Novellus Systems Q3 2006 Earnings Call Transcript

Oct.17.06 | About: Novellus Systems, (NVLS-OLD)

Novellus Systems (NASDAQ:NVLS-OLD)

Q3 2006 Earnings Call

October 17, 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

Steve O'Rourke, Deutsche Bank

Jim Covello, Goldman Sachs

Brett Hodess, Merrill Lynch

Robert Maire, Needham & Co

Jay Deahna, JP Morgan

Gary Hsueh, CIBC World Markets

Stuart Muter, RBC Capital

Steven Paleo, HSBC

Mark Fitzgerald, Banc of America

Patrick Ho, Stifel Nicolaus & Co

Mark Bachman, Pacific Crest Securities

Timothy Summers, Stanford Financial Group

Gavin Duffy, A.G. Edwards

Satya Kumar, Credit Suisse

Operator

Good day everyone and welcome to Novellus System’s Third Quarter 2006 Earnings Conference Call. As a reminder this call is being recorded today, October 17, 2006. I would now like to turn the conference over to Ms. Robin Yim of Novellus Systems. Please go ahead ma’am.

Robert Yim, IR

Thank you, Tony. Good afternoon and thank you for joining the Novellus Systems Third 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 third quarter 2006 were released on PR Newswire shortly after 1 p.m. 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 fourth quarter of 2006. Specific forward-looking statements include but are not limited to our expectations regarding semiconductor 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, revenue, gross margins, effective tax rate and earnings per share, our expectations that our efforts to align our legal entity structure more closely with the geographic mix of our business will have an impact on our prospective tax rate, and other anticipated future events.

We caution you 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 cause actual results to differ materially is contained in today’s press release and our filings with the Securities and Exchange Commission including our Form 10-K for fiscal 2005, our Form 10-Q for the first and second quarters of fiscal 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 such statements.

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

I’ll now turn the call over to Bill.

Bill Kurtz, Chief Financial Officer and Executive Vice President

Thank you Robin and good afternoon everyone. I’m pleased to report today that our key financial metrics for the third quarter met or exceeded the guidance we provided on our mid-quarter update call on August 30th. Bookings of $470 million were up 3% sequentially from the second quarter. By wafer size, third quarter bookings were 80% 300 millimeter and 20% 200 millimeter bringing our year-to-date bookings to 73% versus 27% for 300 millimeter versus 200 millimeter.

Third quarter shipments of $414 million were down 9% as expected and revenues likewise of $440 million were up 8% over the second quarter as expected. Third quarter revenues by geographic region were as follows: United States at 24%, Greater China and Southeast Asia at 32%, Korea 18%, Japan 17%, and Europe 9%.

Turning to gross margins, I’m very pleased to report that we made additional progress and we improved gross margins to 51% in September. Now this is the first time that we’ve exceed 50% on the gross margin line since the year 2000. The 1 point improvement in gross margin from the second quarter ’06 was driven by continued focus on operational efficiency and cost reductions. Looking forward we expect the fourth quarter gross margin to be approximately 51% as well. Also, important to note, we continued to focus on the achievement of our target financial model of 52% to 54% gross margin.

Total operating expenses for the third quarter were $128 million, which was down approximately $1 million from the prior quarter. Our effective tax rate in the third quarter was 35%, a slight decrease from the prior quarter rate of 36%.

Our third quarter net income on a GAAP basis was $70 million or $0.50 per share compared to the second quarter net income of $53 million or $0.42 per share. The primary drivers of the 36% sequential growth in earnings per share in the third quarter are, one, the 8% improvement in revenues combined with the 1 point improvement in gross margin while holding OpEx relatively flat. Now, compared to the prior year, EPS is 171% driven by 31% growth in revenues, an 8 point improvement in gross margins, and a lower share count due to stock repurchases. Excluding the impact of FAS 123R, third quarter EPS would have been $0.60 compared to $0.45 on the same basis in the second quarter.

Now, turning to the balance sheet, we ended the quarter with an improved balance sheet of $808 million of cash, short term investments, and restricted cash, which was an increase of approximately $137 million from the second quarter. The increase is primarily attributable to the positive cash flow from operations driven by net income but also to reductions in both accounts receivable and inventory. Additionally, we bought back approximately 400,000 shares at an average price of $22.79 for a total of $10 million.

Net accounts receivable decreased by $29 million to $411 million. This decrease was a result of both lower shipments but also of an improvement in DSOs from 90 days at the end of the second quarter to 87 days at the end of September quarter. Inventory decreased $15 million sequentially due to continued focus on Lean manufacturing process.

Now, I will turn to an outlook of our key metrics for the fourth quarter of 2006. We expect bookings to be flat to down 10% compared to the September quarter. Shipments are forecasted to be in the range of $410 million to $425 million, and revenue is forecasted to be in the range of $415 million to $430 million. As I mentioned earlier, we expect reported gross margins in the fourth quarter to be approximately 51%.

The effective tax rate for the fourth quarter is forecasted currently to be at 35%. As a note we are currently reviewing our legal entity structure to align it more closely with the geographic mix of our business. We expect this to have an impact on our prospective tax rate. As we are still in the planning stage, we will update you on the impact of this on the current year and the future quarters at our mid-quarter update.

Earnings per share based on the forecasted fourth quarter tax rate of 35% and including all equity compensation expense is expected to be between $0.49 and $0.53. Excluding FAS 123R EPS is expected to be in the range of $0.52 to $0.56.

With that I would like to turn the conversation over to Rick who will comment on the state of our business.

Rick Hill, Chairman and Chief Executive Officer

Thanks Bill. The bookings for the third quarter came in at about the expected level. The third quarter of ’06 was up about 2.8% from the second quarter of ’06, and the third quarter of ’06 was up about 63.9% from the third quarter of ’05. On a year-to-date basis, the third quarter ’06 year-to-date versus third quarter ’06 year-to-date were up 49.8%.

From a statistic standpoint our last peak was in third quarter of ’04. We dropped in the third quarter of ’05 which was down 32.1%, and then to the new peak we’re up 63.9%. So, we went down from the third quarter ’04 peak to the third quarter ’05 32.1%, now we’re back up at 63.9%.

Overall, I think the business is pretty steady right now. U.S. and Japan were up strongly over the second quarter. Europe and Asia were down over the second quarter. All regions except Taiwan were up dramatically from the third quarter ’05, and the third quarter ’06 year-to-date over the third quarter ’05.

So, our outlook is that the fourth quarter shows some softening as we announced in our flat-to-down percent. From a forecasting standpoint there are several major orders that could fall either in the fourth quarter or the first quarter of ’07, so that’s one of the reasons for the softening in the fourth quarter. From a standpoint of our overall financial performance in the third quarter, we exceeded 15% after tax the first time since the second quarter of 2001 and we had extremely strong cash flow, in fact a record level with $140 million from operations, which is a combination of improvement on the income statement as well as improvement on the balance sheet. So, we’re pretty happy with our overall operational performance.

The big cloud on the horizon of course is what’s going to happen in the industry; we don’t see major downturn but we do see somewhat of a softening.

Now with that I’ll open it up for any questions you might have.

Question-and-Answer Session

Operator

Thank you, sir. Today’s question and answer session is held electronically. If you would like to signal to ask a question, please press * and 1 on your touchtone phone. Again that is * and 1 to signal. We’d like to remind everyone that if you have a mute function on your phone, we do ask that you disengage that function before signaling just to be sure that your signal can reach our equipment. Once again that is * and 1 to signal to ask a question. We’ll pause just a moment to assemble our roster. We’ll go first to Edward White with Lehman Brothers.

Edward White, Lehman Brothers

Hi, thanks. I was wondering if you could talk about some of the steps you can take from here to get to your target gross margin model. It’s been good improvement so far and you’ve talked about a lot of the things that have gotten you to where you are. As you look forward, what are going to be some of the key things that can accomplish that?

Rick Hill, Chairman and Chief Executive Officer

Well, some of the key elements are new enhancements that we have coming out in products which improve our productivity and our ability to sell value to the customer, and I think those opportunities are pretty good. If we look at a majority of the pressure on the gross margin today, there are more new emerging products and in the case of SIG that’s been a depressing factor on our gross margin, and so we’ve got to focus on the cost on that particular product line, but the combination of those two I think will be the biggest thing that will get us up to the 52% to 54% model.

Edward White, Lehman Brothers

And then secondly, what about the environment that makes you feel it’s different from say it is softening as opposed to a major down turn? In other words, when you look at what you see out there, what helps you distinguish between the two?

Rick Hill, Chairman and Chief Executive Officer

Well, I think that when I just came back from several weeks in Asia and I talked with our major customers, I find that when I look at what business they’re looking at in the first quarter, and I’ve spoken about these before, 1) demand for NAND Flash and 2) memory demand that will come from the introduction of Vista and the need for both DRAM and NAND Flash for that particular introduction. I think those two factors in and of themselves will absorb most of the excess capacity that is currently in the market. So, I just don’t see this as a protracted downturn.

Edward White, Lehman Brothers

Great, thank you.

Operator

We’ll go next to Timothy Arcuri with Citigroup.

Timothy Arcuri, Citigroup

Hi Rick, two things, the first quest ion is on the shipments. I think on the mid-quarter you talked about some shipments being pushed out from the third quarter into the fourth quarter, and if I look at the shipment guidance for the fourth quarter it’s a little bit soft relative to where bookings were in the third quarter and also when you consider that there was some stuff pushed out from the third quarter into the fourth quarter. The second question is on R&D, and the savings in the third quarter, was it more specific to certain products or certain initiatives that have been eliminated or was it kind of across the board and is it sustainable going forward? Thanks.

Bill Kurtz, Chief Financial Officer and Executive Vice President

Tim, this is Bill, on the shipments. Let me comment on that and then I’ll see if Rick wants to add it with respect to a comment on R&D. With shipments you’ll recall that in the second quarter we had a very strong number and we commented at the time that some of that was because of customer dates moving up, being accelerated into the second quarter. So certainly when we forecasted the third quarter to be down that was effected by some of the pull-ins in the second quarter. As we look at where we are on a year-to-date basis, through the end of the third quarter our shipments recognized and our revenue recognized on a year-to-date basis are about the same, so we’re right now at the end of the third quarter about imbalance. So, as we look forward and project shipments for the balance of the year and revenue for the year, they’re moving somewhat in tandem at this point given that they’ve achieved balance through the end of the third quarter.

Timothy Arcuri, Citigroup

Yeah, I guess my question there Bill was more relative to bookings and not so much revenue versus shipments, but more shipments versus the bookings.

Bill Kurtz, Chief Financial Officer and Executive Vice President

Sure, in the case of bookings, there are some bookings that were made that are going to ship in ’07 and those haven’t changed actually from the original date of the orders. So, we have in our bookings some shipments that are planned for ’07, all of which are in the first half of ’07.

Timothy Arcuri, Citigroup

And then can you guys comment on R&D?

Rick Hill, Chairman and Chief Executive Officer

Repeat the question again Tim on the R&D number.

Timothy Arcuri, Citigroup

I guess Rick what I’m kind of after is you’ve saved about $2.5 million sequentially and you’re spending as low a percentage on R&D as you have at any point since the bubble back in ’00, and I’m wondering if that savings is across the board or are there particular programs that are being eliminated?

Rick Hill, Chairman and Chief Executive Officer

Well, I think it’s a combination from a percentage standpoint of the strong revenue flow, control and focus within R&D, and I think better execution overall rather than elimination of major programs. There are a couple of things that we eliminated that weren’t bearing any fruit, but the majority of it comes from more productivity, more delivering on what we had said we are going to deliver, elimination from a standpoint of completion of some joint development programs that have taken some expenses out, conversion of some eval units which have reduced overall expenses that have hit the R&D line. So, there are several things along those lines, and yes I think they are sustainable.

Timothy Arcuri, Citigroup

Thanks a lot guys.

Operator

We’ll go next to Steve O’Rourke with Deutsche Bank.

Steve O'Rourke, Deutsche Bank

Good afternoon. Rick, could you give some idea of orders by customer type in the quarter and how that trends into the December quarter?

Rick Hill, Chairman and Chief Executive Officer

I think what’s driving the industry today is clearly memory, both from a standpoint of NAND Flash and memory, but there were some strong Logic orders during the quarter as well.

Steve O'Rourke, Deutsche Bank

And how do you see the foundries trending going forward, do you expect them to come back with any meaningful increase in spending over the next several quarters?

Rick Hill, Chairman and Chief Executive Officer

Depending on the sell through at Christmas I would expect to see a resurgence in the foundry, yes.

Steve O'Rourke, Deutsche Bank

And one last question, I think on the last call you had mentioned that you thought ’07 spending would likely be up over ’06. With this softening do you still feel that way?

Rick Hill, Chairman and Chief Executive Officer

Our current prognosis when we talked before was just up slightly in ’07 and I don’t have any new data that would suggest otherwise.

Steve O'Rourke, Deutsche Bank

Fair enough, thank you.

Operator

And we’ll go next to Jim Covello with Goldman Sachs.

Jim Covello, Goldman Sachs

Good afternoon, thank you so much. Just a couple quick ones. Rick, some of the third parties who forecast NAND Flash supply and demand for 2007 are now suggesting maybe a little bit worse of an environment for NAND than they had previously indicated, demand in notebooks and other devices not withstanding, do you have any thoughts on that and in turn what that would mean about capital spending if kind of the iSupply or Gartner forecast that we’ve heard about recently wind up being correct?

Rick Hill, Chairman and Chief Executive Officer

Well, obviously if we don’t absorb the NAND capacity and we don’t get the pull from Vista, it would put us in a surplus position relative to capacity, which would be difficult to absorb. But based on my very recent conversations with customers, I don’t think they feel that way nor do we feel that way from a standpoint of our independent look at it. We think that you’ve seen some rebound in DRAM prices, which is a combination of fungible capacity that was moved over to Flash. I think we are in an absorption period with Flash right now, but when you look at the products that are coming out with increasing amount of Flash in it, I really don’t think that’s a long-term phenomena. I see nothing that changes my view that there is almost an insatiable demand for Flash and we’ll see that continue. So, what I would look for is if we continue to see a glut into February of next year in NAND, then I’d be somewhat concerned, but I don’t expect that we’ll see that.

Jim Covello, Goldman Sachs

Okay, that’s helpful I really appreciate it, and congratulations on the margin controls.

Operator

And we’ll go next to Brett Hodess at Merrill Lynch.

Brett Hodess, Merrill Lynch

Hi, Rick. Given that SIG is one of the areas that’s putting pressure on your margins, I’m wondering if you could talk a little bit about your competitive positioning there right now and the time scale that it would take to improve the margins in that area? Secondly, I’m wondering if you could talk a little bit about have…with 65 nanometer being a bigger piece of the pie next year, if you can give us a little update on what you think the share differential will be from the design wins you’ve had so far.

Rick Hill, Chairman and Chief Executive Officer

Okay, I think from a competitive position within SIG, I think we clearly have an extendable product and a product that has better overall performance. There are particular layers where we have very compelling technological advantages. There are certain layers where nobody wants to pay for that advantage, and therefore it doesn’t matter if you have it or not. That’s the particular area where we have tremendous price pressure and we’re working on taking the cost out of that product as well as expanding some differential advantage relative to productivity and other factors. Relative to 65 nanometers I think we’re extremely well positioned especially with some of our core products and I think we will gain market share with 65 nanometers.

Bill Kurtz, Chief Financial Officer and Executive Vice President

Brett, this is Bill, if I could just add on. We announced Gamma Express at the SEMICON and that product will really begin shipping next year in volume is a better margin product, so we clearly expect next year for the margins to improve as we ship that product.

Brett Hodess, Merrill Lynch

Great, thank you.

Operator

We’ll go next to Robert Maire with Needham.

Robert Maire, Needham & Co

In talking about the weakness that you’re describing or the softening I should say, is that across the board or is that perhaps more in memory because it’s been a little bit overheated? Sort of a second half of that question is that weakening or softening across all products lines or is that more in SIG or in other product lines perhaps?

Rick Hill, Chairman and Chief Executive Officer

I think that when we’re talking about a softening we’re looking at it from a standpoint of the market. Now that market is encompassed by memory obviously in Logic. I think it’s more across the board. Some of it is attributable to the fact that we see some of the spending occurring with Taiwanese memory manufacturers where we’re not as strongly positioned in their buying cycle, and so we see somewhat of a depression from that standpoint, and not only that but some question in their spending period on whether or not they can secure the funds. So, there have been some people who have forecasted spending and are now coming back and they’ve not been able to secure the money for that spending, and so I think these things are all adding up in our mind to somewhat of a little bit less clear fourth quarter, not a terrible fourth quarter but clearly not as clear as it has been in the past.

Robert Maire, Needham & Co

Okay, so it sounds from that answer that’s it’s a little bit on the memory side, that it’s a little bit weaker.

Rick Hill, Chairman and Chief Executive Officer

A little bit on the memory side, yes.

Robert Maire, Needham & Co

And secondary or tertiary players compared to the primary players…

Rick Hill, Chairman and Chief Executive Officer

That’s correct.

Robert Maire, Needham & Co

But of course your product lines, it’s kind of broadly across…

Rick Hill, Chairman and Chief Executive Officer

Broadly, you wouldn’t know the difference.

Robert Maire, Needham & Co

And one final question, you’ve always been very bullish on Flash memory and your indicated in response to a previous question your own internal views on that, any kind of views you can give us as to your expectation of bit growth for next year or capacity, I think there’s something on the order of 30 memory fabs somewhere in process out there, and your view on that market developing in ’07?

Rick Hill, Chairman and Chief Executive Officer

Well, relative to bit growth we don’t go down to that particular detail. We do in our own planning but not on the call. We think that when we look at what our expectations are for supply versus what could happen, and I’ve gone through this before relative to notebooks and the real big key is estimating the penetration within those notebooks, and that’s where the question mark comes in. Our estimation is that we’ll see accelerating bookings in the second half of next year and it’s largely driven again by NAND Flash, and that’s more so even than DRAM, but having a crystal ball is a tough deal.

Robert Maire, Needham & Co

Okay, thank you.

Operator

We’ll go next to Jay Deahna with JP Morgan.

Jay Deahna, JP Morgan

Thanks, good afternoon. Bill, looks like you’re having a really positive impact on the company, and I congratulate your on that. Rick, it looks like the bobcat is going to sleep here, is next year in like the bobcat and out like lion, but my seriously my questions are this: it looks like your cash balance is greater than 20% of market cap at this point, what’s your appetite for acquisitions, what’s your appetite to pick up the buybacks? And then I’ve got a followup question – on the order outlook ASML just torqued the orders in the second quarter and third quarter with long lead times, LAM did up 13% sequential orders in September and guided for flat for the next two basically. You seem to be underperforming those guys, is it a market share situation because those guys are gaining a lot of share or is it a situation where perhaps your exposure to customers that orders big in the third quarter versus the fourth quarter by…that might be a little bit of a difference in terms of your strength at those accounts that could account for some of it? Thank you.

Rick Hill, Chairman and Chief Executive Officer

I think first of all from a standpoint of the bookings by ASML that would be anticipated if we’re going to have a strong second half of next year given their lead times. Relative to LAM I think they’re clearly taking market share from applied materials in huge amounts in the oxide etch market and they’ve done a phenomenal job, and also they’re very well exposed to some of the DRAM players within the Taiwan market place. So I think that bores extremely well for them. I don’t think we’re as exposed as well to those players, those particular customers and their buying cycle, but overall on market share I think on our core products save one or two, particularly in PVCED we find ourselves gaining market share. As I’ve said before, we haven’t performed as we expected on PVD, but I do believe we have the technology and the capability to recoup that. But that’s the best I can give you Jay.

Jay Deahna, JP Morgan

And on the cash and acquisitions?

Rick Hill, Chairman and Chief Executive Officer

Well, I don’t think we’re going to be on the acquisition trail until we make the acquisitions that we’ve made successful. So we’re not planning to do that and relative to the buyback you’re well aware of our aggressive buyback program and the fact that we have bought back a total of 250 million this year and 613 million of the total left to go in the total $1.5 billion buyback.

Jay Deahna, JP Morgan

What’s your trigger point for that, do you just do it consistently or do you have certain evaluation points?

Rick Hill, Chairman and Chief Executive Officer

Well, you know I can’t answer that, so I appreciate it but thank you.

Operator

We’ll go next to Gary Hsueh with CIBC World Markets.

Gary Hsueh, CIBC World Markets

A few quick ones here; one what’s your share count assumption for your EPS guidance of $0.49 to $0.53?

Bill Kurtz, Chief Financial Officer and Executive Vice President

Right now the assumption is for flat share count in the fourth quarter and that’s how we normally project EPS.

Gary Hsueh, CIBC World Markets

Okay, great. And your gross margin line seems to defy gravity here, can you explain to me how you basically smooth over your 45% deferred profit rolling into PNL and how you’re driving the 51% gross margin on arguably flat to kind of down revenue numbers in December?

Bill Kurtz, Chief Financial Officer and Executive Vice President

Okay, let me try and address your questions. First on the deferred profit, you’ll notice that both deferred revenue and deferred profit, both of those went down in the third quarter and that was because as we forecasted we had shipments particularly in Japan which are not recognized as revenue until accepted. Many of those closed in the third quarter which is what caused the revenue number in the third quarter to be higher, so those all tie together. One thing to keep in mind, you can’t really take the relationship between deferred profit and deferred revenue and imply gross margin, because there is also a few other timing related effects on the recognition of build receivables that impact the deferred profit line and it will cause some variation in the quarter-to-quarter numbers between those two. So, I would not want you to use that to imply the future profit of the business. It’s not a good basis for you to do that. In terms of what has allowed us or what has enabled us to improve gross margins to where we are today, it’s a four quarter story at this point and if I try to summarize it for you, one, we did get the warranty cost under control and beyond that we found efficiencies in all parts of the business and put a lot of focus on getting paid for the products that we sell and improving the operations efficiency across the board. As we continue to drive for improvements and achieve product differentiation, we’re confident that we can get into the target range and stay there.

Gary Hsueh, CIBC World Markets

All right, one last question from me, it looks like Intel cut CapEx by $400 million here, are you seeing the impact of that in your December quarter guidance, or is that yet another shoe to drop sometime in ’07?

Rick Hill, Chairman and Chief Executive Officer

Well, we don’t comment on any specific customer, but clearly Intel is a good customer of ours and we’re very, very up-to-date on what they’re doing and we’re trying to give you the best look we can of what we believe will occur within the fourth quarter.

Gary Hsueh, CIBC World Markets

But Rick just to reiterate, last question, you said some of the weakness in December was mostly from the memory guys, is that right?

Rick Hill, Chairman and Chief Executive Officer

That’s what I did say.

Gary Hsueh, CIBC World Markets

Okay, great, thank you.

Operator

We’ll go next to Stuart Muter with RBC Capital Markets.

Stuart Muter, RBC Capital

Yeah, thanks for taking my question. I guess first for Rick in terms of Low-K dielectric films, could you talk about your market position and momentum there; I’m interested in the bulk dielectric as well as the dielectric diffusion barrier layer?

Rick Hill, Chairman and Chief Executive Officer

I think from a standpoint of our competitive position in Low-K dielectric it’s relatively know, we have a modest penetration in what is a relatively small part of the total dielectric market. In the core bulk dielectric films we’re extremely strong, also have a lot of new products relative to…hard mass and several other spacer applications. So from a standpoint of overall dielectrics, largely driven by PECVD and HDP, we’re still very strong. The situation between PECVD and HDP coupled with our new solar cure product really I think positions us extremely well for the next generation of Low-Ks, our ability to cure productively I think is an extremely good opportunity in the Low-K market, probably bigger than the deposition market itself. So, from a standpoint of PECVD gaining market share, from a standpoint of HDP, we keep flip flopping with market share back and forth with our competitor, but overall when we combine our products including our cure capability, I think there is a vector upward in dielectrics.

Stuart Muter, RBC Capital

Okay thanks that’s helpful.

Operator

And we’ll go next to Steven Paleo at HSBC.

Steven Paleo, HSBC

If this wasn’t asked for, I think Jay was hinting to it a little bit. You just posted what you said, record operating cash flow of $140 million or so, yet your stock buybacks have been averaging about $100 million per quarter and I think it was $172 million in the second quarter, yet you only did $10 million in the third quarter despite the record cash flow from operations and despite your $7 in cash on the balance sheet, so really what’s the strategy there and how aggressive are you going to get on your stock buyback? Then, I have one more question.

Rick Hill, Chairman and Chief Executive Officer

There are a lot of factors that affect the stock buyback and the only information that we disclose relative to the buyback is the amount and we have about S613 million left in $1.5 billion buyback and I think we have another three years from right now to complete that.

Steven Paleo, HSBC

Okay, the fact that it was down meaningfully quarter over quarter suggests that maybe the future rate is now going to be at a much lower level going forward?

Rick Hill, Chairman and Chief Executive Officer

It means nothing, you can’t tell anything from the past.

Bill Kurtz, Chief Financial Officer and Executive Vice President

What we can reiterate is that we continue to believe that the excess cash that the business generates beyond what we need to run the business and beyond what we need to maintain for any softness in the businesses we will put it to work to improve long-term shareholder value and you’ve seen us do that. We will pick the timing of that and it’s not going to be something that we’re going to project on a going forward basis, but you can count on us to continue to put it to work for long-term shareholder value.

Steven Paleo, HSBC

Fair enough. Last question, as we finish up 2006 here are some thoughts just on market share, I think James was hinting to the fourth quarter there, I’m curious when I look at you versus Applied or versus LAM Research on a full year revenue basis, I think you guys are underperforming there. So when you think about your market share gain, explain if that’s just customer shifts in patterns or do you think that maybe there was something else more there?

Rick Hill, Chairman and Chief Executive Officer

Well, I think what the major customers were focusing we continue to gain share. I think we have some erosion of share in HDP, but I think we’re recouping that share. And as I highlighted before when we talk about DRAM manufactures within Taiwan and we’re not well positioned, so I think when their cycle is buying it will tend to be somewhat suppressed.

Steven Paleo, HSBC

Okay fair enough, last question Bill, is the industrial group still running about $30 million a quarter in revenue?

Bill Kurtz, Chief Financial Officer and Executive Vice President

They run about $25 million to $30 million.

Steven Paleo, HSBC

Okay, is that consistent?

Bill Kurtz, Chief Financial Officer and Executive Vice President

Yes.

Steven Paleo, HSBC

Thank you.

Operator

And next is Mark Fitzgerald with Banc of America Securities.

Mark Fitzgerald, Banc of America

Can you give us a quick update on both CMP and PVD headway in the quarter in terms of achieving goals on market share, do you think you can tell us about those segments?

Rick Hill, Chairman and Chief Executive Officer

Well, I think from a standpoint of both PVD and CMP we have a very well-defined program with them, we’re very satisfied with the progress that they making. We feel that the products offer the customers significant value, and we’re going to be able to start seeing the fruits of some of that value in the near future.

Operator

We’ll go next to Patrick Ho with Stifel Nicolaus.

Patrick Ho, Stifel Nicolaus & Co

Thanks a lot. Can you give a little more color in terms of some of the improvements you’re making on the cost of goods in terms of I guess the production or the manufacture of your tools and how that’s helping gross margins?

Bill Kurtz, Chief Financial Officer and Executive Vice President

Sure, this is Bill, I can comment. There are several things we’ve been working on that we discussed on prior calls. One is lean manufacturing, and lean manufacturing has been a focus here for the last two years and you’ve seen the effect both in the improvement in gross margin that it’s contributed but also in the reduction of inventory. So, having a real focus around making sure that our bill of materials are scrubbed to meet customer requirements but not over above that and keeping the smallest amount of inventory in place to improve both cycle times and reduce the risk of obsolescence that contributes. We’ve had a strong focus on installation and warranty, and that’s probably had the biggest leverage point that we’ve seen in the past 12 months, and we continue to see opportunity for further improvement in there as well. And then finally, we have been working with our vendor base to continue where possible to consolidate and get better economies of scale. All three of those have contributed over the past year to help us improve our margins to where they are today and we are confident that those margins are both sustainable, and with some additional improvements in our product enhancements we are very confident that we can realize our target model of 52% to 54%.

Patrick Ho, Stifel Nicolaus & Co

Great, thank you.

Operator

And next we’ll go to Mark Bachman with Pacific Crest.

Mark Bachman, Pacific Crest Securities

Thank you for taking my call. Rick, I just like to start out, if we can go back to Mark Fitzgerald’s question, can you just comment a little bit more on what progress has been in CMP and PVD during the third quarter, I just like to get an update, have there been any notable wins, has anybody pushed back on you, what is happening?

Rick Hill, Chairman and Chief Executive Officer

We’re just not going to discuss that level of detail relative to the products. These are public calls and it doesn’t do anything for us to discuss our competitive position or things that we’ve accomplished during the quarter to allow our competition to adjust. I’m really not trying to evade the question. I just don’t want to disclose information that I wouldn’t want to give my competition an advantage of. I mean that’s the only reason I don’t want to delve into that.

Mark Bachman, Pacific Crest Securities

Okay, fair enough, Bill, just one quick followup to Steve’s question, what was it that actually prevented you this quarter from being more aggressive with the share buyback?

Rick Hill, Chairman and Chief Executive Officer

Mark, there are many factors that determine whether or not you can buy back in a given period. Sometimes you’re doing things that are unrelated to the business that might cause you to stop a buyback for a period of time. The only thing we’re going to disclose about the buyback is the fact that we have been authorized to buyback up to $1.5 billion of shares. We’ve bought back close to $900 million and we have $613 million to go. We’ve got three years to do it in, and that’s all we can comment on relative to that. We don’t comment on when or why we buy back, but we try to do it in as fair a fashion as we possibly can when we think it’s best for the overall shareholder value.

Mark Bachman, Pacific Crest Securities

Okay, and then maybe we could just try one other here. Bill, did the deferred profit line boost gross margin at all in the third quarter, and then looking into the fourth quarter is the other income line going to be stable there, is it helping out the EPS at all more in the fourth quarter than in the third?

Bill Kurtz, Chief Financial Officer and Executive Vice President

Okay, on deferred profit, as you’ll know, it changed from the second quarter which was $80 million and it went down to about $75 million, so a drop by about $5 million. As I mentioned the primary reason for that were the acceptances in the third quarter that we had projected with our revenue number. You’ll also see a decrease in deferred revenue. As I pointed our you really can’t imply a gross margin by aligning the deferred profit with the deferred revenue, so I don’t think that was your question but rather the change in the deferred profit was a function of the acceptances in the third quarter, principally in Japan, that were shipments in the second quarter. As far as the other income is concerned we had a slightly level in the third quarter that I would expect on an ongoing basis there was some foreign exchange effects, foreign currency revaluation effects that I wouldn’t project going forward. So, somewhere between the $7 million to $8 million range is a more sustainable range for the company.

Mark Bachman, Pacific Crest Securities

Thank you so much.

Operator

And next we’ll go to Tim Summers with Stanford Financial Group.

Timothy Summers, Stanford Financial Group

Thanks for taking my call. Bill, getting back to the gross margin question for a second are you seeing any price pressure on some of the larger components that you purchased from some of the suppliers that is causing you some concern on the gross margin line?

Bill Kurtz, Chief Financial Officer and Executive Vice President

Well, we have experienced this year some upward pressure particularly in aluminum where aluminum prices have gone up, energy prices have gone up. So, we have had to absorb increases in some of the components that we purchased and some of the subsystems, but overall we still have been able to find efficiencies and get a net reduction. Now, going forward you always fight that battle. This year was also a bit challenging because the supply chains were being stretched pretty tight as the demand accelerated and everybody was looking for parts to make shipments, so there was a bit of a head wind as well because of the demand. Going forward we expect the conditions to be similar as they are right now and therefore we continue to look for efficiencies and offset the increases where possible.

Timothy Summers, Stanford Financial Group

As a followup Rick, you have mentioned in prior calls and meetings that you thought that business was becoming a little bit more seasonal which might suggest order rebound in the first half of ’07 followed by a sort of a pause in the second half of ’07, is that still your sort of global outlook as we look into 2007? Thanks.

Rick Hill, Chairman and Chief Executive Officer

I don’t think I said it was more seasonal. I’ve always commented that I think that there is a more rational deployment of capital going on because there aren’t huge dollars being funneled into the semiconductor industry from a standpoint of the equity markets nor is there subsidized debt going into the semiconductor market. And as a consequence, our customers try to match their supply more closely to their demand, and when they do bring on capacity you want to be able to fill that demand as quickly as possible. So they’ve gone to instead of putting entirely new factories at one swoop, they’ll split it up into phases anywhere from three to four phases and as a consequence you have smaller increments of capacity coming in line, which sort of mute the peaks and the mute the valleys. So, if that is termed seasonality, then maybe it’s been interpreted that way, but it’s more a function of the market I think responding differently. I see there is more correlation to consumer markets today than necessarily industrial markets, and clearly the implementation of Vista has a consumer potential impact that is anticipated to occur at the beginning of the next fiscal year which starts in January and February. We feel that the combination of increased demand on DRAM as well as Flash for that particular product introduction will go a long way to absorbing some of what is viewed as over capacity in both the DRAM market and the Flash market, and I think you’re seeing some of that begin within the DRAM market largely due to corporate beginning to adopt Vista starting to see that and upgrade. So, I think that is what I think is driving the market and that’s the best look I can give you. Looking out in the future is never easy, so I just to try to share the same information we have in our planning cycles.

Timothy Summers, Stanford Financial Group

All right, that helps, thank you.

Operator

We’ll go next to Gavin Duffy with A.G. Edwards.

Gavin Duffy, A.G. Edwards

Yeah, thanks guys. I just had a question Rick about, you said if we have a healthy Christmas season foundries could be a bigger percentage of business next year. So, if we do have a normal Christmas season, how would you kind of see it break out between the foundries, kind of the memory guys, etc. for next year, just rough guess?

Rick Hill, Chairman and Chief Executive Officer

Well, I think that if you look at the investment cycle clearly memory has been strong. When I say memory we’re talking DRAM and Flash. A lot of times I think you can almost throw Flash in with Logic, but we won’t for this discussion. I think that from a foundry standpoint one of the big delays in the foundry business has been driven largely by delays I believe are partly in the PlayStation and the demand for higher end graphics where it’s much more demanding technology and at the larger nodes. I suspect and I hope to see this start to get rectified with the introduction of the PlayStation3, which I know everybody is familiar with, was delayed again recently. But I think that’s one major factor in it, probably more so than anything else. Going into 2008, of course we have an olympic cycle coming up, which is definitely not the level it used to be, but clearly does cause an increase in purchases of consumer electronics, flat panel, I suspect HDTV, there’s a big conversion coming up here in the not too distant future on HDTV broadcasting, so I think that’s going to be another factor that’s going to drive demand. So, those are the big factors and I think when you look at the foundries and you look at the fundamental engine that’s going to keep that going, there are two factors. One, it’s going to be further rationalization of IDMs that are getting out of putting their own manufacturing facilities, and I still think that looks promising for the foundries and you’ll see that continue into ’07. So, as a consequence we need to see a resurgence of investment there. Then, as the demand for more graphics, processors, and specialized high performance devices increases with consumer electronics, you’ll see again a great absorption of the capacity there. So, I think those are the major two factors and that’s why Christmas is a big one normally, because clearly the consumer market is a big factor at Christmas time.

Gavin Duffy, A.G. Edwards

Just one more question. We’re actually hearing from some sources that next year for Vista when it comes out that it will actually half a gig just for graphics of DRAMs, so do you think that the industry is underestimating the amount of DRAM it’s going to take to effectively Vista with all the bells and whistles next year?

Rick Hill, Chairman and Chief Executive Officer

That’s been a factor driving our forecasting models and depending upon how quickly Vista is converted, I think you could potentially run into shortage.

Gavin Duffy, A.G. Edwards

All right, thanks a lot.

Operator

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

Satya Kumar, Credit Suisse

Hi, I had to jump off, Rick, in between so I’m sorry if this was already asked. I just want to make I understood what you said, you said there were some large orders ahead of you which would seem to suggest that bookings may be sustainable at these levels going into the early part of next year or you more thinking of softening. Given that your backlog will over $0.5 billion exiting this year, is it reasonable to think that shipments and revenues will accelerate in the first quarter next year?

Rick Hill, Chairman and Chief Executive Officer

What I mentioned relative to large orders, there are a couple of large orders that are now viewed as potentially happening in the first quarter rather than the fourth quarter, which I think has affected our view of the fourth quarter. In previous conversations I’ve indicated that we came in this year extremely strong like the lion, out like a bobcat, more like a pussycat right about now. The reality is we’ve also said that we thought that next year we’d come in like a lamb and go out like a lion. We still think that’s true although the reality is with some of these potential orders if they slip over into the first quarter, the first quarter might look better. I think overall as I said at the beginning of the call, I don’t see the market at this time going down radically largely for the reasons I’ve articulated, the rational deployment of capital. And having just come back from a long time in Asia and talking with a lot of customers, I think everyone is seeing a similar phenomena and everybody is relatively confident that given strong demand for Vista, good acceptance of the game market place, and the expansion of NAND Flash into notebooks that next year, even though at this point in time there appears to be excess capacity that could be very easily absorbed and we won’t see a huge downturn.

Satya Kumar, Credit Suisse

Thanks for the clarification. Can I get a quick followup? I’m just trying to reconcile the growth rates you’re seeing relative to some of the others players in the market, and I guess part of the reason you’re saying is you might have less leverage to some of the Taiwanese DRAMs and we did see some of the big microprocessor guys cut CapEx, but is there anything else that’s going on in your core business, something like for example film thicknesses, potentially are they changing in a way that it impacts the relative growth rates of the market you participate in. Lots of people in the industry are talking about something called 300 millimeter prime, does this in anyway increase or change the productivity of your system that could perhaps be impacting the market size for the segment that you participate in?

Rick Hill, Chairman and Chief Executive Officer

Well, I think if you obviously look deeply into the market because it’s always been a factor with Novellus with our focus on productivity is we tend to shrink markets. You can shrink markets by shrinking the thickness of the film and having throughputs increase because you’re not putting down as much paint or you can shrink the market because you’ve improved the throughput of your system because you can deposit the film at a greater rate. That has been historical in the market place. You only need to look at Novellus’ introduction of copper into the industry. It basically killed the metal etch business and it dramatically shrunk the PVD market place. That is a methodology we’ve used from a standpoint of competition and it’s why we believe we can continue to compete is because we continually try to increase the value we deliver to our customers. It has been one of the factors that’s helped us in improving our gross margin this year by improving the throughputs and the quality of the films and the products we’re delivering have all helped us also firm up our pricing capability in the market place, and we’re continuing to drive that and in fact have new products that will come out which will even drive it even more. The net being, however, that we want gain more market share and continue to grow the top line and given the fact that we’ll have another record year relative to our revenue line, I think we are successful in doing it. This business is not the same as it was before, but we have a goal of trying to continue to grow and maintain our profitability at a given level and I think we’re being successful at it.

Satya Kumar, Credit Suisse

Thank you.

Operator

This is all the time that we do have for our question and answer session today, and I would like to turn the conference back for any closing or additional comments.

Rick Hill, Chairman and Chief Executive Officer

Thank you very much for joining us for the third quarter earnings report. We look forward to talking with you at the mid-quarter and we look forward to a good fourth quarter and continued strength in the semiconductor industry. Thanks very much.

Operator

This does conclude today’s conference. We do thank you for your participation. You may disconnect at this time.

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