UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 25, 2004

OR

For the transition period from            to

Commission File Number 000-17157

NOVELLUS SYSTEMS, INC.

4000 North First Street, San Jose, California 95134

(408) 943-9700

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

YES þ NO o

As of October 27, 2004, 139,789,533 shares of the Registrant’s common stock, no par value, were issued and outstanding.

NOVELLUS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 25, 2004

TABLE OF CONTENTS

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PART I: FINANCIAL INFORMATION

ITEM 1: CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

     See accompanying notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)

*

Amounts as of December 31, 2003 are derived from the December 31, 2003 audited financial statements.

See accompanying notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND STOCK-BASED COMPENSATION

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. The interim financial information is unaudited and does not include all of the information and footnotes required by U.S. 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 nine months ended September 25, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures of contingent assets and liabilities. We evaluate our estimates on an ongoing basis, including those related to revenue recognition, allowance for doubtful accounts, inventory valuation, deferred tax assets, property and equipment, goodwill and other intangible assets, warranty obligations, restructuring and impairment charges, contingencies and litigation, and stock-based compensation. We base our estimates on historical experience and on other assumptions that are believed to be reasonable under the current circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our intent is to accurately state our assets given facts known at the time of valuation. Our assumptions may prove incorrect as facts change in the future. Actual results may differ from these estimates under different assumptions or conditions.

The accompanying condensed consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries after the elimination of all significant intercompany account balances and transactions.

On June 28, 2004, we acquired Peter Wolters AG, a manufacturer of high-precision machine manufacturing tools. The acquisition was accounted for as a purchase business combination in accordance with SFAS No. 141. Our consolidated financial statements for the period ended September 25, 2004 include the financial position, results of operations and cash flows of Peter Wolters from June 28, 2004.

We operate primarily in one segment, the manufacturing, marketing, and servicing of semiconductor wafer fabrication equipment. Since we operate in one segment, all segment-related financial information required by Statement of Financial Accounting Standards (SFAS) No. 131, “Disclosures About Segments of an Enterprise and Related Information,” or SFAS No. 131, is included in the condensed consolidated financial statements.

Stock-Based Compensation

We account for stock-based employee compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and have adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures.” Accordingly, no expense has been recognized for options granted to employees at current market value.

In the disclosure presented below and in our statement of operations, we recognize stock-based compensation on the graded vesting method over the vesting periods of the applicable stock purchase rights and stock options, generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in greater expense recorded in earlier years than the straight-line method.

SFAS No. 123 requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange-traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Because our employee stock options

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have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of employee stock options.

Had compensation expense been determined based on the fair value as determined by the Black-Scholes model at the grant date for awards, consistent with the provisions of SFAS No. 123, we would have reported pro forma net income (loss) and net income (loss) per share as follows (in thousands, except per share data):

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions for grants made in the three and nine months ended September 25, 2004 and September 27, 2003:

The weighted-average fair value of stock options granted during the period was $14.09 and $16.42 for the three and nine months ended September 25, 2004, respectively, and $20.78 and $17.08 for the three and nine months ended September 27, 2003, respectively.

The pro forma net income (loss) and net income (loss) per share data listed above include expense related to the Employee Stock Purchase Plan, referred to herein as the Purchase Plan. The fair value of issuances under the Purchase Plan is estimated on the date of issuance using the Black-Scholes option-pricing model, with the following weighted-average assumptions:

The weighted-average fair value of purchase rights was $7.92 and $8.78 for the three and nine months ended September 25, 2004, respectively, and $8.83 and $8.74 for the three and nine months ended September 27, 2003, respectively.

2. BUSINESS COMBINATION

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On June 28, 2004, we acquired all of the outstanding stock of Peter Wolters AG, a privately-held manufacturer of high-precision machine manufacturing tools based in Rendsburg, Germany. The acquisition of Peter Wolters enables us to diversify our product offerings. We funded the purchase price of the acquisition, excluding transaction costs, with approximately $149.5 million of borrowings under a credit facility. For further discussion regarding the credit facility, see Note 9. Under the terms of the purchase agreement, we deposited ten percent of the purchase price into escrow. The escrow amount will be released to the former shareholders of Peter Wolters on June 25, 2005, to the extent we have not made claims against the escrow for pre-acquisition contingencies.

The acquisition of Peter Wolters was accounted for as a business combination in accordance with SFAS No. 141, “Business Combinations.” Tangible assets and liabilities were recorded at their estimated fair value and the value of the intangible assets acquired will be valued by us, with the assistance of third-party appraisers, under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.”

The preliminary purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows (in thousands):

Intangible Assets — As of the closing of our acquisition of Peter Wolters on June 28, 2004, $18.1 million of the total purchase price was allocated to intangible assets subject to amortization. Included in these intangible assets are developed and core technologies, customer backlog, and trademark/trade name rights with weighted average lives of 6.0, 0.5, and 10.0 years, respectively.

Goodwill — The potential value of the combined companies’ products and technologies contributed to a purchase price that resulted in goodwill. Goodwill represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. Goodwill is not deductible for tax purposes and is not subject to amortization, however, it is to be tested for impairment at least annually in accordance with SFAS No. 142. Approximately $104.2 million of the total purchase price was allocated to goodwill upon the closing of our acquisition of Peter Wolters on June 28, 2004.

Pro Forma Results - The following table represents the unaudited pro forma consolidated results of operations, assuming the acquisition of Peter Wolters was consummated as of the beginning of the periods presented. The unaudited pro forma information has been prepared for comparative purposes only and may not be indicative of what operating results would have been if the acquisition had taken place at the beginning of the periods presented. In addition, the unaudited pro forma information may not be indicative of future operating periods. The combined operating results below consist of historical results of Novellus and Peter Wolters for the three and nine months ended September 25, 2004 and September 27, 2003. The pro forma disclosure includes charges of approximately $2.1 million, net of tax, in the nine month period ending September 27, 2003 resulting from inventory written-up in purchase accounting and the sell-through of customer backlog. The pro forma disclosure eliminates charges of approximately $1.0 million, net of tax, related to these items from the three months ended September 25, 2004.

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3. NET INCOME (LOSS) PER SHARE

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

Diluted net income (loss) per share is computed using the weighted-average number of shares of common stock outstanding, including shares of restricted common stock subject to repurchase and, when dilutive, potential shares from stock options to purchase common stock using the treasury stock method.

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

Options to purchase approximately 20.4 million and 12.5 million shares of common stock were outstanding for the three and nine months ended September 25, 2004, respectively, but were not included in the computation of diluted net income per common share because the respective exercise prices of these options were greater than the average respective market prices of the common shares and, therefore, the effect would be anti-dilutive. For the three and nine months ended September 27, 2003, all options to purchase common stock were excluded from the computation of net loss per share as the effect would be anti-dilutive during those periods.

4. INTEREST AND OTHER INCOME, NET

The components of interest and other income, net within the consolidated statements of operations are as follows (in thousands):