Novellus Systems, Inc. Q2 2006 Earnings Conference Call Transcript (NVLS)

Novellus Systems Inc. (NVLS)
Q2 2006 Earnings Conference Call
July 19, 2006 4:30 pm ET

Executives

Robin Yim - IR
Bill Kurtz - Chief Financial Officer and Executive Vice President
Rick Hill - Chairman and Chief Executive Officer

Analysts

Edward White - Lehman Brothers
Timothy Arcuri - Citigroup
Michael O'Brien - Bear Stearns
Stuart Muter - RBC Capital
Gary Hsueh – CIBC World Markets
Brett Hodess - Merrill Lynch
Jay Deahna - JP Morgan
Satya Kumar - Credit Suisse
Ben Pang - Prudential Equity
Mark FitzGerald - Banc of America
Steve O'Rourke - Deutsche Bank
Jennifer West – Merriman

Presentation

Operator

Welcome to the Novellus System’s second quarter 2006 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Robin Yim of Novellus Systems. Please go ahead.

Robin Yim

Thank you operator. Good afternoon and thank you for joining the Novellus System second quarter 2006 earnings conference call. With me today on the call are Rick Hill, Chairman and Chief Executive Officer; and Bill Kurtz, Chief Financial Officer.

Financial results for our second quarter 2006 were released on PR Newswire shortly after 1:00 pm Pacific Daylight Time. You can obtain a copy of the news release in the Investor Relations section of our website at www.novellus.com.

Today’s earnings call contains forward-looking statements about Novellus’ business outlook, the future performance of Novellus, and our products and forecasts of key metrics for the third quarter of 2006. Specific forward-looking statements include, but are not limited to, our expectations regarding semi-conductor industry growth and capital equipment spending, the demand for and competitiveness of our products, our expectations that we will continue to maintain our position or grow market share, our projected bookings, shipments, revenues, gross margins, tax rate and earnings per share, and other anticipated future events.

We caution that forward-looking statements are projections and expectations regarding future events. They involve risks and uncertainties that could cause actual results to differ materially from the results contemplated, including inaccurate basis for our financial forecasts. Information concerning risks that could have caused actual results to differ materially is contained in today’s press release. Our filings with the Securities and Exchange Commission including our Form 10-K for fiscal 2005, our Form 10-Q for the first quarter of 2006, and our current reports on Form 8-K. Forward-looking statements are based on information as of today, and we assume no obligation to update any of the statements.

Bill Kurtz will begin today’s call with a review of the financial results for the second quarter, followed by guidance for the third quarter of 2006. Rick Hill will then discuss the state of the business and then we will open up the call for questions.

I’ll now turn the call over to Bill.

Bill Kurtz

Thank you Robin and good afternoon everyone.

I’m pleased to report that all of our key financial metrics for the second quarter met or exceeded the guidance we provided on our mid-quarter update call on June 7. Booking of $458 million were up 10% sequentially from the first quarter. By wafer size, Q2 bookings were 80% 300 millimeter, and 20% 200 millimeter, bringing our year-to-date bookings to 71% 300 millimeter, and 29% 200 millimeter.

Second quarter shipments of $457 million were up 29% from the first quarter and revenues of $410 million were up 12% over the first quarter. Second quarter revenues by geographic region were as follows: United States - 29%, Greater China and Southeast Asia - 25%, Korea - 24%, Japan - 13%, and Europe - 9%.

Turning to gross margin, I’m very pleased to report that we’ve reached an important milestone with reported gross margins of approximately 50% in the June quarter. On an operational basis, gross margin improved over 2.5 points from Q1 and was driven by continued reductions in installation in warranty costs, product cost reductions, operational efficiencies, and higher absorption of fixed manufacturing costs. We are now operating at the expected standard for installation and warranty expenses.

In Q2 we also had a 1.5 point benefit due to a higher level of 100% gross margin acceptances. Now looking forward to Q3, we expect gross margin to be approximately 50.5%. In addition, we continue to focus on improvements to drive towards our long term mode of 52 to 54% gross margin.

Total operating expenses for the second quarter were $130 million, which is up $7 million as expected from the prior quarter on a pro forma basis due to higher profit sharing, annual merit increases and other employee related costs.

Our effective tax rate in the second quarter was 36.3%. We experienced an increase in the tax rate due to higher profitability. Our effective tax rate for Q3 is now expected to be approximately 36%.

Our second quarter net income was $53 million or $0.42 per share compared to net income of $25 million or $0.19 per share on a GAAP basis. On a pro forma basis Q2 EPS was up 65% from the first quarter EPS quarter of 25% per share. The primary driver’s of the significant sequential growth in Q2 earnings per share are a 12% sequential growth in revenues, an operational improvement in gross margins of over 2.5 points, and the impact of our share buy back program, which reduced the share count by approximately 7 million shares. Now excluding the impact of FAS 123R, second quarter EPS was $0.45 versus $0.29 on the same basis in the first quarter.

Turning to the balance sheet, we ended the quarter with $671 million of cash, short term investments and restricted cash, which was a decrease of approximately $83 million from the prior quarter. This decrease is primarily due to the repurchase of 7 million shares of our common stock for $172 million, offset by positive cash flow from operations of approximately $90 million.

Net accounts receivable, $440 million grew by $24 million; however, the increase was driven by higher shipment and was offset by an improvement of DSOs from 99 days at the end of March to 90 days at the end of June, and improvement of nine days.

Inventory decreased in the quarter, and represents an approximate 20% improvement in our inventory turns compared to the prior quarter.

With that, I’d like to summarize our outlook of key metrics for the third quarter of 2006. We expect bookings to be flat to up 7% compared to June quarter. Shipments are forecasted to be in the range of $415 to $430 million, which is down 6% to 9% resulting from customer requested delivery dates. Revenue is forecasted to be in the range of $440 to $450 million, which is up 7% to 10% resulting from higher revenues in Japan. As I mentioned earlier, we expect reported gross margins in Q3 to be approximately 50.5%, and as a result, earnings per share including all equity compensation expense is expected to be between $0.49 and $0.52. Excluding FAS 123R, EPS is expected to be between $0.52 and $0.55.

I would like to now turn the call over to Rick Hill.

Rick Hill

Thank you Bill. As Bill just reported, Q2 was a very strong quarter for Novellus. We had record bookings of $457.5 million and record shipments of $457.3 million. This was accompanied by strong revenue growth up 12.1% at $410 million, plus the continued improvement and operating performance. As Bill just reported, gross profit was 49.9%, including stock option expense, and achieved 50.1% excluding stock option expense.

We did have an overall improvement in our operating expenses as a percent of revenue. We did see a slight increase as a percent of revenue in SG&A, but it was due largely to the large number of shipments in the quarter and the accrual of profit sharing and bonuses that occur in the SG&A line most significantly, and again, an earnings per share of $0.42.

Now during the quarter, we also purchased back [7.172] million shares at an average price of $23.96, which was previously part of our plan where we have a total buyback opportunity, roughly 500 million.

We continue to improve our asset utilization. Inventories came down approximately 10 million on increased shipments, and our DSOs reduced to 90 days from 99. Looking forward as Bill articulated to you, bookings will be flat to up 7% in Q3. Shipments will slow slightly, due to customer requested delivery dates between 415 million and 430 million, that’s down about 6% to 9% from the second quarter. Revenues, however, will continue to increase at a healthy rate of 7% to 10% due to the recognition of revenue from Japan sales that we had reported in the first quarter. Our earnings per share of $0.49 to $0.52 including stock option expense, we think is a great improvement and signals our continued operational improvement within the Company.

Driving this expansion and performance are the following; regionally we continue to see rational capital deployment to meet anticipated needs for Flash and related devices, for the expanding application of NAND Flash.

It’s a little bit of the chicken and the egg in the NAND Flash business today. A major application opportunity that’s been identified by several players, Sony being one, to have NAND Flash drives in portable laptops is an extremely attractive addition to a laptop for both power consumption and also for speed of power on and boot up. As a result, however, in order to drive NAND Flash into the laptop we have to see a continual decline in the price of NAND Flash, and in order to do this of course, we need capacity expansion.

As we all know, there is significant capacity expansion going on in NAND Flash today, and we believe that there is a significant demand in the market place that will fill that capacity. As DRAM prices have firmed, we anticipate some growth in DRAM capacity to track with the penetration of Microsoft’s new Vista Operating System, which we think will spur the use of increased amount of DRAM in computers.

Our continued commitment to improving our product solutions has been another driver here. We’re improving both the quality, the performance and the value to help our customer’s drive down there costs. In today’s environment, that is extremely important.

In addition to that we are continuing to improve our own operational efficiencies throughout the Company. If we look at it on a product-by-product basis, 2006 is shaping up to be years where we’re at or close to record levels of revenue for all of our products with the exception of CMP
and the Surface Integrity Group, or the Strip Product line, although the Surface Integrity Group is performing at a level that is slightly above our expectations for the year.

With that, I’d like to open it up for any questions that you might have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We will take our first question from Edward White with Lehman Brothers.

Edward White- Lehman Brothers

Hi. Question regarding the sequential shipments, you talked about the fact that the decline is due to the customer scheduling. Is that just the timing of when they want the delivery? In other words, they haven’t changed anything, have they? Or is it just when the deliveries are scheduled?

Rick Hill

Delivery schedules is largely driven, and in the second quarter in shipments as you can see, a very strong shipments period, we did have some accelerated deliveries that were requested.

Edward White- Lehman Brothers

Okay, and going forward, I know this is hard to judge, but how does the customer acceptance situation look going forward? You mentioned it was very, very good during the quarter, but how do you think that is going to shape up as we look ahead?

Rick Hill

I think that we’ll continue to see good acceptance levels within the customer base for revenue recognition purposes.

Edward White- Lehman Brothers

Okay, great. Thank you.

Operator

We will take our next question from Timothy Arcuri with Citigroup.

Timothy Arcuri - Citigroup

Citigroup. Hi, thanks. Rick, two things, first of all, can you give us some idea with respect to CMP of, maybe not what the specific targets are for that business, but what metrics you are looking at it on? Is it profitability metric? Is it a market share metric? Then I had a follow up. Thanks.

Rick Hill

Relative to CMP, as we’ve articulated with CMP before, we have a very focused effort within CMP. They are meeting all of the milestones that we have for them. The chief milestones are product performance that can be valuable to the customer base. We believe we’ve achieved that, and we believe that we’ll continue to demonstrate that at multiple customers. Then based on that we want to drive for profitability and growth within the product line. I think the industry suffers from not adequate competition in the CMP market place and to the extent that we can sell value and provide that competition and value to the customer, we’re going to do that. So that’s as specific as I can get for you on that, Tim.

Timothy Arcuri - Citigroup

Okay, thanks. Then, Bill, just one quick follow up. If you look and R&D, it’s been basically flat now for about five quarters, and revenues gone up nicely during that time, so are there some programs that are being - you are paring back on some programs. What’s the outlook for R&D? Has it been more of a cut across programs? Or have they been specific programs that have been cut? Thanks.

Rick Hill

Well, Tim as you articulated and noted, this is Rick answering that question, the dollars themselves have been flat. As you know, we continue to spend R&D dollars in the downturn at a much higher rate than any of our competitors. As a result, you’re beginning to see the delivery of those products, those enhancements into the market place. It isn’t that we’re cutting a huge number of products across the board, or selectively, any different than we have in the past, but you do see a control of R&D and a clear focus on driving the products that we believe will be successful in the market. That is specifically what is being done.

Timothy Arcuri - Citigroup

Nice job, guys, thanks.

Operator

We’ll take our next question from Michael O’Brien with Bear Stearns.

Michael O'Brien - Bear Stearns

Yes, thanks a lot. Just want to get back to the shipments question real quick. I notice some accelerated deliveries. Does that provide you with a little more cushion? I know it’s usually about a 1/4 lag, shipments to revenue. Should we be expecting if shipments are down, that revenue will be down in the December quarter? Or do you think you have a little bit of a cushion where that won’t be the case?

Bill Kurtz

Mike, this is Bill. As you know, we forecast one quarter at a time, so we’re not providing an outlook for the December quarter. What I can say to you is that, if you look at the Q3, you’ve seen a sequential increase in revenue and one way to get a handle on where we stand on the shipments versus revenue recognition is through the year-to-date summary on both metrics. What you’ll see is that with our third quarter guidance, the revenue on a year-to-date basis and the shipments on a year-to-date basis are pretty close, which means we’re now aligned.

Michael O'Brien - Bear Stearns

Okay, so that would suggest that maybe you see a little bit of a dip in revenue, if I’m thinking about that properly.

Bill Kurtz

I did not say there would be a dip in revenue. I said that we have forecasted an increase in revenue in Q3, and at by the end of Q3, both revenue and shipments will be equal. Therefore, they should grow at the same pace on a going forward basis.

Michael O'Brien - Bear Stearns

Okay and just one follow up. Can you just talk a little bit about the dynamics you are seeing working the various markets? A little bit of worry that maybe the boundary has slowed things down, and I don’t think you still feel very bullish on the Flash market and the DRAM markets. If you could add a little more color, that would be great.

Bill Kurtz

I think that ultimately, our industry is always to some extent driven by the computing market. When I say the computing market that encompasses not only the computer market, but also encompasses the game market. I think there have been some delays within anticipated game boxes that certainly drives graphic shifts and other peripheral chips that are largely foundry based, so you are seeing a little bit of a hiccup right now, but I really don’t see that as a long term phenomena. It would only be a long term phenomena if, in fact, there was some external event that caused the industry not to be able to move those products once they are released. Based on what I’ve seen of those products, they will be very successful. As a consequence, without an external event, I think you will see a resumption in growth in the foundry areas as well. Okay, Michael?

Michael O'Brien - Bear Stearns

Okay, thank you.

Operator

(Operator Instructions) We’ll take our next question from Stuart Muter with RBC Capital Markets.

Stuart Muter - RBC Capital Markets

Yes, thanks for taking my question and nice results. Question on the target financial model and the goal of getting operating expenses to around 30%. Do you think that’s achievable if your revenues are hitting around $450 million?

Bill Kurtz

Well, if you look at where we are operating currently, we are pretty close to that right now with our current run rate or revenue. So it’s something within reason.

Rick Hill

We’ve always said from a model standpoint, that our model for gross margin was 52 to 54% with our operating expenses less than 30%. So that pinpoints the operating income in the mid-20 area, which we believe is something that is sustainable. Now, obviously, when the business is extremely strong because of the physical operating leverage we have, we probably can perform better than that, and to the extent that the industry is in a downturn, we’ll perform somewhat worse than that. We continue to drive to the model. We’re not there yet. There are still some things we need to execute on, but I think we’re well on our way to executing. The key to that execution is product execution, and I do feel we’re back on that path.

Stuart Muter - RBC Capital Markets

Excellent. Thank you.

Operator

We'll take our next question from Brett Hodess with Merrill Lynch. Actually, moving on we'll take our next question from Gary Hsueh.

Gary Hsueh – CIBC World Markets

Yes, hi, can you hear me? A couple of quick questions here. If I look at deferred profit, deferred revenue has gone up, but deferred profit, in terms of a percentage basis has gone down significantly. Could you step me through how deferred profit went from 47% in the March quarter to roughly 45% and what the ramifications are, and that bleeding through to the P&L in the back half of the year?

Bill Kurtz

Well, the deferred revenue relates to the shipments versus acceptances, and as we pointed out, we do see now in Q3, some of the Japan shipments that were earlier deferred are being recognized. So that helps you understand the gradual decline in the deferred revenue as our shipments and revenue become more aligned. In terms of the deferred profit, that has two pieces to it. One piece is deferred shipments; the other piece is the acceptances. As I pointed out to you in the second quarter, we had a higher than normal level of acceptances of 100% gross margin, so that’s really what contributed to the reduction in the deferred profit.

Gary Hsueh – CIBC World Markets

Okay. My follow up question is, if I look at the mid-point for guidance for Q3 for revenue and gross margin, suggests that you are getting incremental gross margin back down in the 50% to 60% range. So, I’m assuming that the mix of SAB 101 is staying flat, and the 50% to 60% is a normalized run rate for incremental gross margins in the model. Is that right?

Rick Hill

When you say 50% to 60%, I’m not sure I understand what you mean by that.

Gary Hsueh – CIBC World Markets

In terms of drop through. Incremental drop through.

Bill Kurtz

Incremental drop through from the incremental revenue? Yes, that’s fair. We are seeing the incremental flow through in the third quarter from higher revenues, and that’s approximately in the ballpark. There are also, as you know in any quarter, a number of factors that can affect gross margin. Mixed can be a factor. As we pointed out, some quarters, we have higher levels of acceptances on SAB 104 and in some quarters, we have lower levels. So there are going to be fluctuations around that, but if you normalize everything else, then yes, you’ll see flow through in that range for the incremental revenue.

Gary Hsueh – CIBC World Markets

All right, and if I could sneak in one last question, if you do look at revenue and shipments, however, it does look like revenue and shipments have crossed over, meaning that you are running at a lower shipment level than you are a revenue level in Q3. Is that just a near term probation? Is that not a foreseeable trend?

Bill Kurtz

Yes, it’s not indicative of a trend. They are a function of two different things. First in the revenue, we had commented earlier in the year that we had a higher level of shipments particularly in Q1 and Q2 that were running ahead of revenue that would become acceptances in Q3, some in Q2, but largely in Q3. So you are seeing that effect in the revenue on a sequential basis in Q3. We had pointed that out at least a quarter or two before. So that’s something that you should have expected based on our earlier comments. As far as shipments are concerned, shipments are, as Rick pointed out, we had some higher level of shipments in Q2 due to customer request, which are impacting to some extent what you are seeing in Q3, but I would not interpret a trend from that.

Gary Hsueh – CIBC World Markets

All right. Great, thank you.

Operator

We'll take our next question from Brett Hodess with Merrill Lynch.

Brett Hodess - Merrill Lynch

The question was I want to just be clear that the dip in shipments in Q3 was because you had pull-ins into Q2, not push-outs form Q3?

Bill Kurtz

That’s correct.

Brett Hodess - Merrill Lynch

Then, second question was, with the warranty and installation costs being back to normal, does that also play into - are you seeing higher customer satisfaction? Is that helping on the competitive front at this point?

Rick Hill

It always helps, Brett, when you deliver them stuff that you don’t have to provide warranty.

Bill Kurtz

Now that being said, we are still driving for further and further improvement in the way that we deliver; install and we do see additional potential to improve even beyond the current standard.

Rick Hill

That’s correct.

Brett Hodess - Merrill Lynch

Thank you.

Operator

We'll take our next question from Jay Deahna with JP Morgan.

Jay Deahna - JP Morgan

Thanks very much. Good afternoon. Nice operating results. Quick question here on the Q3 shipments, Bill, you said that shipments in Q3 being down were impacted “By some extent by the pull-ins of Q2.” Are they also being impacted to some extent by some requests by push-outs, because we know that TSMC was moving some things out, etc.? Intel just cut their CapEx a little bit, so just wondering on that, and secondly, your outlook for next year, Rick, is it similar to what you said at your Analyst Meeting, same at your last meeting, you said CapEx up modestly or something like that?

Bill Kurtz

All right, let me handle the first question and then I’ll defer to Rick on the second question regarding 2007. Jay, in Q3, I would say on a net basis, no big change that I’ve seen in the shipments forecast. There are some that have been pushed out and there are some that have been pulled in, but net-net it really hasn’t changed substantially. The major reason for the decline in Q2 as we point in Q3 is the additional shipments that were pulled into Q2. So absent that, I don’t see any other trends that are notable.

Jay Deahna - JP Morgan

Okay.

Rick Hill

All right, Jay, what was the other question about CapEx?

Jay Deahna - JP Morgan

Rick, I think you said at your Analyst meeting at SemiCon West, that CapEx would be up moderately next year? I presume that means mid-single digits or something like that, but I’m just wondering if you could reconfirm that’s your thought process, if that’s what you said.

Rick Hill

Yes, the thought process I think I said at SemiCon was that we said that the second half of this year, we anticipate from a Novellus standpoint, right now, it looks as though it will be up compared to the first half of the year. However, it won’t be up as strongly as the first half was over the second half of last year. Then I indicated that what we might see is a slight slow down in the beginning of ’07, but I saw a relatively strong ’07, that it would be up. The reason it would be up is it would be driven largely by NAND Flash. When I was at Semi, I was in with a bunch of analysts at Jim Bagley’s Bulls and Bears session, and I proffered to him, what would the NAND market look like if in three years, you had 100% of portable laptops shipping with NAND Flash as the drive? I think what you are seeing, is you are going to see a transition of NAND Flash or hard drives to a hybrid NAND Flash hard drive. Then ultimately over the next three years, to pure NAND Flash.

As I said in my opening statements, one of the things we have here is the chicken and the egg. When you look at the size of the market for NAND Flash in the personal computer, and in the video game market place, it is so large that if everybody went to it with their product today, the capacity would be dried up so quickly nobody could make that decision to go right today. So you are seeing a lot of people, smart people, bring in NAND capacity. The IM fab that is going into place, you see Hynex, you see Samsung, you see a host of players expanding NAND capacity.

While I know there is great speculation on the oversupply of NAND, I think that it’s because of the application nature of NAND, driving application. I suspect by the latter half of next year, we’ll continue to see a rebound in this particular area. So I think those are some of the comments that I made at SemiCon.

Jay Deahna - JP Morgan

Does that all sum up to capital spending next year being up, down, or sideways for the industry?

Rick Hill

I think because of the amount of expansion that will have to go into NAND Flash, I tend to think it will be up.

Jay Deahna - JP Morgan

Terrific. Thank you, Rick.

Operator

We’ll move next to Satya Kumar with Credit Suisse.

Satya Kumar - Credit Suisse

Hi, can you hear me? When do you see the NAND Flash companies adopting copper and can you help in the dynamics familiar with. I know you have a stronger PVD position in copper than aluminum. Can you help quantify the opportunity in all applications for Novellus for a copper memory fab versus an aluminum memory fab?

Rick Hill

I think the reality is the whole world will go to copper interconnect, be it 45 or 32 nanometers, some will go early. Some are going earlier than that. It will be a factor of cost. We think it is definitely a cost driver, a downward cost driver. From a standpoint of market size for copper, however, you have to remember, that in the memory market there are fewer interconnect layers. So it isn’t a matter of doubling the size of the market, but certainly it’s an increasing in the market size by 30 to 35%.

Satya Kumar - Credit Suisse

If you look at the PVD electroplating and CVD overall your available market, do you think it will be higher with copper fabs as aluminum fabs?

Rick Hill

There’s no question.

Satya Kumar - Credit Suisse

Just one point of clarification on the shipments once again in September. September shipments are 415 to 440, that’s below the 475 million bookings net point. Does that mean that December shipments can actually increase if I just look at how the bookings are progressing here?

Rick Hill

As long as we have the backlog, that could very well happen, yes.

Satya Kumar - Credit Suisse

Thank you. Very helpful.

Operator

We'll take our next question from Ben Pang with Prudential Equity.

Ben Pang - Prudential

Quick question here in terms of the NAND Flash and your outlook for the remainder of the year. In your flat to up 7% bookings guidance for the next quarter, is the biggest moving part Flash memory? The second part is, you mentioned 2007 Flash memory to be the driver for capital spending, do you expect to see any seasonality there with the NAND Flash people have to get the capacity online by the second quarter or something like that? Thank you.

Rick Hill

I think that the expansion of NAND capacity is not a one time shot, so relative to seasonality, I don’t see it necessarily seasonalized. I do see a lot of effort going into bringing on NAND capacity right now, which certainly will play into next year, but the thing is with capacity you have two elements. One, you have putting the capacity in, and then absorbing that capacity. Then you usually have a lull after that before you go to the next level. So I think that is more of a cycle trend than it is relative to seasonality. In other words, I think what you are articulizing (sic) is, gee, if it’s all going to get sold at Christmas time and you back that up, that means it better all have the capacity in by May of next year.

I think those dye are cast. I think those are the factories that will in fact, be filled up by then. But the question will be then what has to go happen next? That’s a function of what you see for the application of those devices. I’ve tried to articulate the things that we’re looking at to make sure we’re prepared and we’re focusing on the right things.

It doesn’t mean that it happens absolutely, but I think that when you look at some of the products that are coming out and the acceptance of those products and the fact that people really do want an extended battery life. They really do want instant on. I think you can see the ability to, the impact that Flash can make on the laptop market. I think the only reason you see a little bit of a lull, if you will, is because the minute everybody converts the laptops to Flash, you are in an immediate over capacity situation, and then you don’t have the ability to get the price you want.

So I think that’s the chicken and the egg situation that we’re going to be contending with over the next nine months.

Ben Pang - Prudential

Just one follow up. In the fourth quarter, do you believe that your NAND Flash, the component of your orders devoted to NAND Flash is going to be higher than the third quarter?

Rick Hill

I don’t know. I didn’t look at those numbers coming into this meeting, and typically I don’t like to comment on that forward looking (audio gap).

Ben Pang - Prudential

Thank you very much.

Operator

From Banc of America, Mark FitzGerald has our next question.

Market FitzGerald - Banc of America

On the PVD tool, can you give us some idea of where these systems have been shipped that you have been having problems with? Were there add-ons in terms of getting signed off?

Rick Hill

Thanks Mark. I think that from a standpoint of PVD, we have made sensational progress on some of the places that we’ve had issues. I don’t think we have a lot of situations where there are sign off difficulties, but aside from that I think we’ve extended the technology beyond even where we thought we would be at this point in time. I’m looking forward to seeing that operation continue with the level of execution that I’ve seen since the beginning of the year.

Market FitzGerald - Banc of America

So it’s basically the support that you’ve been giving them in the last 12 months that’s behind us, in terms of an expense?

Rick Hill

I think that from a standpoint of expense, we’re going to have as you’ve seen, our R&D expenses has stayed pretty flat. To the extent revenues go up, I don’t see huge infusions necessary in that business.

Market FitzGerald - Banc of America

Okay. Thank you.

Operator

We’ll move next to Deutsche Bank’s, Steve O’Rourke.

Steve O'Rourke - Deutsche Bank

Thank you. Good afternoon. Rick, just a follow on to that question of Mark’s. Installation warranty costs and their trend, should we assume that they are flat lining now, or least coming down and steadying up?

Rick Hill

Nothing is flat lining. We don’t allow it to flat line. You can always get better. We are continued to focus on programs to continue to drive warranty costs down as well as overall service costs for our customers. I think we still have a lot of room there, although we are performing at levels of targets that we had set some time ago. We’re going to continue to drive beyond those targets.

Steve O'Rourke - Deutsche Bank

When you consider evaluation tools in the field, can you give us an idea compared to a year ago, as a percent, how many evaluation tools are out there now, in aggregate?

Rick Hill

I’d say 30% of what was out there a year ago.

Steve O'Rourke - Deutsche Bank

Fair enough. Thank you.

Operator

David Duley with Merriman has our next question.

Jennifer West - Merriman

This is actually Jennifer for Dave. I had a follow up on the warranty question. Can you give me more detail on the warranty cost? Maybe how long the acceptance periods are now? How much of a drag those were on your Q1 and Q2 numbers?

Rick Hill

I think from a standpoint of an acceptance periods, they didn’t affect the acceptance periods as much as they did the gross margin line.

Bill Kurtz

This is Bill. Let me help you. If I go back to where we were end December of ’05, since December of ’05, we’ve seen a 300 basis point improvement in our gross profit as a result of the getting warranty and installation back to standard. Now we had suffered that 300 basis points over a couple of quarters of 2005, but we now have it back to where it was before. So in terms of the impact on margins, which is what I think what you are trying to get at, we’ve recovered that 300 basis points.

As we look forward, we continue to look for opportunities across the business in operations and customer support to both reduce the cycle time, that is have installation occur faster, and have them be maintained post installation with fewer maintenance activity, all towards the objective of reducing the ongoing cost, and improving customer satisfaction. That has multiple benefits to us. So while we can’t quantify further improvements, rest assured, we are working on it, and it’s one of the programs that we are looking to help us benefit to work towards our long term model.

Jennifer West - Merriman

All right. Thank you.

Operator

(Operator Instructions) We will take a follow up question from Jay Deahna with JP Morgan.

Ajay for Jay Deahna - JP Morgan

This is Ajay with JP Morgan for Jay Deahna. We have a question on the APF films that look like they are going to be a growth driver in the CVD area?

Rick Hill

I’m sorry; could you just repeat your question? You have a question about which…?

Ajay for Jay Deahna - JP Morgan

About APF and strained films in the CVD area. I wanted to get some color on what successes have we seen in those areas? Do you see that as a growth market going forward?

Rick Hill

If you’re speaking to films relative to straining at the transistor for speed improvement, I think there is good success there at 90 nanometers and 65 nanometers. It becomes more difficult at 45 for shear physical reasons, but it is creating technological opportunities for better ways to cure the films to put the appropriate amount of tensile or compressive stress on the films, but it again becomes a very, very difficult task that does small geometries. Are you talking about actual hard mask technology?

Ajay for Jay Deahna - JP Morgan

That is correct.

Rick Hill

Hard mask technology is going to continue to grow and I think it is a particularly attractive field where we believe the expertise we have at Novellus is well suited to dramatically lower the cost as it proliferates across multiple levels. Currently, it isn’t a huge market, but I think it will become one.

Ajay for Jay Deahna - JP Morgan

Thank you.

Operator

There are no further questions at this time.

Rick Hill

Thank you very much for joining our second quarter conference call. We’re very pleased with the second quarter results and we look forward to talking with you at the mid-quarter update. Thank you very much and we’ll talk to you then.

Operator

Once again that does conclude today’s conference call. We thank you for your participation and have a great day.

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