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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 29, 2002

OR

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

For the transition period from           to          

Commission File Number          

NOVELLUS SYSTEMS, INC.

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

         YES NO

As of July 31, 2002, 145,070,611 shares of the Registrant’s common stock, no par value, were issued and outstanding.

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NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED JUNE 29, 2002

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PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOVELLUS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes.

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NOVELLUS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

* Amounts as of December 31, 2001 are derived from the December 31, 2001 audited financial statements.

See accompanying notes.

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NOVELLUS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes.

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 29, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. For further information, refer to the consolidated financial statements and footnotes thereto included in Novellus’ Annual Report on Form 10-K for the year ended December 31, 2001.

On January 10, 2001, Novellus merged with GaSonics International Corporation (“GaSonics”). The merger was accounted for as a pooling-of-interests transaction in accordance with generally accepted accounting principles. In the transaction, Novellus acquired all outstanding shares of GaSonics in a stock-for-stock merger, with all outstanding shares of GaSonics capital stock converted into approximately 9,240,000 shares of Novellus common stock. In addition, all outstanding options to purchase shares of GaSonics capital stock were automatically converted into options to purchase approximately 1,400,000 shares of Novellus common stock. Merger related expenses of approximately $13.2 million were recorded in the first quarter of 2001 and were included in special charges within the statement of operations.

Novellus adopted Statement of Financial Accounting Standards No. 142, (“SFAS 142”) “Goodwill and Other Intangible Assets” in the first quarter of 2002. SFAS 142 discontinues amortization of goodwill and intangible assets deemed to have indefinite lives and requires such assets to be reviewed at least annually for impairment. SFAS 142 also includes provisions on the identification of intangible assets, reclassification of certain intangibles from previously reported goodwill, and reassessment of the useful lives of existing intangibles. As of January 1, 2002, Novellus had a goodwill balance of approximately $20.1 million. Consequently upon adoption, the application of the non-amortization provisions of SFAS 142 resulted in an increase in pre-tax operating income of $0.9 million and $1.8 million, in the three and six months ended June 29, 2002, respectively. If Novellus had adopted the provisions of SFAS 142 in the first quarter of 2001, the increase in pre-tax operating income would have been $0.9 million and $1.8 million, in the three and six months ended June 30, 2001, respectively. Novellus would have recorded earnings per share, on a diluted basis, $0.40 and $0.96 for the three and six months ended June 30, 2001, respectively. In the first quarter of 2002, Novellus conducted a test for impairment of its goodwill using the two-step process prescribed in SFAS 142. The first step identifies when impairment may have occurred, while the second step measures the amount of the impairment, if any. The conclusion of the test was that the Company’s goodwill assets were not impaired.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires Novellus to 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, Novellus evaluates its estimates, including those related to allowance for doubtful accounts, inventories, investments, deferred tax assets, income taxes, warranty obligations, restructuring, and contingencies and litigation. Novellus bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Novellus believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its condensed consolidated financial statements.

Revenue Recognition

Novellus recognizes revenue in accordance with SEC Staff Accounting Bulletin No. 101 (“SAB 101”), “Revenue Recognition in Financial Statements” and “SAB 101: Revenue Recognition in Financial Statements-Frequently Asked Questions and Answers” (“SAB 101 FAQ”). Novellus recognizes revenue when persuasive evidence of an arrangement exists, delivery has

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

occurred or services have been rendered, the seller’s price is fixed or determinable, and collectibility is reasonably assured. Certain of Novellus’ product sales are accounted for as multiple-element arrangements. If Novellus has met defined customer acceptance experience levels with both the customer and the specific type of equipment, then Novellus recognizes equipment revenue upon shipment and transfer of title, with the remainder when it becomes due (generally upon acceptance). All other equipment sales are recognized upon customer acceptance. Revenue related to spare part sales is recognized on shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Unearned maintenance and service contract revenue is not significant and is included in other accrued liabilities.

Allowance for Doubtful Accounts

Novellus evaluates its allowance for doubtful accounts based on a combination of factors. In circumstances where Novellus is aware of a specific customer’s inability to meet its financial obligations to us, Novellus records a specific allowance for bad debts against amounts due to reduce the net recognized receivable to the amount Novellus reasonably believes will be collected. For all other customers, Novellus recognizes a reserve for bad debts based on a certain percentage of total revenues, which is based on Novellus’ historical experience over five years. If circumstances change (e.g. higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations to us), Novellus may amend its estimates of the recoverability of amounts due to Novellus.

Inventory Reserves

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

Warranty and Installation

Novellus’ warranty and installation policy generally states that Novellus will provide installation services as well as warranty coverage, for a predetermined amount of time, on systems and modules for material and labor to repair and service the equipment. Novellus records the estimated cost of warranty coverage and installation upon system shipment. The estimated cost of warranty and installation coverage is determined by the warranty term as well as the average historical warranty and installation expense for a specific tool. Should actual product failure rates, material usage, or installation costs differ from Novellus’ estimates, revisions to the estimated warranty and installation liability may be required.

Investments

Novellus classifies its marketable securities as available-for-sale in accordance with the provisions of the Statement of Financial Accounting Standard (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Securities classified as available-for-sale are reported at fair market value with the related unrealized gains and losses included, net of tax, in accumulated other comprehensive income (loss). Realized gains and losses and declines in value of securities judged to be other than temporary are included in other income. Interest on all securities is included in interest income. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment’s current carrying value, thereby possibly requiring impairment charges in the future. The fair values of investments are determined using quoted market prices if available. If quoted market prices are not available, investments are estimated using discounted cash flows and market interest rates.

Deferred Tax Assets

Novellus records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. While Novellus has considered future taxable income and ongoing prudent and feasible tax planning strategies in

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

assessing the need for the valuation allowance, in the event Novellus determined that it would be able to realize its deferred tax assets in excess of its net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made. Likewise, should Novellus determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax assets would decrease income in the period such determination was made.

Restructuring

Novellus accounts for the need to record restructuring charges in accordance with Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring),” EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” and Staff Accounting Bulletin No. 100, “Restructuring and Impairment Charges.” In accordance with this guidance, management must execute an exit plan that will result in the incurrence of costs that have no future economic benefit. Also under the terms of EITF 94-3, a liability for the restructuring charges is recognized in the period management approves the restructuring plan. In the third quarter of 2001, Novellus established restructuring reserves for its operations. In the first quarter of 2002, Novellus had a reduction in force, which required reserves for severance benefits. These reserves required the use of estimates. Though Novellus believes that these estimates accurately reflect the costs of these plans, actual results may be different. See Note 8 to Condensed Consolidated Financial Statements.

Contingencies and Litigation

Novellus makes an assessment of the probability of an adverse judgment resulting from current and threatened litigation. Novellus would accrue the cost of an adverse judgment if, in Novellus’ estimation, the adverse settlement is probable and Novellus can reasonably estimate the ultimate cost to Novellus. Novellus has made no such accruals at June 29, 2002.

2. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 is effective for fiscal years beginning after June 15, 2002. Novellus does not expect the adoption of SFAS 143 to be material to its financial condition or results of operations.

In August 2001, the FASB issued SFAS No. 144, “Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and provides a single accounting model for impairment of long-lived assets. Novellus does not expect the adoption of SFAS 144 to have a material effect on Novellus’ financial condition or results of operations.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” For most companies, SFAS 145 will require gains and losses

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NOVELLUS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

on extinguishments of debt to be classified as income or loss from continuing operations rather than as extraordinary items as previously required under SFAS 4. Extraordinary treatment will be required for certain extinguishments as provided in APB Opinion No. 30. The statement also amended SFAS 13 for certain sales-leaseback transactions and sublease accounting. Novellus is required to adopt the provisions of SFAS 145 effective January 1, 2003. Novellus does not expect the adoption of SFAS 145 to have a material effect on the Company’s financial condition or results of operations.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” and must be applied beginning January 1, 2003. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than when the exit or disposal plan is approved. Novellus is currently evaluating the impact of this adoption.

3. INVENTORIES

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

4. LINES OF CREDIT

As of June 29, 2002, Novellus has lines of credit with four Japanese banks, which expire at various dates through October 2002, under which Novellus can borrow up to $30.2 million at the banks’ prime rates (ranging from 0.46% to 0.50%) as of June 29, 2002. These facilities are available to Novellus’ Japanese subsidiary, Novellus Systems, Japan. At June 29, 2002 and December 31, 2001, amounts outstanding were $17.9 million and $26.2 million, respectively, at annual weighted-average interest rates of 0.48% and 0.62%, respectively. All borrowings under the lines of credit were by Novellus Systems, Japan.

5. NET INCOME PER SHARE

Net income per share is calculated in accordance with SFAS No. 128. Basic net income per share excludes the dilutive effect of employee stock options. Diluted net income per share includes the dilutive effect of employee stock options. The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):