Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q 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 included or incorporated by reference in this Quarterly Report, other than statements that are purely historical, are forward-looking statements. Words such as "anticipate," "expect," "intend," "plan," "believe," "seek," "estimate," and similar expressions also identify forward-looking statements. The forward-looking statements include, without limitation: our anticipation to reclassify net gains recorded as of September 27, 2008 from OCI to Net sales within the next twelve months; our expectation that the adoption of certain accounting pronouncements will not have a significant impact on our Condensed Consolidated Financial Statements; our estimated amortization expense for currently recognized identifiable intangible assets in the fourth quarter of 2008 and for the years ending December 31, 2009, 2010, 2011, 2012 and 2013, respectively; our expectation that the remaining obligations in connection with vacated facilities will be satisfied no later than the lease terms, which expire on various dates through 2017; our expectation that the ultimate disposition of the Linear litigation will not have a material adverse effect on our business, financial condition or operating results; our expectation that $29.1 million of unrecognized compensation cost related to unvested stock options, of which $4.4 million is expected

to be recognized in the fourth quarter of 2008, and $12.8 million, $9.1 million, $2.7 million and $0.1 million is expected to be recognized in 2009, 2010, 2011 and 2012, respectively; our expectation that $24.9 million of unrecognized compensation cost related to restricted stock awards, of which $3.5 million is expected to be recognized in the fourth quarter of 2008 and $10.3 million, $6.3 million, $4.6 million and $0.2 million will be recognized in 2009, 2010, 2011 and 2012, respectively; our efforts to continue to work closely with our customers and make substantial investments in research and development in order to deliver innovative products which enhance productivity for our customers to utilize the latest technology; our belief that our continued investment in research and development has positioned us for future growth; our expectation that the average selling price for memory chips will stabilize; our expectation that our customers capital spending will increase over the long term as demand from various industries continues to steadily rise; our belief that the shift to DRAM and NAND products will stimulate the development of more efficient tools to satisfy our customers' needs; our belief that our customers are seeking more affordable technology to drive down their prices so they can continue to grow the market demand for their products; our continued focus on operational execution and a pairing down of certain research and development activities to improve profitability by reducing our cost structure; our expectation that net orders will fluctuate due to the cyclicality of the semiconductor industry; our plan to continue to focus on expanding our market presence in Asia; our belief that significant additional growth potential exists in the Asia region over the long term; our belief that significant investment in research and development is required to remain competitive; our plan to continue to invest in new products and enhancement of our current product lines; our intention to hold auction-rate securities to recovery; our belief that we will ultimately be able to liquidate our investments in auction-rate securities without significant loss through successful auctions, redemptions of securities by the issuers or upon maturity; our belief that the impairment of the auction-rate securities is temporary because they have either been guaranteed by the federal government or in the case of closed-end funds they are backed by more than 200% collateral; our anticipation that the illiquidity of the auction-rate securities will not negatively affect our ability to execute our current business plan and operations; our intention to continue to seek legal protection through patents and trade secrets for our proprietary technology; our belief that our current cash position, cash generated through operations and equity offerings, and available borrowing capacity will be sufficient to meet our needs through the next twelve months; our belief that the ultimate outcome of actions that have arisen in the normal course of business will not have a material adverse effect on our business, financial condition or results of operations; our expectation that sales of our products to relatively few customers will continue to account for a high percentage of our net sales in the foreseeable future; our expectation to continue to experience significant fluctuations in our quarterly operating results; our expectation to use the proceeds from certain credit agreements for working capital and other general corporate purposes, including the repurchase of shares; and our expectation to repurchase shares from time to time in the open market, through block shares or otherwise.

Our expectations, beliefs, objectives, intentions and strategies regarding the future, including, without limitation, those concerning expected operating results, revenues and earnings and current and potential litigation are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from results contemplated by the forward-looking statements. These risks and uncertainties include, but are not limited to: unanticipated trends with respect to the cyclicality of the semiconductor industry; inability to reclassify net gains from OCI to Net sales within the next twelve months; inaccuracies regarding growth potential in the Asia region over the long term; sustained decrease in or leveling off of customer demand; inability to predict the impact of the Linear litigation on our business, financial conditions or operating results; inability to accurately predict the impact of new accounting pronouncements on our Condensed Consolidated Financial Statements; inability to accurately assess the period in which the Company will recognize unrecognized compensation related to unvested stock options and restricted stock awards; inaccuracies related to the timing and satisfaction of remaining obligations related to vacated leases; inability of the Company to meet certain performance conditions that may result in forfeiture of certain restricted stock awards; unexpected increase in costs associated with manufacturing memory chips; inability to anticipate cyclical changes in customers' capacity utilization and demand; the negative impact of higher cost of services on gross margins; inability to realize efficiencies from outsourcing; inefficiencies in the allocation of funds towards our research and development efforts to our existing and new product lines; unexpected difficulties in introducing new and enhanced products in a timely manner in order to remain competitive; unexpected changing product needs of our customers; loss of a major customer; the need to seek new customers and diversify our customer base; unanticipated need for additional liquid assets in the next twelve months; our failure to accurately predict the effect of the ultimate outcome of current litigation on our business, financial condition, results of operations or material adjustment to our financial statements; inherent uncertainty in the outcome of litigation matters; our potential inability to enforce our patents and protect our trade secrets; inability to accurately predict our ability to recover the carrying value of our investment in auction-rate securities, market changes negatively affecting auction-rate securities and the government's inability to guarantee the underlying securities; inability to accurately predict customers capital spending over the long term and continued customer capital spending reductions in the semiconductor industry; further periodic downturns in the semiconductor industry which could have a material adverse effect on the semiconductor industry's demand for semiconductor processing equipment inability to accurately predict mega-fabrication trends in memory manufacturing; uncertainties related to the acceptance of new technology into the memory market; introduction of new products by competitors; inability to gain and leverage market position during the economic downturn; and unexpected shift in market demands for both memory and logic products; uncertainties related to growth in the electronic industry; and inability to successfully select, develop, and market new products, or enhance existing products.

The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties set forth under the heading "Risk Factors" in Item 1A of Part II, and are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of the filing of this Quarterly Report on Form 10-Q. Readers should also review carefully the cautionary statements and risk factors listed in our Annual Report on Form 10-K for the year ended December 31, 2007 and in our other filings with the SEC, including our Forms 10-Q and 8-K and our Annual Report to Shareholders.

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 our business. The following are included in our MD&A:

• Overview of our Business and Industry;

• Financial Performance Overview;

• Results of Operations;

• Critical Accounting Policies; and

• Liquidity and Capital Resources.

Overview of Our Business and Industry

Novellus Systems, Inc. is a California corporation organized in 1984. At Novellus, we primarily develop, manufacture, sell and support equipment used in the fabrication of integrated circuits, commonly called chips or semiconductors. Customers for these products manufacture chips for sale or for incorporation in their own products, or provide chip-manufacturing services to third parties. The segment of our business serving this area is the Semiconductor Group. In 2004, Novellus entered into market segments beyond semiconductor manufacturing with the acquisition of Peter Wolters AG, a German company specializing in lapping and polishing equipment for a number of industries. With the acquisition of Switzerland-based Voumard Machine Co. SA in 2005 we expanded our product offerings to include high-precision machine manufacturing tools. We call this segment the Industrial Applications Group (IAG).

In the Semiconductor Group, 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 deliver innovative products which enhance productivity for our customers and utilize the latest technology. We believe these investments have positioned us for future growth.

In the Industrial Applications Group, our business depends on capital expenditures made by manufacturers in sectors such as vehicles, aircraft and electronic products, parts and components. At the broadest level, machine tools demand is highly sensitive to macroeconomic conditions as our customer base includes some of the most cyclically sensitive industries in the economy. As a result, such variables as the outlook for overall economic growth, fixed investment and durable goods shipments directly affect the growth of our business. Our industrial business also depends on niche applications in addition to the general machine tool cycle. As we continue to expand our capabilities in this segment, our operations are increasingly impacted by the wafer industry which, similar to the semiconductor segment, is also characterized by intense competition and rapidly changing technology.

As a supplier to the global semiconductor and semiconductor-related industries, we are subject to business cycles and trends which are difficult to predict. As indicated above, our products are used to manufacture semiconductors that are used throughout the electronics industry, including the personal computer, mobile phone, consumer electronics and portable media player markets. Our customers operate principally in the semiconductor memory and logic markets.

The demand for our products is affected by the profitability of our customers which is driven by capacity and market supply for their products. In fiscal 2006 and 2007, our memory customers built excess capacity as they did not accurately predict demand for their products. As a result, memory capacity additions during those years outpaced the current rate of demand. The overcapacity of memory customers coupled with weak memory pricing, tight liquidity in the credit markets, and the negative economic environment has caused those customers to delay capital spending and, in some instances, constrain or retire some of their capacity output. These actions are expected to stabilize average selling prices for memory chips. While we have seen capital expenditures slow in the recent past, we expect our customers' capital spending to increase over the long term as demand from various industries continues to steadily rise. This is mainly driven by worldwide technology consumption of chips that has grown at an annual historical rate of 10%.

As we look further at end market demand, notwithstanding any potential worldwide economic slowdown or recession, we have also begun to see growing demand for DRAM and NAND memory devices, enabled by lower memory average selling prices. We believe this shift will stimulate the development of more efficient tools to satisfy our customers' needs. The manufacture of memory chips requires tremendous economies of scale that involve large fabrication facilities. Our customers seek more affordable technology to drive down their costs so they can grow the market demand for their products.

Given the historically cyclical nature of the semiconductor industry, we continue to focus on operational execution and a paring down of certain research and development activities to improve profitability by reducing our cost structure. As a result, we achieved our goal of reducing quarterly operational expenses below $110 million in the third quarter of 2008. In October 2008, we announced that we would continue to drive down operational expenses to a level sufficient to achieve cash break-even with a quarterly revenue base of $187 million by the end of the fourth quarter. We define cash break-even as the point at which a net loss plus non-cash expenses such as those associated with stock compensation, depreciation and amortization equals zero.

We focus on certain key quarterly financial data to manage our business. Net sales, gross profit, net income and net income per share are the primary measures we use to monitor performance. We also use certain non-GAAP measures, such as shipments and net orders, to assess business trends and performance. Shipments consist of products shipped to customers, without regard to net sales adjustments such as deferrals associated with customer acceptance. Net orders, which are also referred to as bookings, consist of current period orders less current period cancellations. Shipments and net orders are used to forecast and plan future operations. We do not report orders for systems with delivery dates more than 12 months from the latest balance sheet date.

The following table sets forth certain quarterly financial information for the periods indicated (in thousands, except per share data and percentages):

                                                                               Quarterly Financial Data
                                                           2008                                                 2007
                                            Third         Second          First         Fourth          Third         Second          First
                                           Quarter        Quarter        Quarter        Quarter        Quarter        Quarter        Quarter
Net sales                                 $ 250,098      $ 257,740      $ 314,713      $ 363,463      $ 393,277      $ 416,335      $ 396,974
Gross profit                              $ 111,524      $ 110,963      $ 144,940      $ 171,863      $ 194,307      $ 208,110      $ 194,909
Net income (loss)                         $   1,397      $  (2,385 )    $  15,529      $  52,861      $  49,711      $  57,345      $  53,783
Net income (loss) per share - Diluted     $    0.01      $   (0.02 )    $    0.15      $    0.47      $    0.41      $    0.45      $    0.42
Shipments                                 $ 230,153      $ 240,320      $ 312,857      $ 363,055      $ 387,817      $ 436,382      $ 389,052
Change in shipments from prior quarter           (4 )%         (23 )%         (14 )%          (6 )%         (11 )%          12 %           (0 )%
Net orders                                $ 202,765      $ 234,628      $ 297,025      $ 343,086      $ 305,329      $ 332,201      $ 412,219
Change in net orders from prior quarter         (14 )%         (21 )%         (13 )%          12 %           (8 )%         (19 )%          (7 )%

We expect that net orders will continue to fluctuate due to the cyclical nature of our industry. 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.

Financial Performance Overview

The following is an overview of our financial performance for the nine months ended September 27, 2008 compared to the nine months ended September 29, 2007:

• Net sales decreased 31.8% to $822.6 million from $1.2 billion;

• Net income decreased 91.0% to $14.5 million from $160.8 million;

• Diluted net income per share decreased to $0.15 from $1.28;

• Shipments decreased 35.4% to $783.3 million from $1.2 billion; and

• Net orders decreased 30.0% to $734.4 million from $1.0 billion.

Results of operations for the nine months ended September 27, 2008 include $13.6 million of charges recorded in the second quarter of 2008 due to a decision to focus on our core product lines. These charges include: (a) impairments of inventory and evaluation systems of $6.4 million, (b) write-downs of certain research and development assets of $3.8 million and (c) reductions in workforce of $3.4 million. Of these charges, $6.5 million are in Cost of sales, $4.3 million are in Research and development expenses and $2.8 million are in Selling, general and administrative expenses.

Results of Operations

Net Sales



                                                           Three Months Ended                                             Nine Months Ended
                                    September 27, 2008        June 28, 2008        September 29, 2007        September 27, 2008        September 29, 2007
                                                                                       (In thousands)
Semiconductor Group                $            207,050      $       208,272      $            348,625      $            685,672      $          1,093,027
Industrial Applications Group                    43,048               49,468                    44,652                   136,879                   113,559

Net sales                          $            250,098      $       257,740      $            393,277      $            822,551      $          1,206,586

The net sales we report are correlated to shipments and the timing of customer acceptance. Deferred revenue at the end of the third quarter of 2008 was $70.2 million.

Semiconductor Group net sales in the third quarter of 2008 remained relatively flat with the second quarter of 2008 and are down 41% and 37% compared to the prior year third quarter and year-to-date net sales, respectively. Net sales have continued to decline compared to prior periods as a result of ongoing weakness in the overall economy and the semiconductor industry in particular.

The primary functional currency of IAG is the Euro. Changes in the exchange rate increased IAG net sales for the third quarter and year-to-date by 10% and 15%, respectively, compared to the same periods in the prior year. Demand decreased at IAG during the third quarter of 2008 after an increase in demand from its wafer customers for the prior four quarters.

Geographical net sales as a percentage of total net sales were as follows (based upon the location of our customers' facilities):

                                                       Three Months Ended                                                  Nine Months Ended
                              September 27, 2008          June 28, 2008          September 29, 2007          September 27, 2008          September 29, 2007
Asia                                          58 %                   61 %                        66 %                        61 %                        67 %
North America                                 29 %                   27 %                        25 %                        28 %                        26 %
Europe                                        13 %                   12 %                         9 %                        11 %                         7 %

A significant portion of our net sales is generated in Asia, primarily because a substantial portion of the world's semiconductor manufacturing capacity is located there. Our Asia region includes Korea, Japan, Singapore, Malaysia, China and Taiwan. 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



                                                          Three Months Ended                                                  Nine Months Ended
                                 September 27, 2008          June 28, 2008          September 29, 2007          September 27, 2008          September 29, 2007
                                                                                    (Dollars in thousands)
Gross profit                    $            111,524        $       110,963        $            194,307        $            367,427        $            597,326
Gross margin                                      45 %                   43 %                        49 %                        45 %                        50 %

The increase in gross margin in the third quarter of 2008 compared to the second quarter of 2008 is due to $6.5 million of charges incurred in the second quarter of 2008, related primarily to impairments of inventory and evaluation systems. Excluding those charges, gross margin decreased by one percentage point due to product mix and lower absorption of fixed overhead costs as shipment volumes decreased. Gross margin in third quarter and year-to-date 2008 decreased from prior periods as a result of lower absorption due to a decline in shipment volumes and an increase in the percentage of total sales represented by IAG products, whose margins are generally lower than those of Semiconductor Group products.

Selling, General and Administrative (SG&A)



                                                          Three Months Ended                                                     Nine Months Ended
                                September 27, 2008           June 28, 2008           September 29, 2007           September 27, 2008           September 29, 2007
                                                                                     (Dollars in thousands)
SG&A expense                   $             53,858         $        62,530         $             67,420         $            176,717         $            206,531
% of net sales                                   22 %                    24 %                         17 %                         21 %                         17 %

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

SG&A expense decreased in the third quarter of 2008 from the second quarter of 2008, in part as a result of $2.8 million of charges incurred during the second quarter related to the reduction in workforce. Excluding those charges, SG&A decreased by $5.8 million as a result of lower headcount and a focus on reducing operating expenses. The decrease in SG&A expense during the three and nine months ended September 27, 2008 over the same prior year periods, is primarily due to lower headcount, profit sharing, commissions and other sales and marketing related costs as a result of decreased sales volumes. SG&A expense, as a percentage of net sales, increased compared to prior year periods primarily due to the decline in net sales.

Research and Development (R&D)



                                                          Three Months Ended                                                     Nine Months Ended
                                September 27, 2008           June 28, 2008           September 29, 2007           September 27, 2008           September 29, 2007
                                                                                     (Dollars in thousands)
R&D expense                    $             51,649         $        59,815         $             61,384         $            168,804         $            185,158
% of net sales                                   21 %                    23 %                         16 %                         21 %                         15 %
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