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Novellus Systems, Inc. (NASDAQ:NVLS)

Q4 2006 Earnings Conference Call

January 24, 2007 4:30 pm ET

Executives

Robin Yim - VP, IR

Bill Kurtz - EVP & CFO

Rick Hill - Chairman & CEO

Analysts

Satya Kumar - Credit Suisse

Edward White - Lehman Brothers

Jim Covello - Goldman Sachs

Harlan Sur - Morgan Stanley

Brett Hodess - Merrill Lynch

Steve O'Rourke - Deutsche Bank

Gary Hsueh - CIBC World Markets

Timothy Arcuri - Citigroup

Mark Fitzgerald - Banc of America

Stephen Chin - UBS

Mahesh Sanganeria - RBC Capital Markets

Bill Ong - AmTech

Patrick Ho - Stifel Nicolaus

Daniel Berenbaum - Susquehanna Financial Group

Steven Pelayo - HSBC

Mark Bachman - Pacific Crest

Jay Deahna - JP Morgan

Presentation

Operator

Welcome to Novellus fourth quarter 2006 earnings conference call. As a reminder, this call is being recorded today, January 24th, 2007. I would now like to turn the conference over to Ms. Robin Yim of Novellus Systems. Please go ahead, ma'am.

Robin Yim

Thank you, Deanna. Good afternoon, and thank you, for joining the Novellus Systems fourth quarter 2006 earnings conference call. Joining me on the call today are Rick Hill, Chairman and Chief Executive Officer, and Bill Kurtz, Executive Vice President and Chief Financial Officer. Financial results for our fourth quarter and fiscal year 2006 were released by PR Newswire shortly after 1:00 PM Pacific 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 first quarter of 2007. Specific forward-looking statements include, but are not limited to, our expectations regarding semiconductor industry growth and capital equipment spending, our progress in securing bookings with leading semiconductor manufacturers, the demand for and competitiveness of our products, our expectations that we will continue to maintain our position or grow market share, management's projected bookings, shipments, revenues, gross margin, reduced tax rate beyond 2007, and earnings per share targets for the first quarter of 2007, our financial model for 2007 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 results contemplated.

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 and our Forms 10-Q and 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 fourth quarter and fiscal year 2006, followed by guidance for the first quarter of 2007. Rick Hill will provide an overview of the business conditions, and we'll open up the conference call for a question-and-answer session. I'll now turn the call over to Bill.

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Bill Kurtz

Thank you, Robin, and good afternoon, everyone. Each of our Q4 key metrics, except shipments, met or exceeded the guidance we provided on our mid-quarter update on December 4th. Net bookings of approximately $442 million were down 6% from the third quarter compared to our mid-quarter update guidance of down 6% to 10%. The decrease in bookings was caused primarily from decreased demand from both logic and memory customers.

By wafer size, Q4 bookings were 90% 300 millimeter, 10% 200 millimeter for the quarter and for the year, 80% 300 millimeter, and 20% 200 millimeter. Net new orders for the year in total were approximately $1.8 billion, an increase of 43% over 2005. Fourth quarter shipments were $390 million, down 6% compared to the prior quarter, and came in below our revised guidance range of 410 to 420, due to customer push-outs of deliveries from Q4 '06. Shipments for the year were approximately $1.6 billion, an increase of 21% over 2005.

Revenues in Q4 were approximately $439 million, down 1% from the September quarter, and were at the high end of the mid-quarter guidance range of $430 million to $440 million. Our year-end backlog at the end of the fourth quarter was approximately $566 million. Revenues for the year were approximately $1.7 billion, an increase of 24% over 2005.

Our fourth quarter revenues by geographic region are as follows: United States 29%, Greater China 29%, Korea 15%, Japan 16%, and Europe 11%. Fourth quarter gross margins were slightly higher than the previous quarter at 51.4% and for the year, gross margins improved to approximately 50% overall from 45% in 2005. That's a 500 basis point improvement over the last 12 months on average.

Total operating expenses for the quarter were approximately $124 million, which were down approximately $5 million from the September quarter due primarily to the anticipated savings from our holiday shut down, as well as an approximate $2 million restructuring benefit to expense resulting from an improvement in the estimated sublease income for our Arizona lease facilities.

For Q4, operating margin came in at 23% on a GAAP basis, and approximately 23% on a pro forma basis. For the year, operating margin was 18% on a GAAP basis, and 19% on a pro forma basis. And the improvement on the year-over-year basis was nearly 840 basis points. Now, it's also important to note that the improvement in operating income and operating margin includes covering an additional $27 million of stock comp expense associated with the implementation of FAS 123(NYSE:R) in 2006 that was not included in the 2005 results.

Now, as I discussed on our last two calls, we have been working to improve the alignment of our legal entity structure with the geographic mix of our business. In the fourth quarter, we implemented a new, global business structure to manage the business we have with our international customers. As a result of this implementation, we recorded an incremental tax expense of $46 million. This was partially offset by an $8.5 million benefit attributable to the settlement of an IRS audit.

As a result, our fourth quarter GAAP tax rate was 62%. For the full year, our 2006 effective tax rate was 44% on a GAAP basis, and 33% on a pro forma basis. For fiscal year 2007, we would expect a reduction in our effective tax rate to approximately 30% to 32%, reflecting the benefits from phasing in the implementation of the new global business structure. In addition, we anticipate further opportunities to improve our tax rate in 2008 and beyond with a full implementation of our new global business structure.

Fourth quarter GAAP net income was approximately $43 million or $0.34 per share on a fully diluted basis, including the special charges and benefits noted in my previous comments. There is a table in the press release that itemizes all of the special charges and benefits for you. Fourth quarter pro forma net income was approximately $79 million or $0.63 per fully diluted share. This compares to a third quarter net income of $70 million or $0.50 on the same basis.

Now, the primary driver of the improvement in our pro forma net income and EPS in Q4 are a slight improvement in gross margin, combined with the savings realized from the shut down, along with lower income taxes resulting from the reinstatement of the R&D credit and a higher than forecasted deduction for ETI for the year.

Now, excluding the impact of FAS 123R, fourth quarter EPS was $0.67, an improvement of $0.07 from what we reported in the third quarter. For the year, pro forma EPS excluding FAS 123(R) was $2, and this compares to $0.86 on the same basis for the prior year. Now, that represents 133% improvement. And this is the best comparison that you can make to understand our year to year improvement in the business.

Now, turning to the balance sheet, we ended the year with $993 million of cash, short-term investments and restricted cash, which represents an increase of approximately $200 million for the year. This increase in cash resulted from very strong cash flow from operations of $447 million, partially offset by approximately $250 million used for stock buybacks in 2006. There were no stock buybacks in the fourth quarter.

Net accounts receivable at the end of Q4 totaled $311 million, a reduction of $81 million for the year. The reduction in accounts receivable was a result of a combination of improved collections, and the impact of factoring of Japanese customer receivables in the fourth quarter. This implementation of factoring did accelerate approximately $65 million of receivables into cash in the fourth quarter.

Overall, our DSO on a shipments basis improved to 67 days, down from 99 days in the prior year. Inventory went up slightly due to shipment push-outs as I noted. However, despite this small increase, inventory turns still improved to 4.2 times this year, an improvement of 24% from the prior year.

Now, I will complete my comments with a summary of the financial outlook for the first quarter. First, bookings are forecasted to be down 5% to 10% on a sequential basis compared to the fourth quarter. Shipments are forecasted to be in the range of $400 million to $420 million, a growth from the prior quarter. Revenue, on the other hand, is forecasted to be in the range of 395 to 405.

Now, both shipments and revenues are impacted in Q1 by the implementation of our new global business structure, which causes some delay in our recognition of shipments and revenues in Q1. This is a one-time impact that is timing-related only. We estimate the implementation subtracted approximately $20 million of shipments and $10 million of revenue that would have otherwise been recognized. This difference will fall into Q2.

Gross margins are forecasted to be approximately 49% in Q1. The sequential decline in gross margin in Q1 is primarily the result of both customer and product mix. We remain focused on our goal to achieve our long-term gross margin model of 52% to 54%. Our effective tax rate in Q1 is expected to be approximately 31%. EPS, excluding any additional restructuring or stock comp -- and including stock compensation expense, is expected to be in the range of $0.41 to $0.44. Excluding stock compensation expense, EPS would be $0.44 to $0.47.

So with that, I'd like to turn the call now over to Rick.

Rick Hill

Thank you, Bill, and good afternoon, ladies and gentlemen. And thank you for joining our fiscal year 2006 year-end conference call. As Bill has just reported to you, we had record bookings. Those bookings of $1.786 billion eclipsed fiscal year 2000 bookings of $1.631 billion. Record shipments of $1.616 billion eclipsed, again, 2004 shipments of $1.39 billion. Record revenues for 2006, $1.658 billion eclipsed 2004 record revenues of $1.36 billion, so pretty good performance on that topline.

In addition, we had record cash generation in 2006 of $447 million, partly contributed to -- approximately $65 million of that was due to a factoring implementation of Japan receivables during the fourth quarter. In 2006, we generated $235 million in net income, and that's, again, a second only to fiscal year 2000. That was including stock comp at $235 million, and it was $253 million without stock comp. In 2006, our earnings per share of $1.86 including stock compensation, again, was second only to fiscal year 2000 of $2.40. Without stock option, our earnings per share in 2006 was $2.

Quarter four was an exceptionally good quarter. Our earnings per share of $0.63, again, was second only to the fourth quarter of 2000. So in quarter four, we hit 18% after-tax profit, including stock comp, and 19.1% after-tax without stock compensation. All in all, it was a great year. Successes during the year include growth in most areas, improvement on our financial model, and great strides on product performance across-the-board. Disappointments in PVD, we didn't achieve our targeted revenue for the year, and so we have to redouble our efforts in 2007.

Now, let's talk a little bit about bookings, shipments and revenues. Bookings came in at the level expected despite substantial push-outs. And shipments were below expectations due to push-outs, and that will affect revenues adversely in Q1 2007 as Bill has reported. Revenue came in about where we had expected at the mid-quarter update. If I look at gross margin, we see some pressure on gross margin. It is due largely to mix of both customers and product, and we do see ourselves still on the track to be able to achieve our 52% to 54% model, as Bill has articulated.

On the balance sheet front, a lot of good news. Cash has built back up to $1 billion, despite the fact that over the year, we repurchased $250 million in stock in 2006. That was 10.4 million shares. So that average price was a little bit less than $25 per share. We improved our DSOs. We only had a slight uptick in inventory, you might note, in the quarter, and that was despite the fact that we had the significant push-outs we did have. Our property, plant, and equipment is trending downward as we predicted, as we carefully manage any capital improvements and expenditures.

Going forward, Bill has told you that our bookings outlook in the first quarter is down 5% to 10%. We see this caused by a weakening somewhat in Japan. Korea remains relatively stable. The US is beginning to weaken. Europe is weakening. And Greater China is stable. Shipments are up 3% to 8%, partly due to those push-outs now going up into the first quarter. And it's offset by some timing issues, due to the creation of our international subsidiary and some timing of recognition of shipments and revenue. Revenues will be down 8% to 10%, tracking along with the bookings.

From a standpoint of gross margins, as Bill said, we're expecting around that 49%, approximately 49% number. Again, that can vary depending upon what happens during the quarter with relative push-outs or pull-ins and the mix of customers. Our earnings per share is projected to be off in the first quarter to $0.41 to $0.44.

So, overall, we think it's extremely a good year for Novellus. We believe that we're extremely well positioned with our entire product portfolio this year better than we've ever been positioned. We do see a slight pause in the market. We've articulated our view of this in the past. We don't see a huge fall off, and we are projecting to see a pick up in the latter half of 2007.

So with that, I'll open it up to any Q&A you might have.

Question-and-Answer-Session

Operator

[Operator Instructions]

We will go first to Satya Kumar.

Satya Kumar - Credit Suisse

Yes, hi. Thanks for taking my question. Rick, on this pick up that you talked about that you're seeing in the back half of the year, that seems to contrast pretty sharply with what Lam talked about last week, where they talked about memory being down 40 to 50% in the back half.

Could you help us reconcile what you might be seeing that might be different than what Lam is seeing, i.e., is this because of your lower exposure to some of the Taiwanese DM companies, are you more exposed to some of the logic guys are spending, but more in the back half?

Rick Hill

Well, again, my projection of what's going to happen in the future is a function of what I think capital expenditures are going to become, relative to our customer set. We are strongly exposed to the memory business. I remain bullish on memory, both flash and DRAM. DRAM being driven, as I said before, by the implementation of Vista, so I expect to see that continue.

I also expect to see foundries pick up in activity as we see more consolidation within the industry and the movement to fabless semiconductor companies within the United States, hence further shipped away from the US producing capability.

I think on the Flash front, I think you're going to see more and more hard drive replacement by NAND Flash toward the end of the year. And I think again, that will help absorb some of what is viewed as excess capacity in the Flash market. But predicting the future is an inexact science at the best. And so this is what our views are. But there's no certainty that those will occur, and I did not, or do not listen to the Lam reports. We try to look at our own data independently. So that's the best I can do to help you.

Satya Kumar - Credit Suisse

That's helpful, Rick. If I can ask a quick follow-up. I noticed that share count was a bit -- was flat in the quarter. Can you talk a little bit about buyback strategy here?

Rick Hill

Well, as you know, we still have an additional $500 million available to us for a buyback. That's the most information we give out relative to our strategy on buyback. And during the quarter, I do not believe we bought any shares back.

Satya Kumar - Credit Suisse

Thank you.

Operator

Thank you. We’ll next to Edward White of Lehman Brothers.

Edward White - Lehman Brothers

Hi. I was wondering if you could talk a little bit more about the push-outs that you mentioned. Any particular pattern there, or does it give you any information on how your customers are looking at the year?

Bill Kurtz

I think that the push-outs that we're seeing currently are driven largely by strategies of companies to decide whether they're going to outsource or insource, more than anything else. And as a consequence, I don't think it's a long-term trend. I think it's a reorganization of where devices are going to be produced.

I think it is a short-term phenomena, as I do believe that the fundamental technologies these companies have are strong, and the underlying demand for semiconductors remains good.

Edward White - Lehman Brothers

One follow-up. On PVD, you said you were going to revisit that this year, take another look at strategies there. Can you give us some sense as to some of the things you may be thinking about for that business to improve the performance this year versus last year?

Bill Kurtz

Well, I would say that there's no revisiting PVD. We believe that this year, we had some -- or last year, we had some difficulties at nodes down at 45 nanometers and below. I believe all of those technical problems are behind us. But it did impact our penetration within this year. And I believe we'll be able to overcome that in 2007. But that's as most revisiting we're doing.

Edward White - Lehman Brothers

Okay, great. Thank you.

Operator

Thank you. We’ll go next to Jim Covello with Goldman Sachs.

Jim Covello - Goldman Sachs

Hi Rick. Thanks so much for taking the question. The first question I have is, you've always talked about how it's important that your customers are making money in order for them to continue to invest. And especially on the NAND side, we're at the point where these guys are losing a lot of money now. So how do you think about that?

And then in conjunction with that, how fungible do you think DRAM and NAND capacity is? Obviously, we saw a lot of DRAM go to NAND when NAND was tight. Now that NAND is very loose, do you see any of that sliding back to DRAM? And if you do, what implication does that have? Thanks.

Rick Hill

I think obviously our customers need to make money in order for them to continue to invest. So that hasn't changed, and can't change. I think there are clearly people who are making money relative to NAND Flash. There are people who are losing money relative to NAND Flash.

I believe that there are some very efficient producers who have a very sound Flash strategy and will continue to drive that strategy. And I do believe that there is a significant fungibility between DRAM and NAND Flash, and you will see that.

Jim Covello - Goldman Sachs

And so does that concern you relative to maybe some of the orders that the DRAM companies are forecasting for later on in 2007? In other words, can they get some of the incremental capacity they need from the excess NAND, as opposed to making new orders to the equipment suppliers?

Rick Hill

I think where it would concern me most would be in more the lower market share NAND suppliers. Because they -- getting into the market late, and the lion's share of the players who are very, very competitive and can switch their NAND back to DRAM would fundamentally wait until a large segment of their investment were made.

And then they would make that switch in the hopes of eliminating that investment. You wait until your guy invests -- your competition invests their funds, and then you take the market away from them. And so I think that will tend to be what you'll see. So if some of your late DRAM investors begin to invest now, I think what they will find is the market will implode on them.

Jim Covello - Goldman Sachs

Thank you.

Operator

Thank you. We’ll go next to Harlan Sur of Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi. Good afternoon. Question for you, Rick. Given the weakness that we've seen here in the non-memory segment part of the semiconductor market, just your thoughts as it relates to foundry and IDM spending, CapEx spending in the first half of this year.

Rick Hill

Well, I think when you look at the announcement that TI just made the other day, there's no way that you can be anything but bullish on the foundries. They've demonstrated their ability to provide cost effective semiconductor technology, and even beyond that, provide state-of-the-art technology. I think that's true in Taiwan, as well as mainland China. And I think these are huge monumental shifts that are going to have significant impact, positive impact on the foundry model.

Harlan Sur - Morgan Stanley

Okay. But as it relates to a more sort of near term and first half of this year, what are your thoughts there?

Rick Hill

I think you'll begin to see foundries picking up their capital expenditures in order to absorb increased demand from people who are getting out of the fab business.

Harlan Sur - Morgan Stanley

Okay, great. Thank you. And then a question for you, Bill.

Bill Kurtz

Yes.

Harlan Sur - Morgan Stanley

The R&D spend is down about 7% sequentially, and as a percent of sales that's the lowest I've seen in the past several years. So the question is, is this a level that can continue to support the product development activities in PVD, CMP and strip? And if so, where did those incremental R&D dollars come out of?

Bill Kurtz

Yeah. The fourth quarter, as I pointed out, does include the effect of our shut down, which does impact the R&D number. You should probably go back to the third quarter number to get a more normalized run rate for R&D going forward. And at that level, we are -- we have the funding we need to support the product plans and the growth of our business.

Harlan Sur - Morgan Stanley

Okay, great. Thank you.

Operator

Thank you. We'll go next to Brett Hodess of Merrill Lynch.

Brett Hodess - Merrill Lynch

Good afternoon. Two questions. Given that the gross margin goal is still intact, I'm wondering if you can give us some kind of a thought across the year about how your internal cost programs on the products will rollout. Is there a point in the year where we might see an acceleration in the move towards that gross margin goal?

Rick Hill

Well, I think you will see that the gross margin will vary quarter-to-quarter, one on mix and one -- from a customer mix standpoint, and one on mix standpoint from the product. But what you'll also see is that gross margin will tend up as volume tends up. So at lower volumes, of course, you always have the fixed cost nut you have to crack. So that will be pressuring downward.

But new products and substantial new highly technical products I think bode well for us going forward. So it's hard to project that it would be a linear function. I think you'll find it will be much more of an up significantly in one quarter, moderately down in another.

Brett Hodess - Merrill Lynch

Great. Thank you.

Operator

Thank you. We'll go next to Steve O'Rourke with Deutsche Bank.

Steve O’Rourke - Deutsche Bank

Thank you. Good afternoon. Rick, I think you mentioned substantial push-outs when you talked about bookings in your prepared remarks. When you think about the foundries also, and utilization potentially going down below 80% here in the first half, usually when you get push-outs in orders, it's not just a one quarter thing. What gives you confidence that it may just be a one quarter thing?

Rick Hill

Well, I don't think I alluded to it being a one quarter thing.

Steve O’Rourke - Deutsche Bank

Okay.

Rick Hill

In fact, we projected -- we said we had push-outs at the end of the fourth quarter in our mid quarter update. And I just told you we expect to see some push-outs within the first quarter. Whether or not it continues into the second quarter, I don't know. But then we do believe the second half will be up -- upward as we see the success of Vista as one, and I think a penetration of NAND Flash into laptops for two.

Steve O’Rourke - Deutsche Bank

Okay. And one other question. You also alluded to something, TI aligning with TSMC, Freescale maybe aligning with IBM. What do these partnerships mean for broader tool selections at the leading edge? What does it mean for Novellus?

Rick Hill

Well, all of the semiconductor companies in the world are our customers, and we're engaged with them. I think what it does, is it will start to narrow the number of evaluation sites that we're at, which is a good thing. I mean, if you talk about R&D, this will help our R&D because we won't have to engage on as many fronts. But we're still competing to supply that capacity with the best technology at the lowest cost we possibly can.

And I think that when you look at the pressure our customers have on lowering their costs, our knowledge, skills, and ability in productivity coupled with technology is very, very good. And we have to demonstrate that by winning our lion's share of the business. And I think we've got a great slate of products that are in pretty darn good shape right now that should be able to have us garner more than our fair share going forward.

Steve O’Rourke - Deutsche Bank

Thank you.

Operator

Thank you. We'll go next to Gary Hsueh with CIBC World Markets.

Gary Hsueh - CIBC World Markets

Thanks for taking my question. I've got two questions here for you. It looks like you're seeing a little bit of a pick-up in shipments here in the March quarter, just due to an artifact with your relocation of your headquarters and your tax base. Do you see any kind of bunching up, even more of a bunching up in terms of your shipments out in the June quarter?

I know you said you didn't listen to the Lam Research call, but they actually guided their June quarter shipment number up, pretty staggeringly up 25% to 30%. Anything in your kind of forecast, anything from your customer suggest the same kind of trend?

Rick Hill

Yes, first of all, we didn't -- we talked about shipments being up in the first quarter, which we attributed to some of the push-outs in the fourth quarter. They weren't up as much as we thought they would be up because we do have a little bit of a timing delay due to our international headquarters, or they would have been up greater.

Gary Hsueh - CIBC World Markets

Right.

Rick Hill

Therefore, we expect to see that happen in the second quarter. We don't forecast what's going on in the second quarter. We only forecast the first quarter. So we don't comment beyond the next quarter during these conference calls. So I haven't said anything about the second quarter or beyond.

Gary Hsueh - CIBC World Markets

Okay, Rick. But it sounds like what you're saying is the transition of your headquarter, your tax base to Singapore, that's also going to affect your shipments in June positively. Is that what you're saying?

Rick Hill

I didn't say anything about its effect in June.

Bill Kurtz

Let me try. This is Bill. Think of it simply as a slight delay in the recognition of our shipments and revenue that only has the effect in the first quarter in which you implement, and it takes a few days out of the recognition. So there's about $20 million a shipment that would have otherwise been recognized in Q1 that will now get recognized in Q2.

Gary Hsueh - CIBC World Markets

Okay.

Bill Kurtz

But once you experience the timing effect, it doesn't have a future effect because you now have a full 30 day period going forward. So it only has a slight dampening in the first quarter and then after that, it evens out.

Gary Hsueh - CIBC World Markets

Okay. And Bill, my follow on question is for you. If we're going to start modeling a slight pull back here, in terms of your revenue number, and if we look at a more mild kind of pull back here in the second half of '07, if I look at revenues kind of dipping down into, let's say the mid 300 level, is there anything you can kind of do on the cost side of things to hold gross margin at a higher level than kind of the mid 40% range the last time you hit the revenue range --

Rick Hill

We don't comment beyond the first quarter, Gary. So --

Gary Hsueh - CIBC World Markets

Well, I guess just structurally, if you get back into around $350 million, $360 million in revs, is there something going on, or something -- leverage you can pull where you can get your gross margin a little bit higher than where you hit last time?

Bill Kurtz

Well, overall, we're in a stronger position than we were, you know, in the last cycle with respect to the operational efficiencies, the reductions in installation and warranty and just the overall strength in the product portfolio. So all things being equal, we're in a stronger position on gross margin than we were in the last cycle.

Now, what we can't project for you is the future fluctuations of the cycle beyond the quarter that we can see at this point. So we've given you our guidance for the first quarter, and we've given you a general characterization that we expect the second half to be stronger.

But we couldn't be more specific with you about the individual numbers for the quarters until we get closer to, you know, the point at which we can provide guidance for Q2 and beyond.

Gary Hsueh - CIBC World Markets

Okay. Great. Got it. Thank you.

Bill Kurtz

Right. But as a general statement, we are in a stronger position now than we were in the last cycle on profitability, both on margin and operating margin line as well.

Gary Hsueh - CIBC World Markets

Understood. Thank you.

Bill Kurtz

You're welcome.

Operator

Thank you. We'll go next to Timothy Arcuri of Citigroup.

Timothy Arcuri - Citigroup

Hi, guys. Actually I had three things. First of all, Rick, you didn't buyback any stock. I guess there's kind of two reasons that that could be the case. Number one, you didn't feel the price was right. Or number two, you were restricted from doing so. Which one of those was the reason?

Rick Hill

We don't answer that.

Bill Kurtz

We don't comment on that, Tim.

Timothy Arcuri - Citigroup

Okay.

Bill Kurtz

But that's a good try.

Timothy Arcuri - Citigroup

Okay. All right. Second thing, do you think -- you know, if you listen to one of your biggest memory customers talk about the loading of their CapEx this year, it sounds pretty dramatically front half loaded, with CapEx being down somewhere in the 50% range, second half versus first half this year.

Do you think -- is that representative of what the overall, you know, memory industry will be based upon what you see second half versus first half?

Rick Hill

We don't see that at this juncture.

Timothy Arcuri - Citigroup

Okay. And then I guess last for you, Rick. If you take the SICAS data. so you take the public data, and you look back the last 12 years and you look at absolute wafer capacity add year-over-year, of the top four years, three of them have come in the last three years, so '04, '05, '06. The only year that's bigger, was '00.

So you know, we're adding an awful lot of capacity in three straight years. And I'm wondering, you know, everyone assumes that things are going to snap back immediately as they typically have in the past. But could it be maybe a little different this time?

When you look at the capacity numbers, are you a little concerned that we're adding that much capacity relative to any years in the last 12, you know, three years in a row, and kind of what the shape of the recovery might look like?

Rick Hill

Well, I think we went in '01, '02, and '03 and didn't add anything. So when you net-net it out, and believe me, we have these numbers on charts that are as detailed as you can get, we're not convinced that from a unit demand standpoint the capacity is so far ahead of the demand.

But, you know, everybody has numbers. And you can look at them any way you want. You know, I think we have more rational deployment of capital. We continue to see it go on. Yes, we've had an extremely good year this last year. But so has the consumer seen an extremely good last year.

It is all dependent upon the success of, you know, new products coming out, one of which is Vista, which we've articulated. And whether industry and the consumer adopt it to the level we think they will, we think that will have a dramatic effect on DRAM.

We also think that with the power of Flash, it's going to become more pervasive in the laptop. And as a consequence, its capacity will be absorbed as well and, you know, new applications relative to the combination of your MP3 player and a telephone. And I don't think you've seen the last of that particular product offering.

And I think it's one that makes sense. You don't want to carry two boxes in your pocket. So I think that could have a very profound and positive impact on consumption as well. But that again, we're only giving you our feel. We don't have any more data than you. We're just giving you a perspective.

And I think you've got to average out capacity, not just looking at it discreetly at 2000 and then discreetly at, you know, '06, you've got to really look at the capacity that the periods of time when virtually nothing was -- when it went away, the dark years of '01, '02, and '03.

'01 was artificially high for us, given the SAB 101 effect. But when you really look at what the capacity that was added was, it wasn't very significant, nor in '02 or '03. So that's just our perspective.

Timothy Arcuri - Citigroup

Yes, I understand. All right. Thanks, Rick.

Operator

Thank you. We'll go next to Mark Fitzgerald of Banc of America.

Mark Fitzgerald - Banc of America

Hey, Rick, what do you mean by you think there's going to be push-outs in the first quarter? I mean have people already come in and told you that? Or how do you come by that?

Rick Hill

Well, we look at what's transpired so far, okay? And then we also look at what the business climate is. And we make judgments. And when people come in and they want deliveries at a certain period of time, and then they push a month, we make a judgment on whether they will push two months.

Mark Fitzgerald - Banc of America

Okay. And can you give us any idea what segments you're most concerned about in terms of those projects?

Rick Hill

No. We won't go any deeper than that.

Mark Fitzgerald - Banc of America

Okay. And then a product question here. You guys got a response to the Producer GT platform in terms of improving wafer throughputs in the pipeline at this point? Or how are you going to respond to that product out of Applied?

Rick Hill

Well, first of all, it doesn't even come and match the vector yet. So that's one point to it. And as I have said before, I think we're better positioned with a product portfolio today than we ever were.

Mark Fitzgerald - Banc of America

So you think you'll maintain market share or gain market share in dielectric?

Rick Hill

I believe we will, yes.

Operator

Thank you. We will go next to Stephen Chin of UBS.

Stephen Chin - UBS

Hi, great. Thank you. Just Rick, on the CMP product, did you say that product hit your internal goals in 2006? And can we expect Novellus to focus equally as much on CMP as the PVD product in 2007?

Rick Hill

Well, we certainly are committed to CMP, and we'll continue to focus on it. But I didn't comment on CMP.

Stephen Chin - UBS

And maybe on PVD, when you say you're going to make an increased effort in PVD in 2007 --.

Rick Hill

Well, we can hardly make a greater effort than we made in 2006. But I think the effort that we made in 2006 has yielded us a system that is more reliable, has more flexibility, and more extendibility for technology than anything on the market. Now what we've got to do is sell it, and regain the confidence that we used to have in the customer base, that we sort of threw away about a year ago.

Stephen Chin - UBS

And I think I understand that. But the question I had was, did you think there could be -- I mean, should we model increased manufacturing or OpEx costs in '07 to further support those efforts, or -- ?

Rick Hill

I don't think you need to model in anything more than you have been modeling in.

Stephen Chin - UBS

Okay. Thank you.

Operator

Thank you. We will go next to Mahesh Sanganeria of RBC Capital Markets.

Mahesh Sanganeria - RBC Capital Markets

Yes. I have a couple of questions on R&D and SG&A. You said R&D expense was down about $5 million because of the shutdown. How come that did not impact the SG&A? Shouldn't that have the same affect?

Bill Kurtz

This is Bill. It had some impact on SG&A, but it had a greater impact on R&D, which is affected both by the labor and the project materials.

Mahesh Sanganeria - RBC Capital Markets

But the SG&A is going up sequentially from $68 million to $69 million in December.

Bill Kurtz

SG&A also includes the profit share accruals which, given the level of profit in Q4, that showed some increase on the number. In addition in SG&A, we had some slight increase in our legal expenses. But the base selling and general and administration expenses remain relatively flat.

Mahesh Sanganeria - RBC Capital Markets

Okay. So one more on the interest expense that's been drifting up, I suppose based on increase in the interest rate and increase in cash.

Bill Kurtz

That's right.

Mahesh Sanganeria - RBC Capital Markets

Is that the right level to model if you don't do an aggressive buyback?

Bill Kurtz

The current period has about a $2 million gain in it that I would say is non-recurring. But outside of that, if you take the $2 million out, that would be a normalized level for modeling the business going forward.

Mahesh Sanganeria - RBC Capital Markets

And can you talk about that? What kind of gain is that?

Bill Kurtz

It's just a gain in other income that relates to the revaluation of the assets acquired in the Voumard acquisition about one year ago.

Mahesh Sanganeria - RBC Capital Markets

Okay. Thanks a lot.

Bill Kurtz

You’re welcome.

Operator

Thank you. We will next to Bill Ong of AmTech.

Bill Ong - AmTech

When Sass Somekh joined Novellus a couple years ago, one of the objectives was to strengthen the non-CVD core business, the PVD and CMP product line, and just given his technical accomplishments at Applied. So given his upcoming retirement and given that Novellus really didn't achieve the type of market share goals that were set out, does it make it even more challenging you trying to expand beyond this one product portfolio?

Rick Hill

Well, I don't think so. I think Sass, who has been here three years by the way, will retire after being here three years, has hit an age where he wants to do something else in his life. He's made a valuable contribution. And I think we have a strong development team, strong general management capability, and we'll just continue along as we have been before.

Bill Ong - AmTech

Okay. Thank you.

Operator

Thank you. We’ll go next to Patrick Ho of Stifel Nicolaus.

Patrick Ho - Stifel Nicolaus

Thanks a lot. When you mentioned in terms of the gross margins, it's due to mainly product and customer mix for Q1 '07, is any of it related to near term pricing? Or is it just purely, as you say, just the type of products going out to specific customers?

Rick Hill

Purely mix at this juncture.

Patrick Ho - Stifel Nicolaus

Not seeing additional pricing pressures at this point?

Rick Hill

Not at this juncture.

Patrick Ho - Stifel Nicolaus

Great. Thank you.

Operator

Thank you. We'll go next to Daniel Berenbaum with Susquehanna Financial Group.

Daniel Berenbaum - Susquehanna Financial Group

Yes. Hi, Rick. Several of your OEM competitors have talked about lowering pricing for their spares out in the market in an effort to regain market share from third party competitors. Is this an effort that you also have ongoing? Do you see this as an opportunity perhaps to regain some market share in your spares from these third party providers?

Rick Hill

Well, I think that from a standpoint of the spares business, we have both proprietary spares and non- proprietary, from the standpoint of -- you know, we don't want to impose upon our customers undue cost. So we try to be as competitive as possible.

But in areas where we put an enormous amount of design into the product and we can add value to our customers, our customers are willing to buy those spares from us. And as a consequence, they're willing to pay us a premium oftentimes on those spares. And we think that that will continue.

And we think that there's a broader section or selection of those parts that we can bring enhanced values to our customers by providing a package as they try to become more efficient in their procurement, as they try to become more efficient in their logistics. And so we do see an opportunity here to regain market share in a lot of these areas, but not all of them by any stretch.

Daniel Berenbaum - Susquehanna Financial Group

So then, maybe as a quick opportunity, could you maybe quantify that opportunity a little bit? And also are your spares margins accretive to corporate margins? Thanks.

Rick Hill

Our spares margins are consistent with the corporate model, and you know the reality is we're not in the business just to be in spares. We're in the business to provide products that enhance our customers' capabilities. So I would never -- for us, spares is not the main line of the business.

We're not a spares and service Company. I know there are some of the equipment companies, some of the big ones, who have decided to go into the service business, and that's their strategy. Our strategy is to maintain focus on products.

Daniel Berenbaum - Susquehanna Financial Group

Great. Thanks.

Operator

Thank you. We'll go next to Steven Pelayo of HSBC.

Steven Pelayo - HSBC

Yes. First, a couple questions here. First for you, Bill. You seem like your guiding revenues down about $35 million at the mid-point gross margin is down about 150 basis points. To get the mid-point of your EPS guidance, it seems to me your OpEx is up about $5 million or so.

Do you just not have the flexibility there? I know you had shut down days and you bring those back in the March quarter. But do you not have flexibility there on the operating expenses to offset some of the revenue and margin declines?

Bill Kurtz

Well, I think you should double check your model there. We do see some increase in the OpEx because of the impact of the shut down savings, which would not reoccur.

Steven Pelayo - HSBC

Would it be the other income line that you're talking about, this extra $2 million? Is that with saving and -- ?

Bill Kurtz

Yes, I think that's also part of what you need to factor into your model. But you're in about the right range of what you should expect.

Steven Pelayo - HSBC

All right. And one other thing, it looks like your deferred profit line in dollars was down about 45% quarter-over-quarter. And if you do a deferred profit over deferred revenue, it looks like that margin was down about 900 bips quarter-over-quarter. Should I be reading anything into that? Is that really that weak mix that's going to be coming through?

Bill Kurtz

Yes, those two calculations aren't -- you can't really divide those into each other and project future margin. So I've commented on it before, but just to be clear, right, you really shouldn't divide those into project future margin, because that's not what it represents.

For example, this can get complicated, but your deferred revenue reflects the shipments that you've deferred that are awaiting acceptance. Deferred profit represents the embedded profit, forward shipments that have different bifurcation formulas. And because of that, and you don't have a standard bifurcation process, you're going to get differences in those numbers.

And overtime, they equal out, but quarter-to-quarter, there will be imbalances in the assumption. So I would caution you not to divide them in to project future margins.

Steven Pelayo - HSBC

All right. Then one quick clarification from you, and one for Rick, actually. It's your fiscal year is over now for 2006. I think last year you guys had 20% of revenues from Samsung, 13 from Intel. Do you have those numbers today? Or do we need to wait for the 10-K?

Bill Kurtz

We will put them in the 10-K and you know publish them to everyone at that point. We do have over 10% customers this year, and we will include that in our 10-K.

Steven Pelayo - HSBC

All right. Rick, then last question for you, kind of a big picture one here. Obviously a lot of chatter about the consolidation potential in the industry, and a lot of private equity chatter going on the semiconductor side. I am wondering what you think about that relative to semiconductor equipment.

It seems that maybe we're arguing for a little less volatility in this space. These companies seem to have right-sized their business models a little bit more. Can you just talk a little bit about your thoughts on consolidation in the industry and the relative attractiveness for those types of strategies?

Rick Hill

Well, Steve, I think we've done a fair amount of consolidating within the industry, and we're focusing on delivering. And I think we're being successful in a couple cases. We're behind where we want to be in a couple of cases. But overall, it is going on, and it will continue to go on.

Relative to private equity, I think that Novellus is doing for our shareholders what they believe -- what we believe is right. It isn't as though I could walk over to a private equity person and say, gee, if you provide me a bunch of cash, I'll go do all of these things that I won't do for my shareholders, because we'll do whatever it takes for our existing shareholders, and that's our philosophy.

So while I've seen some people go the private equity route. I don't see that as necessarily something that's in the best interest, because we have the capability. We have the balance sheet. We have the access, to do anything that we would do for a private equity firm for our existing shareholders, and we'll do so.

Steven Pelayo - HSBC

Okay. And then from a big picture perspective, I think you answered my question relative to Novellus consolidating the other people. Do you see Novellus as needing to be part of a larger entity to offer more, broader product portfolio, that type of thing, bigger global footprint, whatever it may be better customers?

Rick Hill

Well being this is my fourteenth annual call I've been asked that question I think for 14 years, back when we were about $100 million. And with a record revenue year of $1.8 billion, I guess the only answer I can give you is I don't think we need to be part of anyone else. But if the opportunity were right and was right for our shareholders, I'll do what's right for our shareholders.

Steven Pelayo - HSBC

Great. Thanks a lot, guys.

Operator

Thank you. We'll go next to Mark Bachman of Pacific Crest.

Mark Bachman - Pacific Crest

Yeah. Hi, Rick. I just want to go back here and just revisit the buyback question a little bit. During the quarter, several executives were actually selling shares. And I believe that your transactions were actually covered underneath 10B5-1 plans. But there were still several other transactions by other execs that were not.

So my question is could there be a scenario where the Company is restricted from using its buyback program, but where your executives could still be transacting in the stock?

Rick Hill

I don't even know how to comment on that. First of all, I'm not aware of the executives. So I don't know off the top of my head. There's a very narrow few people in the Company who are involved in the share buyback program. And so it doesn't restrict the entire Company from doing whatever they're doing with their own equity. So I can't really comment on it.

Mark Bachman - Pacific Crest

Okay. I think, Bill Kurtz was one of them, Jeff Benzing was another. So that's your CFO and your COO. And so I'm just wondering if they were transacting, could they still be doing it if you were blacked out from the buyback?

Rick Hill

I don't -- I'll have to go ask a lawyer about it. And I didn't ask a lawyer about it. Thank you.

Mark Bachman - Pacific Crest

All right. Thanks, Rick.

Operator

Thank you. We'll go next to Jay Deahna of JP Morgan.

Jay Deahna - JP Morgan

Thanks. Good afternoon. A couple of questions, Rick. Lam Research, when they reported, indicated that they received several push-outs of tool deliveries from the first quarter to the second quarter, including a very major one from a memory customer, which changed their expectations for shipments in the first quarter from up five to ten from 90 days ago, to down seven. And as the market interpreted that as the beginning of the end of this memory spend, or something to that effect.

I want to know if you're seeing any substantial push-out of tool deliveries, from 1Q to 2Q from, a, particularly in memory customer. And, b, do you see any change in your expectations in demand for equipment, generally speaking, from memory customers this year versus 90 days ago?

Rick Hill

Okay. I'll have to answer the last question first. And I don't see major change in demand. I think it's on track. I think the big players in this industry have indicated an upward spending cycle.

I have not talked about any push-outs out of the first quarter into the second. In fact, I have indicated I might expect some because I've seen movement from month-to-month, and therefore, I'm alluding to the fact that I might suspect I'll push them into the second quarter, but I have no factual data on that.

Jay Deahna - JP Morgan

Okay. Great. And then in your prepared comments, you said something about some major push-outs of orders that occurred in 4Q. I was wondering what category of customer that came from?

Rick Hill

Largely logic customer.

Jay Deahna - JP Morgan

Okay. Fine. Then the last one is, if you look at the SIA data for DRAM shipments.

Rick Hill

Yes.

Jay Deahna - JP Morgan

What you'll see is that in 2002, 2003, when you transition to the 128 meg and then the 512 meg, you blew through the previous peaks in unit shipments from the previous three generations of DRAM, on generally consistent 50% annual bid growth.

And I think the reason why is because you started going to bit density transitions every three years instead of two, as the impact of the multi-level cell capacitor started waning. You've had an explosion in DRAM units to satisfy demand, as opposed to moving to the next generation fairly quickly.

Rick Hill

Right.

Jay Deahna - JP Morgan

And at the same time you had the advent of multi-core processors and the Flash phenomena, which are large die.

Rick Hill

Right.

Jay Deahna - JP Morgan

So if you're looking at wafer start capacity and you're comparing that to 2000 when you had no major new category, no slowdown in bit density transitions, and no huge significant increase in die sizes, is that really a fair compare?

Rick Hill

Well, I think you're going to see major increases in bit consumption with the advent of Vista. Now, that's an assumption. Now, if that proves to be wrong, then we're on a different curve. But I think by most accounts, that's predicted. Yes?

Jay Deahna - JP Morgan

Correct.

Rick Hill

So I think that's a big driver. The second thing relative to Flash, Flash continues to consume area, because densities aren't at the level yet, where they're optimum. I do see the ability, you know, to increase bit densities in Flash for at least two more generations, at which time then you'll have a stalling of bit densities, which I think will play into more unit consumption.

Because demand will still be strong, and so it's some of those subtle factors that you know, obviously you're on to, and you recognize. We're all guessing on what's going to happen. It all is a function of the end product and what happens.

And as you know as well as I do, if people don't need it for Vista, they won't buy it. That would be a negative. And if we don't see the proliferation of the NAND Flash into laptop PCs, I think that will be somewhat of a negative, unless this phone MP3 combination player booms, I think that will consume a fair amount. You'd certainly rather have that in Flash, than you'd have it in a hard disk.

So I think those are all valid things to be looking at relative to forecast what semiconductors are doing. We try to do it. And I try to give you in a very, very short period of time what we're thinking.

Jay Deahna - JP Morgan

Right. And then last but not least, a couple years ago, you were sort of unique among large cap equipment OEMs in suggesting that maybe capital intensity would go down. In fact, it's gone up. And going forward here, as life gets more complicated, I'm wondering if you still think there's a catalyst for that to go down? Or if we're through that at this point?

Rick Hill

The question, you know, you and I we had had this discussion before. What do you mean by going down? If it's the expenditure as a percent of revenue, or expenditure as a percent of revenue on new capacity?

Jay Deahna - JP Morgan

Well, I'm just looking at the overall semi CapEx to semi industry revenues on an annual basis. Historically, they've averaged in the low 20s. They got down into the mid-teens when things were pretty crappy there in '02, or whatever. And they've kind of trended back up towards 20%.

And going forward here, clearly you got large die requirements and that more process steps, more difficulty. So I'm just wondering, what would be a catalyst to bring that down? And then secondly, if you look at some of these fabs that have been announced lately, they're enormous, hundreds of thousands of wafer starts per month.

Rick Hill

Right.

Jay Deahna - JP Morgan

One would think would mean that the intensity of equipment versus bricks and mortar in CapEx would increase.

Rick Hill

Yes, except productivity continues to drive along. I mean, if you look at the output of our systems today. You know, if you were to take our PECVD system, and think about how many units we would be selling if we were outputting the same number of wafers per hour we were in 1993, we would be about ten times as big as we are right now. So I mean, it's been a huge productivity increase, and I see a huge productivity increase coming in some of these areas over the next 12 to 18 months.

There's tremendous pressure, tremendous pressure for productivity. I mean, in order to keep this industry going, everybody has got to make a profit. And you just can't -- and I understand the capital productivity argument. But there are -- it's cash in, cash out, and there's only so much cash they can expend on capacity. And so our goal is always to try to give them the best value for their capital expenditure, which is driving that number down. So I'd love to see them spend 100% of their revenue on me. But I just know that's a short train ride. But I think that's - I do think we're going to get locked into this 17% to 20% range.

Operator

Thank you. That will conclude today's question-and-answer session. At this time, I'd like to turn the conference back over to Mr. Rick Hill for any additional or closing remarks.

Rick Hill

Well, thank you very much for joining us for the 2006 annual earnings report. It was a great year. We appreciate your dedication to Novellus, and you are joining us throughout the year. We look forward to a mid-quarter update which will happen some time the end of February, first week in March. And we look forward to continued growth and success in the semiconductor capital equipment industry. Thank you very, very much.

Operator

Thank you for your participation. That does conclude today's conference. You may disconnect at this time.

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