty policy generally states that we will provide warranty coverage for a predetermined amount of time on systems and modules for material and labor to repair and service the equipment. We generally 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 have had and could in the future 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

 

Restructuring activities after December 31, 2002 were recorded under the provisions of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (SFAS 146); SFAS No. 112, “Employers’

Accounting for Postemployment Benefits;” and SAB 100, “Restructuring and Impairment Charges.” SFAS 146 requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred, rather than when the exit or disposal plan is approved.

 

We account for business combination restructurings under the provisions of EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” and SAB 100. Accordingly, restructuring accruals are recorded when management initiates an exit plan that will cause us to incur costs that have no future economic benefit. Certain restructuring charges related to long-lived asset impairments are recorded in accordance with SFAS No. 144. The restructuring accrual related to vacated facilities is calculated net of estimated sublease income. Sublease income is estimated based on current market quotes for similar properties and expected occupancy dates. If we are unable to sublet these vacated properties as forecasted, if we are forced to sublet them at rates below our current estimates due to changes in market conditions, or if we change our sublease income estimate, we will adjust the restructuring accruals accordingly.

 

Hedge Accounting for Derivatives

 

We utilize foreign currency forward exchange contracts to hedge certain anticipated foreign currency sales transactions. When specific criteria required by SFAS No. 133, “Accounting for Derivative and Hedging Activities,” (SFAS 133) have been met, changes in fair values of hedge contracts relating to anticipated transactions are recorded in other comprehensive income rather than net income until the underlying hedged transaction affects net income. By their very nature, our estimates of anticipated transactions may fluctuate over time and may ultimately vary from actual transactions. When we determine that the transactions are no longer probable within a certain time frame, we are required to reclassify the cumulative changes in the fair values of the related hedge contracts from other comprehensive income to net income.

 

Stock-Based Compensation Expense

 

We account for stock-based compensation in accordance with the provisions of SFAS 123R. Under the fair value recognition provisions of SFAS 123R, stock-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized as expense ratably over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of stock-based awards, which includes estimates of stock price volatility, forfeiture rates and expected lives, requires judgment that could materially impact our operating results. See Note 14 to Consolidated Financial Statements for discussion of the impact of SFAS 123R on our Consolidated Financial Statements and significant estimates used.

 

Litigation

 

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, “Accounting for Contingencies,” requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial position or our results of operations.

 

Liquidity and Capital Resources

 

Our operating and capital resource requirements are primarily financed from cash flows from operations and borrowings. Our restricted cash and cash equivalents balance was $143.8 million as of December 31, 2006. Our primary source of funds as of December 31, 2006 consisted of approximately $853.3 million in unrestricted cash, cash equivalents and short-term investments. This amount represents an increase of $198.3 million from the December 31, 2005 balance of $655.0 million. The increase was due primarily to cash generated from operations of $447.2 million, offset by the repurchase of common stock for $249.9 million.

 

Net cash provided by operating activities for the year ended December 31, 2006 was $447.2 million. The primary sources of cash from operating activities were net income, as adjusted to exclude the effect of non-

cash charges of depreciation and amortization, stock-based compensation and restructuring charges, and changes in working capital levels, including accounts receivable and inventories. During 2006 we began to utilize programs to factor or sell accounts receivable, which has resulted in increased cash and lower accounts receivable in 2006 compared to 2005.

 

Net cash used in investing activities in the year ended December 31, 2006 was $234.2 million, which consisted primarily of cash paid for capital expenditures of $39.4 million and net purchases, sales and maturities of short-term investments of $176.1 million. As of December 31, 2006, we did not have any significant commitments to purchase property and equipment.

 

Net cash used in financing activities for the year ended December 31, 2006 was $197.9 million, which was due primarily to the repurchase of common stock for $249.9 million and payments on long-term debt of $10.2 million, partially offset by proceeds from employee stock compensation plans of $42.4 million.

 

In December 2006, we entered into a credit agreement with certain lenders (the Agreement), which established a senior unsecured five year revolving credit line with an aggregate committed amount of $150.0 million with the option to increase the total line by up to an additional $100.0 million under certain circumstances. We expect to use the proceeds for working capital and other general corporate purposes, including the repurchase of shares. The Agreement contains customary affirmative and negative covenants, financial covenants, representations and warranties, and events of default, which are subject to various exceptions and qualifications. No amounts have been borrowed under the Agreement as of December 31, 2006.

 

During 2004, we entered into a credit arrangement denominated in Euros that allowed for borrowing of up to $153.1 million and borrowed the entire amount available to fund the acquisition of Peter Wolters AG and for general corporate purposes. Borrowings are secured by cash or short-term investments on deposit which are included within restricted cash and cash equivalents on our Consolidated Balance Sheet. All borrowings under the credit arrangement are due and payable on or before June 28, 2009.

 

We have available short-term credit facilities with various financial institutions totaling $80.2 million, of which $46.3 million was unutilized as of December 31, 2006. These credit facilities bear interest at various rates, expire on various dates through December 2007 and are used for general corporate purposes. As of December 31, 2006, our subsidiaries had $19.5 million of borrowings outstanding under the short-term lines of credit at a weighted-average interest rate of 2.3%.

 

We also have long-term credit facilities with various institutions totaling $318.5 million, of which $190.7 million was unutilized as of December 31, 2006. These credit facilities bear interest at a weighted-average rate of 3.8% and expire through December 2037. As of December 31, 2006, we had $127.9 million in long-term debt outstanding.

 

On February 23, 2004, our Board of Directors renewed a stock repurchase program originally approved in September 2001. Under the repurchase program as renewed, we were authorized to repurchase up to $500.0 million of our outstanding common shares. On September 20, 2004 we announced that our Board of Directors had authorized an additional $1.0 billion for repurchase of outstanding common stock through September 14, 2009. As of December 31, 2006, we had approximately $613.3 million of remaining unused authorization for such repurchases.

 

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.

 

Off-Balance Sheet Arrangements

 

Standby Letters of Credit

 

We provide standby letters of credit to certain parties as required for certain transactions we initiate during the ordinary course of business. As of December 31, 2006, the maximum potential amount of future payments that we could be required to make under these letters of credit was approximately $14.5 million. We have not recorded any liability in connection with these arrangements beyond that required to appropriately account for the underlying transaction being guaranteed. We do not believe, based on historical experience and

information currently available, that it is probable that any amounts will be required to be paid under these arrangements.

 

Guarantee Arrangements

 

We have guarantee arrangements on behalf of certain of our consolidated subsidiaries for line-of-credit borrowings, overdrafts and operating leases. In the event of default on these arrangements by our subsidiaries, we would have a maximum exposure of $181.7 million as of December 31, 2006.

 

Contractual Obligations

 

We have non-cancelable operating leases for various facilities. Rent expense was approximately $12.2 million, $11.8 million and $11.0 million for the years ended December 31, 2006, 2005 and 2004, respectively, net of sublease income of $2.3 million, $2.8 million and $3.7 million, respectively. Certain of the operating leases contain provisions, which permit us to renew the leases at the end of their respective lease terms.

 

The following is a table summarizing future minimum lease payments under all non-cancelable operating leases, with initial or remaining terms in excess of one year.

 

 

The following is a table summarizing our contractual obligations under long-term borrowing arrangements. This table excludes amounts recorded on our balance sheet as current liabilities at December 31, 2006.

 

 

Liabilities related to our pension and post-retirement benefit plans, are reported in our Consolidated Balance Sheets but are not reflected in a contractual obligation table due to the absence of stated maturities. We have net obligations at December 31, 2006 related to our pension plans and post-retirement medical plan of $6.7 million. We funded $0.5 million to these plans in fiscal 2006. We expect to make payments of $1.5 million in fiscal 2007.

 

Purchase Commitments

 

We have firm purchase commitments with various suppliers to ensure the availability of components. Our minimum obligation at December 31, 2006 under these arrangements was $113.7 million. All amounts under these arrangements are due in 2007. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or cancelled. Certain agreements provide for potential cancellation penalties. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We have made adequate provision for potential exposure related to inventory on order which may go unused.

 

Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123R. SFAS 123R requires measurement of all employee stock-based compensation awards using a fair-value method and the recording of such expense in the consolidated financial statements. In addition, the adoption of SFAS 123R requires additional accounting related to the income tax effects and disclosure regarding the cash flow effects resulting from share-based payment arrangements. In January 2005, the SEC issued Staff Accounting

Bulletin No. 107, “Share-Based Payment” (SAB 107), which provides supplemental implementation guidance for SFAS 123R. We selected the Black-Scholes option-pricing model as the most appropriate fair-value method for our awards and will recognize compensation cost on a straight-line basis over our awards’ vesting periods. We adopted SFAS 123R in the first quarter of fiscal 2006 and recognized $34.9 million of expense related to stock-based compensation in 2006.

 

In December 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (SFAS 151). The standard clarifies that certain abnormal amounts be expensed as incurred, rather than included as a cost of inventory. SFAS 151 also requires that the allocation of fixed overhead costs to inventory be based upon a normal production capacity. We adopted the standard effective January 1, 2006, which resulted in an increased carrying value of inventory and decreased cost of sales of approximately $2.5 million and an increase to net income of $1.5 million, net of tax, or $0.01 per diluted share for the year ended December 31, 2006.

 

In June 2006, the EITF issued EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43” (EITF 06-2), which clarifies the accounting for compensated absences known as a sabbatical leave whereby the employee is entitled to paid time off after working for an entity for a specified period of time. The provisions of EITF 06-2 are effective for us as of January 1, 2007. We are currently evaluating the impact of adopting EITF 06-2 on our Consolidated Financial Statements.

 

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (FIN 48). FIN 48 creates a single model to address uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. In addition, FIN 48 clearly scopes out income taxes from SFAS No. 5, “Accounting for Contingencies” (SFAS 5). The provisions of FIN 48 are effective for us as of January 1, 2007. We are currently evaluating the impact of adopting FIN 48 on our Consolidated Financial Statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 establishes a common definition for fair value to be applied to U.S. GAAP guidance requiring use of fair value. Also, SFAS 157 establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of SFAS 157 on our Consolidated Financial Statements.

 

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158). SFAS 158 requires that employers recognize on a prospective basis the funded status of their defined benefit pension and other postretirement plans on their consolidated balance sheet and recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. SFAS 158 also requires additional disclosures in the notes to financial statements. SFAS 158 is effective as of the end of fiscal years ending after December 15, 2006. We adopted SFAS 158 as of December 31, 2006, which resulted in recording an increased pension liability and other comprehensive loss of $0.9 million, net of tax of $0.4 million.

 

Interest Rate Risk

 

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our short-term and long-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 with 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 their issuers. The portfolio includes only short-term investments 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 interest rate of the majority of our short-term and long-term obligations is floating. 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 tables below present the amounts we recorded and related weighted average interest rates by year of maturity for our investment portfolio and debt obligations as of December 31, 2006 and 2005. The amounts presented in the tables below approximate fair value.

 

 

 

The “less than 1 year” category of short-term investments contains $14.8 million and $8.1 million of other investments that do not have contractual maturities at December 31, 2006 and 2005. Also included in short-term investments is interest receivable of $5.2 million and $5.7 million as of December 31, 2006 and 2005, respectively, that is not included in the tables above.

 

Foreign Currency Risk

 

We conduct business in various foreign countries located primarily in Europe and Asia. We are therefore primarily exposed to changes in exchange rates of currencies in those regions. To address these currency risks, we expanded our foreign currency exposure management policy in 2006. We utilize foreign currency forward contracts to mitigate our risk to changes in exchange rates by hedging intercompany balances denominated in currencies other than the U.S. dollar, hedging our U.S. dollar net investment in certain foreign subsidiaries and by designating certain forward contracts as cash flow hedges on transactions in which costs are denominated in U.S. dollars but the related revenues are generated in a foreign currency. The intent of our 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. For further discussion of the accounting treatment of our derivative instruments see Note 2 of our Consolidated Financial Statements. The tables below present the notional amounts (at the contract exchange rates), the weighted-average contractual foreign currency exchange rates and the estimated fair value of our contracts outstanding at December 31, 2006 and 2005.

 

 

 

NOVELLUS SYSTEMS, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS