Introduction

Management's Discussion and Analysis (MD&A) is intended to facilitate an understanding of Applied's business and results of operations. This MD&A should be read in conjunction with Applied's Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A consists of the following sections:

• Overview: a summary of Applied's business, measurements and opportunities.

• Results of Operations: a discussion of operating results.

• Segment Information: a discussion of segment operating results.

• Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash, contractual obligations and financial position.

• Critical Accounting Policies: a discussion of critical accounting policies that require the exercise of judgments and estimates.

Overview

Applied provides Nanomanufacturing Technologytm solutions for the global semiconductor, flat panel display, solar and related industries, with a broad portfolio of innovative equipment, service and software products. Applied's customers are primarily manufacturers of semiconductors, flat panel liquid crystal displays (LCDs), solar photovoltaic cells and modules (solar PVs), flexible electronics and energy-efficient glass. Applied operates in four reportable segments: Silicon, Applied Global Services, Display, and Energy and Environmental Solutions. Product development and manufacturing activities occur primarily in North America, Europe, Israel and Asia. Applied's broad range of equipment and service products are highly technical and are sold primarily through a direct sales force.

Applied's results are driven primarily by worldwide demand for semiconductors, which in turn depends on end-user demand for electronic products. Each of Applied's businesses is subject to cyclical industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, LCDs, solar PVs and other electronic devices, as well as other factors, such as global economic and market conditions and technological advances in fabrication processes.

The following table presents certain significant measurements for the past three fiscal years:

Fiscal Year                                                     2008              2007              2006
                                                               (In millions, except per share amounts and
                                                                              percentages)

New orders                                                    $   9,155         $   9,677         $   9,888
Net sales                                                     $   8,129         $   9,735         $   9,167
Gross margin                                                  $   3,443         $   4,492         $   4,292
Gross margin percent                                               42.4 %            46.1 %            46.8 %
Net income                                                    $     961         $   1,710         $   1,517
Earnings per share                                            $    0.70         $    1.20         $    0.97

Fiscal 2008 financial results reflected decreased demand for semiconductor equipment and, to a lesser extent, service products, due to unfavorable market conditions in the semiconductor industry, partially offset by increased demand for LCD and solar products. New orders decreased from fiscal 2007 due to lower demand for semiconductor equipment from memory, foundry and logic chip manufacturers, partially offset by increased demand by LCD customers and, beginning in the first quarter of fiscal 2008, the recognition of orders for Applied's SunFabtm Thin Film Line for manufacturing solar panels. Net sales decreased during fiscal 2008 compared to fiscal 2007 due to the decline in investment from memory and logic customers, partially offset by increased sales of crystalline silicon (c-Si) solar manufacturing products. Net income decreased in fiscal 2008 compared to fiscal 2007 due to lower net sales, offset in part by lower operating expenses. Fiscal 2008 financial results included charges associated with restructuring programs.

Fiscal 2007 financial results reflected improved conditions in the semiconductor industry that began with the industry's recovery in 2006, while conditions in the display industry were mixed as manufacturers postponed capacity additions despite strong consumer demand for LCD TVs. Total orders decreased slightly from fiscal 2006, primarily due to the significant decline in demand for display manufacturing products, partially offset by increased demand for products and services in all other segments. Net sales increased during fiscal 2007 over fiscal 2006, primarily due to strong demand from dynamic random access memory (DRAM) and flash memory chip manufacturers, partially offset by a significant decline in LCD equipment sales as manufacturers absorbed capacity following substantial investment in 2006. Net income improved in fiscal 2007 compared to fiscal 2006 due to higher sales and lower operating expenses, offset in part by lower interest income. Fiscal 2007 financial results included restructuring and asset impairment and other charges associated with ceasing development of beamline implant products, and an in-process research and development (IPR&D) expense associated with the acquisition of certain net assets of Brooks Automation, Inc. (Brooks Software).

Fiscal 2006 results reflected a recovery in the semiconductor and flat panel display industries along with the global economy, as end-user demand for electronic products and LCDs drove increased customer investments in advanced silicon (particularly memory) and display products compared to fiscal 2005. During this period, Applied's semiconductor customers increased both high-volume production and leading-edge 65nm and 45nm chip development. Improvements in operating performance were offset in part by restructuring and asset impairment charges, and an IPR&D expense associated with the acquisition of Applied Films Corporation (Applied Films).

Applied expects an unusually challenging environment for fiscal 2009. The turmoil in the financial markets and weakening global economy are compounding the impact of the highly cyclical markets in which Applied operates. Current negative trends in consumer spending and pervasive economic uncertainty have led some customers to decrease factory operations and to reassess their projected spending plans. As a result, on November 12, 2008, Applied announced that it will implement a restructuring program beginning in the first quarter of fiscal 2009. In addition, Applied's ability to forecast customers' future investments and its financial targets are limited in this uncertain macroeconomic climate. Applied currently expects that orders and revenue will be down overall and across most segments in fiscal 2009, with the exception of the Energy and Environmental Solutions segment.

Results of Operations

The following table presents certain quarterly and full fiscal year financial information:

                                                  Fiscal Quarter                    Fiscal
                                    First       Second       Third      Fourth       Year
                                           (In millions, except per share amounts)

      2008:
      New orders                   $  2,500     $ 2,414     $ 2,030     $ 2,212     $ 9,155
      Net sales                    $  2,087     $ 2,150     $ 1,848     $ 2,044     $ 8,129
      Gross margin                 $    935     $   967     $   742     $   799     $ 3,443
      Net income                   $    262     $   303     $   165     $   231     $   961
      Earnings per diluted share   $   0.19     $  0.22     $  0.12     $  0.17     $  0.70
      2007:
      New orders                   $  2,538     $ 2,648     $ 2,284     $ 2,206     $ 9,677
      Net sales                    $  2,277     $ 2,530     $ 2,561     $ 2,367     $ 9,735
      Gross margin                 $  1,063     $ 1,137     $ 1,216     $ 1,077     $ 4,492
      Net income                   $    403     $   411     $   474     $   422     $ 1,710
      Earnings per diluted share   $   0.29     $  0.29     $  0.34     $  0.30     $  1.20
      2006:
      New orders                   $  2,041     $ 2,488     $ 2,670     $ 2,688     $ 9,888
      Net sales                    $  1,858     $ 2,248     $ 2,543     $ 2,518     $ 9,167
      Gross margin                 $    838     $ 1,045     $ 1,223     $ 1,186     $ 4,292
      Net income                   $    143     $   413     $   512     $   449     $ 1,517
      Earnings per diluted share   $   0.09     $  0.26     $  0.33     $  0.30     $  0.97

Applied's business was subject to cyclical industry conditions in fiscal 2008, 2007 and 2006. As a result of these conditions, there were significant fluctuations in Applied's quarterly new orders and net sales, both within and across the fiscal years. Demand for manufacturing equipment has historically been volatile as a result of sudden changes in chip and LCD supply and demand and other factors, including global economic and market conditions and rapid technological advances in fabrication processes.

New Orders

New orders by geographic region, which are attributed according to the location
of customers' facilities, were as follows:


                    Fiscal Year         2008        2007        2006
                                                (In millions)

                    Taiwan             $ 2,110     $ 2,703     $ 2,098
                    North America(1)     1,680       1,518       1,901
                    Asia-Pacific(2)      1,530       1,262       1,272
                    Korea                1,477       1,639       1,758
                    Japan                1,224       1,520       1,823
                    Europe               1,134       1,035       1,036

                                       $ 9,155     $ 9,677     $ 9,888

(1) Primarily the United States.

(2) Includes China.

New orders for fiscal 2008 decreased 5 percent to $9.2 billion from $9.7 billion in the prior year, due to lower demand for semiconductor equipment from logic, memory, and foundry chip manufacturers, partially offset by increased demand for LCD and solar equipment, including the initial recognition of orders for the Applied SunFabtm Thin Film Line. Demand for LCD equipment slowed substantially in the fourth quarter of fiscal 2008, as Display customers absorbed capacity following robust demand over the preceding three quarters.

New orders for fiscal 2007 decreased 2 percent to $9.7 billion from $9.9 billion in the prior year, reflecting delays in investment by LCD customers, partially offset by increased demand for solar equipment, semiconductor equipment, and service products. Demand for semiconductor equipment slowed in the second half of fiscal 2007 as customers absorbed added capacity, while demand from LCD customers recovered in the fourth quarter of fiscal 2007.

Fiscal 2006 orders of $9.9 billion reflected increased semiconductor manufacturing equipment orders from memory manufacturers, increased service orders as a result of higher customer factory utilization and new product introductions, and increased display orders as customers invested in next-generation equipment.

Applied's backlog for the last three fiscal years was as follows: $4.8 billion at October 26, 2008, $3.7 billion at October 28, 2007, and $3.4 billion at October 29, 2006. Backlog increased in fiscal 2008 primarily due to the inclusion of orders for products obtained through the acquisitions of Baccini S.p.A. (Baccini) and HCT Shaping Systems S.A. (HCT) that met Applied's order recognition criteria during the third quarter of fiscal 2008 but did not qualify for order recognition at the time of the acquisition, partially offset by debookings, primarily of semiconductor equipment, and unfavorable currency adjustments. Backlog consists of: (1) orders for which written authorizations have been accepted and assigned shipment dates are within the next 12 months, or shipment has occurred but revenue has not been recognized; (2) contractual service revenue and maintenance fees to be earned within the next 12 months; and
(3) orders for SunFab lines that are anticipated to be recognized as revenue within the next 12 months. Due to the potential for customer changes in delivery schedules or cancellation of orders, Applied's backlog at any particular time is not necessarily indicative of actual sales for any future periods.

Net Sales

Net sales by geographic region, which are attributed according to the location
of customers' facilities, were as follows:


                    Fiscal Year         2008        2007        2006
                                                (In millions)

                    Taiwan             $ 1,837     $ 2,679     $ 2,079
                    North America(1)     1,520       1,554       1,708
                    Korea                1,309       1,847       1,699
                    Asia-Pacific(2)      1,296       1,206       1,157
                    Japan                1,218       1,493       1,518
                    Europe                 949         956       1,006

                                       $ 8,129     $ 9,735     $ 9,167

(1) Primarily the United States.

(2) Includes China.

During fiscal 2008, net sales decreased by 16 percent, to $8.1 billion from $9.7 billion in fiscal 2007, due to decreased investment from memory and logic chip manufacturers, partially offset by increased demand from solar and LCD customers. During fiscal 2007, net sales increased by 6 percent, to $9.7 billion from $9.2 billion in fiscal 2006, led by strength in memory capacity expansion throughout the year. In fiscal 2006, net sales of $9.2 billion followed the trend of increased orders for the year.

Gross Margin

Gross margin as a percentage of net sales decreased to 42.4 percent in fiscal 2008 from 46.1 percent in fiscal 2007, compared to 46.8 percent in fiscal 2006. The decrease in the gross margin percentage from fiscal 2007 to fiscal 2008 was attributable to lower net sales and lower margin product mix. The decrease in the gross margin percentage from fiscal 2006 to fiscal 2007 was principally attributable to inventory-related charges of $56 million associated with ceasing development of beamline implant products, incremental charges attributable to acquisitions consisting of inventory fair value adjustments on products sold, amortization and product mix, partially offset by higher revenue levels and lower material costs. Gross margin during fiscal 2008, 2007 and 2006 included $32 million, $27 million and $37 million, respectively, of equity-based compensation expense.

Research, Development and Engineering

Applied's future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Applied believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers' most advanced designs. Applied historically has maintained its commitment to investing in RD&E in order to continue to offer new products and technologies. RD&E expenses were $1.1 billion (14 percent of net sales) in fiscal 2008, $1.1 billion (12 percent of net sales) in fiscal 2007 and $1.2 billion (13 percent of net sales) in fiscal 2006. RD&E expense during fiscal 2008, 2007 and 2006 included $59 million, $56 million and $76 million, respectively, of equity-based compensation expense. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied's existing products resulted from internal development activities and innovations involving new technologies, materials and processes. In certain instances, Applied acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market.

In fiscal 2008, Applied focused on the development of processes and systems for the continued scaling of semiconductor devices. Applied pioneered a self-aligned double patterning approach that can enable 22nm and below device fabrication using conventional optical lithography. The Company also developed technology for the

implementation of through-silicon vias, an emerging solution for interconnecting 3D chip stacks to achieve better device performance, lower power consumption, reduced costs and the integration of heterogeneous devices. Efforts were also focused on developing the systems and technology to reduce the cost-per-watt of solar electricity.

In fiscal 2007, Applied focused on developing systems for customers' new chip designs with 45nm and below geometries, including systems to enable faster transistors using strain engineering and high-k/metal gate technologies, and patterning processes to enable customers to extend their existing 193 nm lithography tools through additional technology generations. Applied also continued to invest in solar research and development.

In fiscal 2006, Applied continued its development of systems to increase chip performance, especially for flash and DRAM devices. Applied also focused on developing systems for 32nm and 22nm copper/low k interconnect processing technologies to address critical manufacturing challenges that chipmakers face as they transition to future device generations, helping them to bring new products to market more rapidly while minimizing risk. Applied also continued to focus on developing LCD systems to process larger glass substrates.

There were no IPR&D charges recorded in fiscal 2008. During fiscal 2007, Applied recorded an IPR&D expense of $5 million associated with the acquisition of certain net assets of Brooks Software, a division of Brooks Automation, Inc. During fiscal 2006, Applied recorded an IPR&D expense in the amount of $14 million related to the acquisition of Applied Films. Applied's methodology for allocating the purchase price relating to purchased acquisitions to IPR&D was determined through established valuation techniques. The IPR&D was expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed.

Marketing, Selling, General and Administrative

Marketing, selling, general and administrative expenses were $965 million
(12 percent of net sales) in fiscal 2008, $952 million (10 percent of net sales)
in fiscal 2007, and $907 million (10 percent of net sales) in fiscal 2006. The increase in marketing, selling, general and administrative expenses from fiscal 2007 to 2008 was principally attributable to increased operating costs from business acquisitions and equity compensation expenses, offset in part by cost control initiatives. The increase in marketing, selling, general and administrative expenses from fiscal 2006 to 2007 was principally attributable to increased operating costs from acquired businesses, investments in the solar business expansion, and increased variable compensation expenses. These expenses were partially offset by lower equity compensation expenses and savings from cost control initiatives, including ceasing development of beamline implant products and transitioning to managed service providers to perform certain information technology and business infrastructure support. Marketing, selling and general and administrative expenses during fiscal 2008, 2007 and 2006 included $88 million, $77 million and $104 million, respectively, of equity-based compensation expense.

Restructuring and Asset Impairments

During the first quarter of fiscal 2008, Applied announced a global cost reduction plan (the Plan) that primarily affected its Silicon and Applied Global Services segments and related support organizations. As part of the Plan, Applied reduced its global workforce through a combination of job elimination and attrition. For fiscal 2008, Applied recorded restructuring charges of $29 million relating to the Plan, consisting primarily of employee termination costs to reduce its workforce. The affected employees were based in North America, Europe and Asia, and represented multiple functions.

During the second quarter of fiscal 2007, Applied's Board of Directors approved a plan (the Implant Plan) to cease development of beamline implant products for semiconductor manufacturing and curtail the operations of its Implant group based in Horsham, England. Under the Implant Plan, Applied closed its research, development and manufacturing operations in Horsham in October 2007. Costs under the Implant Plan for fiscal 2008 consisted of restructuring charges of $11 million associated with facilities. Costs under the Implant Plan in fiscal 2007 consisted primarily of inventory-related charges reported as cost of products sold of $56 million, other operating expenses of $10 million, and restructuring and asset impairment charges of $30 million. Also as part of the Implant Plan, Applied recorded restructuring charges of $22 million, consisting primarily of employee termination costs to reduce its workforce. The majority of the affected employees were based in Horsham, England, and represented multiple functions. Asset impairment charges included $8 million of fixed asset write-offs. The Implant group operated in

the Silicon segment, and the results of its operations were not material to Applied's financial position or results of operations.

During the first quarter of fiscal 2006, Applied's Board of Directors approved a plan to disinvest a portion of Applied's real estate and facilities portfolio (the Disinvestment Plan). Properties with an estimated fair value of $56 million were reported as assets held-for-sale and reclassified from property, plant and equipment on the Consolidated Balance Sheet. During fiscal 2006, Applied recorded an asset impairment charge of $124 million to write down the following properties to estimated fair value: (1) facilities in Narita, Japan, Chunan, Korea, Hillsboro, Oregon, and Danvers, Massachusetts; and (2) 26 acres of unimproved land in Hillsboro, Oregon. During fiscal 2006, Applied sold the Danvers facility for net proceeds of $16 million and recognized a gain of $4 million. During fiscal 2007, Applied sold the Hillsboro, Chunan, and Narita facilities and the Hillsboro land for total net proceeds of $38 million and recognized a gain of $3 million. Also in fiscal 2006, as part of the Disinvestment Plan, Applied recorded lease termination charges in the amount of $89 million related to the closure of its leased Hayward, California facility.

For further details, see Note 6 of Notes to Consolidated Financial Statements.

Net Interest and Other Income

Net interest and other income was $89 million for fiscal 2008, $98 million for fiscal 2007, and $149 million for fiscal 2006.

The decrease in net interest and other income for fiscal 2008 from fiscal 2007 was primarily due to a reduction in short-term investments and a decrease in interest rates during fiscal 2008, offset by a decrease in interest expense associated with scheduled debt maturities that occurred in September 2007. The decrease in net interest and other income from fiscal 2006 to 2007 was primarily due to a reduction in cash and investments during the fourth quarter of fiscal 2006 when Applied repurchased 145 million shares of its outstanding common stock for an aggregate purchase price of $2.5 billion under an accelerated stock buyback program.

Income Taxes

Applied's effective income tax provision rate was 31.8 percent for fiscal 2008, 29.9 percent for fiscal 2007, and 30.0 percent for fiscal 2006. Applied's effective tax rate was higher for fiscal 2008 compared to fiscal 2007 as fiscal 2007 reflected benefits of $36 million principally related to the favorable resolution of audits of prior years' income tax filings, partially offset by a $13 million charge from the expensing of equity-based compensation. Applied's effective tax rate of 30.0 percent for fiscal 2006 reflected benefits of $61 million principally related to the favorable resolution of audits of prior years' income tax filings, partially offset by a $17 million charge from the expensing of equity-based compensation.

Applied's future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of Applied's pre-tax income, and non-tax deductible expenses incurred in connection with acquisitions. Management carefully monitors these factors and timely adjusts the effective income tax rate accordingly.

Segment Information

Applied operates in four reportable segments: Silicon, Applied Global Services, Display, and Energy and Environmental Solutions. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 10 of Notes to Consolidated Financial Statements. Applied does not allocate to its reportable segments certain operating expenses, which it manages separately at the corporate level. These unallocated costs include those for equity-based compensation and certain components of variable compensation, corporate marketing and sales, corporate functions (certain management, finance, legal, human resources and RD&E), and unabsorbed information technology and occupancy. Effective in the first quarter of fiscal 2008, Applied renamed two of its reportable segments. The Fab Solutions segment was renamed Applied Global Services, and the Adjacent Technologies segment was renamed Energy and Environmental Solutions. In addition, Applied changed its management reporting system for services to report all service results in the Applied Global Services

segment. Applied has reclassified segment operating results for fiscal 2007 and 2006 to conform to the fiscal 2008 presentation.

Discussions below include the results of each reportable segment.

Silicon Segment

The Silicon segment includes semiconductor capital equipment for deposition, etch, rapid thermal processing (RTP), chemical mechanical planarization (CMP), and metrology and inspection. Development efforts are focused on solving customers' key technical challenges, including transistor performance and nanoscale patterning, and on improving chip manufacturing productivity to reduce costs.

Certain significant measures for the past three fiscal years were as follows:

                    Fiscal Year         2008        2007        2006
                                                (In millions)

. . .