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Executives

John D. Hertz - Chief Financial Officer, Principal Accounting Officer, Vice President and Corporate Controller

Robin S. Yim - Former Vice President of Investor Relations

Richard Hill - Chairman and Chief Executive Officer

Analysts

Benedict Pang - Caris & Company, Inc., Research Division

Stephen Chin - UBS Investment Bank, Research Division

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Timothy M. Arcuri - Citigroup Inc, Research Division

James Covello - Goldman Sachs Group Inc., Research Division

Satya Kumar - Crédit Suisse AG, Research Division

Olga Levinzon - Barclays Capital, Research Division

Christopher Blansett - JP Morgan Chase & Co, Research Division

Mahesh Sanganeria - RBC Capital Markets, LLC, Research Division

Krish Sankar - BofA Merrill Lynch, Research Division

Edwin Mok - Needham & Company, LLC, Research Division

Patrick J. Ho - Stifel, Nicolaus & Co., Inc., Research Division

Weston Twigg - Pacific Crest Securities, Inc., Research Division

Novellus Systems (NVLS) Q3 2011 Earnings Call October 26, 2011 4:30 PM ET

Operator

Good day, and welcome to Novellus' Third Quarter 2011 Earnings Conference Call. As a reminder, today's call is being recorded, October 26, 2011. I would now like to turn the conference over to Ms. Robin Yim of Novellus Systems. Please go ahead, ma'am.

Robin S. Yim

Thank you, Tom. Good afternoon, everyone, and thank you for joining the Novellus Systems Third Quarter 2011 Earnings Conference Call. Joining me on the call today are Rick Hill, Chairman and Chief Executive Officer; Tim Archer, Chief Operating Officer; and John Hertz, Chief Financial Officer. Financial results for our third quarter 2011 were released on Marketwire 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 novellus.com.

Before we begin, let me remind everyone that today's discussion contains forward-looking statements about Novellus' business outlook, the future performance of Novellus, our products and forecasts as key metrics for the fourth quarter of 2011. Specific forward-looking statements include, but are not limited to, estimates, projections and forecasts for our industry in 2011 and 2012; PC unit growth, demand for PCs and electronics, semiconductor and smartphone markets; contract prices in demand for DRAM and NAND; and our customers' capital expenditures, the forecasted bookings, shipment volumes, revenues, gross margin, earnings per share and tax rates for the fourth quarter of 2011 and our effective tax rate for the year and other unanticipated future events.

We caution you that forward-looking statements are projections and expectations regarding future events, which may involve risks and uncertainties that could cause actual results to differ materially from the results contemplated. Information concerning these risks is included in today's press release and our filings with the Securities and Exchange Commission, including our Form 10-K for fiscal 2010, our Form 10-Q for the first and second quarters of 2011 and our most recent Form 8-K. Forward-looking statements are based on information as of today, and we assume no obligation to update any of these statements.

John Hertz will begin today's call with a review of the financial results for the third quarter. Then Rick Hill will discuss the state of the business and our industry outlook, followed by guidance for the fourth quarter of 2011, and then he'll open the call for the question-and-answer session.

So now I'll turn the call over to John.

John D. Hertz

Thank you, Robin, and good afternoon. I'll report on our third quarter results, which were within the guidance ranges for all financial measures with EPS at the high end of the guidance range, and that's despite all other metrics landing at the lower end of our guidance range. And I'll discuss in further detail in a moment, the EPS upside resulted from combination of factors within operating expense, other income and a better-than-expected tax rate for the quarter.

So with that, our third quarter net bookings were $227 million, that is down 27% sequentially and within our guidance range of down 15% to 30%.

Shipments in the quarter were down 16% from Q2 at $302 million and within our guidance range of $300 million to $320 million. Third quarter revenues were down 12% sequentially at $307 million and within our guidance range of $300 million to $320 million. The geographic breakdown of our revenues in the quarter was as follows: United States, 36%; Greater China, 22%; Korea, 21%; Japan, 10%; Europe, 11%.

Now turning to gross margins. Third quarter gross margin was 48.2%, compared to the guidance range of 49%, plus or minus 1 point. Unabsorbed overhead associated with lower production volumes combined with an increased mix of international applications revenue did have the quarter-over-quarter decline in the margin.

Operating expenses in the quarter totaled $91 million on a GAAP basis, that's down $4 million from Q2, which resulted in an operating margin of 19%. Our third quarter operating expenses were favorably impacted by a net $1.6 million nonrecurring benefit as detailed in our press release and resulting primarily from the favorable resolution of a vendor dispute that was partially offset by severance payments associated with some restructuring actions in our Industrial business.

Our third quarter interest expense increased to $6 million, that's due to a full quarter's impact of interest on the convertible bonds and other income increased to $2.8 million, primarily due to put option premiums as well as positive impact of strengthening U.S. dollar.

In conjunction with our stock buyback program, during the quarter we sold put options that gave the counterparties the right to sell up to 2 million shares of Novellus stock to the company at a stated price on a stated date. Those put options expired unexercised.

Our third quarter tax rate was 7.3%, which is below the low end of our Q3 guidance as articulated in our mid-quarter update. We now expect our effective tax rate for the year to be 14% versus the 16.5% we estimated as we finished the second quarter. Our third quarter tax rate benefited from the true-up of that tax rate expectation in the third quarter. We expect our tax rate for the fourth quarter to be 14% plus or minus a couple of points.

Our third quarter GAAP net income and fully diluted earnings per share came in at $51 million and $0.73, respectively as based on a fully diluted share count of 70 million. Excluding previously discussed nonrecurring items, our diluted EPS was $0.72 per share.

Now turning to the balance sheet. We ended the quarter with $923 million of short- and long-term cash and investments, which includes $133 million of restricted cash. We generated $100 million in cash flow from operations in the third quarter.

In Q3, we purchased 5.2 million shares at an average cost of $29.19 per share, totaling $151 million. Year-to-date, we have purchased 28.5 million shares for $976 million, at an average cost per share of $34.21. Our previous repurchase authorization expired this month and today we are announcing that our Board of Directors has approved a new authorization totaling $500 million through December 2014.

Capital expenditures for the third quarter were $6 million and noncash expenses in the quarter included $9 million of depreciation and amortization and $11 million of stock-based compensation.

DSOs were up to 65 days, compared to Q2 at 61 days and our inventory turns remained at 3x. The weaker business environment caused our third quarter working capital metrics to deteriorate slightly in the quarter, but despite those headwinds, we continue to generate a more than respectable level of operating cash flow at 33% of revenue.

So all in all, despite a weaker business environment, we produced solid earnings with a 16.7% profit after tax and generated $100 million of operating cash flow.

That concludes my prepared comments on the financial. Now, I'd like to turn the call over to Rick to provide an update on the state of the business and guidance for the fourth quarter of 2011.

Richard Hill

Thank you, John, and good afternoon, ladies and gentlemen. I'd like to start by saying that Q3 was a solid quarter. Despite slowing CapEx, we earned $0.73 a share with a 16.7% net margin, and we generated $100 million in operating cash flow.

Our results clearly reflect a marked improvement in our operating leverage. In addition, as John reported, we bought back an additional 5.2 million shares at $29.19. This was roughly an additional 7.3% of the actual shares outstanding at the end of Q2. That leaves our actual outstanding shares at the end of quarter 3 to be 66.5 million shares.

As far as the business environment goes, on a macro level, liquidity is better, but the structural problem that exists on a government level still have not been fixed, so it's, overall, a mixed bag. Closer to home, what we find is DRAM remains weak, and the demand for computers and electronics is soft in Europe and the U.S. These conditions are offset however, by the fact that Asian demand for consumer PCs remain robust. Enterprise demand for PCs worldwide is still strong and the growth in smartphones, tablets and gadgets using NAND remains strong. SSDs are also growing nicely, and the reason problems in Thailand may accelerate uptake on SSDs although, they're not a one-for-one replacement with hard disk drives. SSD usage continues to grow in enterprise storage system as bit density and cost per bit continues to improve.

Now while customer utilization in foundries are still expected to remain below seasonal levels in the fourth quarter, we are starting to see our customers resume their investment activity. As the fourth quarter draws to a close, there's also a potential to see an attempt to accelerate shipment into the fourth quarter to take advantage of accelerated depreciation.

Smart Money would say that we'll see some customers who have shipments that are going to happen in January come to most semi-capital equipment companies and try to accelerate those shipments into the fourth quarter. The reason they would do that is rather than depreciating equipment over 5 or 7 years or 10 years, they'd be able to take the depreciation all in 2011, because this is something that is going to go away. And therefore, going forward, they'd have the added capacity, but they wouldn't have the depreciation expense. So this may or may not happen, but it's something that is a potential and so, from a capacity standpoint, we're planning that the smart companies will attempt to do that.

With that, I'll provide guidance for the fourth quarter.

We expect our bookings to improve and be up 10% to 30%. Working off of the weaker bookings from the previous quarters, our shipment levels are forecasted to be in the range of $270 million to $300 million, that's roughly down 5% at the midpoint of guidance.

We are forecasting revenues to range from $260 million to $290 million. That's down 10% sequentially at the midpoint. Acceptance timing is the major difference between revenue and shipments as some products are first-time shipments of a kind, and therefore, they are not recognizable revenue until acceptance. Our gross margins should be in the range of 46%, plus or minus 1%. This is a result of decreased factory output or utilization and a greater percent of our IAG operation shipments in the fourth quarter, where gross margins are historically lower than that in the Semiconductor business. And our earnings per share on a GAAP basis is expected to be in the range of $0.42 to $0.62.

This also includes, however, a $0.07 that has been produced by the sale of our Romard [ph] manufacturing facility which occurred early in the fourth quarter.

With that, that concludes my prepared remarks and our guidance for the fourth quarter. Now I'll open it up for any questions you might have.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Mahesh Sanganeria with RBC Capital Markets.

Mahesh Sanganeria - RBC Capital Markets, LLC, Research Division

Just 2 quick question on the order. Can you talk about a little bit more on the orders? Where are you seeing Q3 to Q4 upside on the segment and regional level?

Richard Hill

Well, we don't -- we never break out orders going forward on where we see them. But clearly as I highlighted in my verbiage, the areas that remained pretty solid are clearly areas that are focused on SSD technology and NAND Flash technology as well as the broad base of the overall PC business, which I highlighted still to be fairly robust, except in the U.S. and in Europe.

Mahesh Sanganeria - RBC Capital Markets, LLC, Research Division

And just a follow-up on that. I'm not looking for a guidance but just to provide your outlook. Usually your pretty good at talking to customers and getting a sense. Do you think that this is may be in order inflection? Or we are just bouncing along the bottom? The key concerns we have is that the foundries UMC reported and the guided 65% utilization and then Lam talked about some pushouts in NAND. So that's the reason more concerned as to what exactly driving the orders so it and isn't sustainable?

Richard Hill

Yes. So I think that you have to look at this both from a macro standpoint and then get down into a micro standpoint. And so what you see is you might find some companies reporting lower utilization. And if you get down into the micro, you'll tend to find that what happens is the supply chain that they're part of may be losing in the end consumer gain and so therefore, they're suffering worse than may be someone else's. So consequently, if you look at it on a macro level, if I weren't watching the news, I think fundamental demand is still pretty solid. And so that demand is going somewhere else. And we all know that it's going in the smartphone area. You see how hot the galaxy phone is out of Samsung, how hot iPhones are out of Apple and iPads are out of Apple and Kindle products and an all of these other fancy what I'll call, gadgets, that are coming out.

And so if you go and you look at that supply chain, you tend to see that people are doing reasonably well and have a fairly good confidence. What shades their confidence is the macro, as I've said in previous conversations. It's been macro from the sense that a, they were worried about a liquidity crisis, but we've seen a Europe tried to dispel that by making, putting enough euros that nobody's ever going to be short euros, but they haven't systemically fixed the problem yet, so that's still in front of u. But it all us all feel good. And as a consequence, I think people are saying, "Okay, let's go ahead and take the risk and let's make some investments here going forward."

There is no question that corporations are trying to become more efficient. That's keeping spending fairly solid in the enterprise area. In the United States in particular. The ability to be able to take all of your depreciation this year in an area where in the United States it's sort of like a sin to make profits and so you might as well take as much as your depreciation as you can in 2011, okay? To minimize profit. And going forward, you don't have the depreciation carryover. So I still think there's some of that phenomena that's occurring within the marketplace. And so when you get back down to our business in general, what you find is the supply chains where the successful products are really growing, you're finding people feeling good about what the future looks like. In areas where you're part of a supply chain where the future is not looking so good, you're being a tentative now until you can reshape your business, and I think that's a little bit of the dynamic that's going on in the marketplace.

Mahesh Sanganeria - RBC Capital Markets, LLC, Research Division

And just one more quick follow-up, the tax benefit part you talked about. Is that upside in shipment, have you already factored that into your guidance? So do you think that, that might create an upside?

Richard Hill

That's not factored into the midpoint of our guidance.

Operator

And we'll take our next question from Stephen Chin with UBS.

Stephen Chin - UBS Investment Bank, Research Division

Just a clarification on the December bookings guidance. Is this also due to more turns business happening in the quarter with your customers looking more shipments in the fourth quarter and does this mean that first quarter could decline from a onetime benefit? Is that the trend that might happen?

Richard Hill

Well, let's separate bookings from shipments. I don't think that there's a predominance of turns within that bookings. I think it's just normal investment cycle. It's pretty hard to get a new order and ship it by the end of the year at this juncture, okay? So that's not the case. However, you can imagine that we have our shipments planned out for the next quarter and a half, and I'm only conjecturing that if I were sitting on the receiving end of that equipment, and I had a decision on whether to receive my equipment in the first couple of weeks of January or receive them at the end of the year, I would try to get the equipment manufactured to accelerate it, if I were on their side. In order to be able to take that depreciation all in 2011, because that's going away, okay? This may not happen and you can take our midpoint numbers and it does not have that conjectured in there. So for whatever that's worth. And that's on a shipment basis. That doesn't affect the bookings.

The bookings I think are just the recognition that there is some investment level coming back. But you got to remember, it's coming off a low base. So even though is up 10% to 30%, I'm still not happy with that. I'd like to see it be a lot more robust. And in order to see that more robust, we've got to see how this computer business is going to fall out. My big belief is as we see more SSD-based computers hit the marketplace, you're going to see consumer PC demand grow, and that's going to be good for the equipment companies, because it is going to require increased capacity.

Stephen Chin - UBS Investment Bank, Research Division

Okay. Just a follow-up on the order guidance, does the guidance assume any weakness from the floods in Thailand? And does that create pent-up demand for semicon equipment in 2012, is that kind of your thinking?

Richard Hill

I think the problem in Thailand is a little bit on the short-term, from a short-term standpoint rather than a long-term. And so in this particular case, I don't see any immediate -- certainly this rise isn't going to affect our ability to ship computers. It might affect some ability to ship computers. But I think, there again, you're going to have winners and losers. If you've got WD who's got their capacity there, and Seagate's doesn't. Seagate will try to make up that capacity. And people will try to make shipments by switching faster to SSD. So potentially, you see some SSD manufacturers do substantially better, and I think that's how this plays out.

Operator

And we'll take our next question from Krish Sankar with Bank of America-Merrill Lynch.

Krish Sankar - BofA Merrill Lynch, Research Division

A couple of questions. In your guidance, order booking guidance, the spread is about $45 million or so, what drives the upper end and the lower end?

Richard Hill

What drives the upper end and the lower end is how soon people want to have that product shipped, and we're not going to do any unnatural acts in order to be able to bring in bookings. That's our philosophy at this juncture. We're not trying to accelerate. There's nobody incentivized to get a big booking number, but based on what we've been told, we see it as high as up 30%. But if due to macro events, which can happen any day as we've all seen over the last 6 months, we don't want to have a number up there -- we don't want to be pushing the high end even though we know it's a potential.

Krish Sankar - BofA Merrill Lynch, Research Division

And is there any one geography that is standing out versus Q3 or do you think it's more just your argument that it's coming off a low basis?

Richard Hill

I think it's coming off a low basis, the biggest argument.

Krish Sankar - BofA Merrill Lynch, Research Division

Got it. And then another question I had was in terms of your Peter Wolters business, it's been pretty strong so far and a lot of it was China exposure. How do you see that going, heading forward and do you think that's having a slightly negative impact on gross margins or is it more because of volume?

Richard Hill

Well, definitely because its average gross margins are less than our semiconductor products. It has somewhat of a negative effect from a standpoint of percentage. From actual gross margin dollars, however, it's a good. And we actually see that business gaining in strength. We've created some new capabilities in there that play very, very well into high-technology consumer products, and we're starting to see uptake in that particular area. As I highlighted before, we completed, or maybe I didn't announce this yet, but we had completed a signing of an agreement with DMTG in China in Dalian, China and that's going extremely well. We've begun to get tools from them that we're selling, and that looks very, very promising. So I see that, that particular business is continuing to be strong and should be stronger. And so it'll just be additive when we see the semiconductor industry also come back to the levels that it should be at given the levels of demand for overall electronics.

Operator

We'll take our next question from Jim Covello with Goldman Sachs.

James Covello - Goldman Sachs Group Inc., Research Division

I guess, Rick, if you can help us characterize kind of the current level, I don't care if it's shipments or bookings and then may be next quarter shipments bookings, technology buys versus capacity buys.

Richard Hill

Well, I think that -- and I made this comment on Fox News, probably a week ago, but I think one of the things that is making me optimistic is I do see technology transitions beginning to happen, which are going to play in to increasing bit densities in the NAND Flash area, higher performance in the logic area, and these things are good things for the semiconductor capital equipment makers. And then particularly deposition is having an impact now. And it's been a while since we've been the growth engine. Certainly when the levels of interconnect were expanding, we were the growth engine. I think we're coming back of age, particularly in the memory arena, and you're going to see more and more deposition-based purchases in order to be able to make these products economically. And so there are a substantial amount of technology buys going on at this time, as well, which are helping.

James Covello - Goldman Sachs Group Inc., Research Division

So is it fair to say then, Rick, I mean, a normal -- this would kind of be more of normal downturn where the technology buys kind of continue on like last time or even the technology buys got shut off because of liquidity issues? And then, maybe it's sort of a normal kind of weaker environment with 1 or 2 customers expanding capacity for kind of customers' specific reasons and where do we go from here is sort of depending on what happens first, the guys who are just making technology buys needing to come back and add some capacity or the guys who were actually expanding capacity kind of just going back to make technology buys, is that sort of the give or take on what the next legs of the cycle are one way or the other?

Richard Hill

Well, I think the real next leg of the cycle is going to be seeing sovereign nations get their financial house in order, which then gives people a confidence level that we're not going to have a big surprise. And as I highlighted in my initial comments, you've got Europe over there at least starting the printing presses to make sure that euros are available. Now we all know that, that's nothing more than the band-aid but that I think now we've got to get our fundamental economics in the United States fixed, and I think there's a lot of pressure from the populist to get it fixed. And so I do believe it's going to be fixed. And so I'm relatively optimistic about the future. And I think that you'll follow this type of growth, which has a lot of technology and it, but you will follow this with capacity expansions, if not in the beginning, certainly by the second half of 2012. It would be hard for me to believe it'll stay down beyond then. If that's what you're looking for.

Operator

We'll take our next question from C.J. Muse with Barclays Capital.

Olga Levinzon - Barclays Capital, Research Division

This is Olga calling in for C.J. Just wanted to probe a little bit more on the Industrial revenue side, you talked about how that's been a big portion of the gross margin drag in both September and December. Can you quantify exactly a rough percentage of the revenues that you saw there in both -- in the September quarter and your December quarter guide?

Richard Hill

We're up -- it represents over 10% of our revenues in quarter 3 and more than -- closer to 15% or may be just a little bit above 15%, I'm trying to do the math in my head very quickly. Say it's around 14% in Q4, I would say.

Olga Levinzon - Barclays Capital, Research Division

Got it. And are there any levers in place both within your semiconductor business and within the Industrial segment to drive the gross margins there higher as you move into 2012?

Richard Hill

Well, I think the key to gross margins being higher is technology. And as I highlighted, there's a lot of technology shipments going out that we think bring tremendous value in the semiconductor space and even with the Peter Wolters space, we're seeing our gross margin expansion as we add more technology value to what we're doing. So I think the lever is really, as I tell the engineers within the company, gross margin is their report card, because it's a representation of how good their design is, how unique it is and how much we can then therefore, sell the product for. And that's the mantra in the company. And I think when I look at our portfolio of products going forward, I'm pretty confident that our ability to have expanded gross margin is there, because we've got the right products with really good technology that still lower our customers' cost but also have lowered our overall costs.

Olga Levinzon - Barclays Capital, Research Division

Got it. And then just a final question, you talked a lot about the adjacent market opportunities during your Analyst Day in July. Did you see any incremental revenues from some of the packaging, LED and other opportunities that you talked about? And how do you think about that heading into 2012?

Richard Hill

Well, we've laid that out at SEMICON. I don't have that data right in front of us, but if I had to tell you what my temperature is, I'm more bullish that a lot of our customers, in order to be competitive, want to accelerate the availability of that technology. Again because they're operating the same way to the extent their engineers use advanced technology and have something to offer their customer, they can improve their gross margin and improve their competitiveness. And so if anything, I'm more bullish.

Operator

And we'll take our next question from Tim Arcuri with Citi.

Timothy M. Arcuri - Citigroup Inc, Research Division

I actually have 2 questions. So first on the buyback. You bought back -- well, share count is down about 50% over the last 5 years. You have about...

Richard Hill

To be exact, it's down 2/3. We bought back 108.6 million shares for a total of $3 billion at an average price of $27.73. And what I didn't say during my remarks, although John mentioned it, the Board approved $500 million more buyback through December of 2014, and we feel the stock is a good value and we'll continue to execute on that buyback.

Timothy M. Arcuri - Citigroup Inc, Research Division

It's pretty amazing. I mean, it's an example for all other companies for sure. But my question is if you sort of play out the new authorization out to the end of 2014 and you'll probably exhaust it before that, but if you trust straight line it out to the end of 2014, you're going to end up with like 45 million or 50 million shares outstanding at that point. I mean, you're basically taking the company private before everyone's eyes, so what is the endgame? Is there sort of an optimal number of shares that you want to cut the share count to or you're just going to keep on buying back stock?

Richard Hill

Well, it happens that I've gone and I visited my shareholders and raised that question too. And interestingly enough, I've had a resounding reply from those shareholders that basically tell me, "Rick, just keep what you're doing, keep doing it." Okay. And so as a result, I'm going to listen to my shareholders, and I'm going to keep doing what we're doing.

Timothy M. Arcuri - Citigroup Inc, Research Division

Great, okay. And then second question and may be this is a little bit nitpicky on the margin, but for John. If I look at the margins relative to Q1 2010, they're about 300 basis points lower, if I look at your guidance, they're about 300 basis points lower than they were in the first quarter of 2010 and granted this is revenues contracting versus then when revenue was going up. But is there some dynamic happening there? Is it may be customer concentration or something happening? I'm just sort of wondering.

John D. Hertz

It's a few things. But I think the biggest variable, Tim, is that the Industrial business is a bigger component, actually a much bigger component of the overall revenue mix in our Q4 than it was in Q1 of '10. In Q1 of '10, it was a very small piece of the revenue.

Operator

And we'll take our next question from Satya Kumar with Credit Suisse.

Satya Kumar - Crédit Suisse AG, Research Division

Rick, can you just explain [ph] what's going in NAND Flash. I mean, your competitor, last week, talked about seeing some pushouts in NAND Flash, so it probably happened in the full week spread the last week, but it sounds like you're talking about bookings growing a little bit, and you mentioned NAND Flash was a little bit stronger. Has NAND now decided to improve in the last week or you only saw the resting [ph] a steady outlet for NAND?

Richard Hill

Yes, there's no news that I know of, okay? And again, keep in mind, I'm talking both technology and expansion. So it's not just -- it isn't just capacity expansion.

Satya Kumar - Crédit Suisse AG, Research Division

Okay, so that's helpful. You also mentioned that shipments getting pulled down to Q4 for the anticipated [ph] depreciation, presumably spot customers that have been doing all of this year. Do you think that North American semiconductor CapEx could come down just to push heavy in 2012?

Richard Hill

Well, it's a good question. It's a good question and. All I'm looking at -- really, what we've done is we've lined up where our North American customers have their shipments scheduled right now. And recognizing those that are on the cut, obviously if they're scheduled out in February, it's pretty hard to pull them in December. But certainly, those that are taking shipments, the first several weeks of January, I'd be surprised if they're not pounding on the door trying to get them earlier, that would be the smart financial move on their part.

Satya Kumar - Crédit Suisse AG, Research Division

A question[ph] , Rick, this is the last on foundries, if I look at the capital cost driving a new capacity at 28 nanometers of foundry going up substantially when you compare to 40 nanometers. Did you recall a known transition where the capital cost while adding capacity has increased there as much as it has in any one node for the foundry and I'm thinking I have to go back to when you went from batch [ph] like to hear your thoughts? And because of that, do you expect that the foundries would be, perhaps, adding 28-nanometer capacity at a slower rate or a faster rate, how do you think about that?

Richard Hill

Well, I think we're all running into the problem of -- we've operated on a model where as we move down the technology curve, we've continued to lower costs. And we're now at a point where we're starting to drive costs up for some applications, but not all applications. To the extent the technology enables performance that heretofore wasn't available, those are great new products and they're successful. And I think there are a lot of products where this is happening, okay? Where you are getting performance enhancements and therefore, the incremental cost are worth it. The incremental design cost. Forget the processing costs, just the cost to do the designs are going up as well. However, it's an enabling technology for FPGAs to have more power, which can accelerate the ability to put out new products. In other words, design moves more than software than just hardware, but from an equipment standpoint, you're still going to sell as much equipment. You're just going to now be making standard parts as opposed to custom parts. So to answer your question, I think we are all wrestling with the problem of we're getting close to the technological wall in picking the right technologies that continue to allow you to continue to lower the unit cost for the end customer is still crucial. And I think as I said -- I highlighted, one of the areas that still the biggest single opportunity in the industry is the transition of electromechanical devices in the form of hard disk drive, completely to solid state. That's still in front of us.

If you look at the demand for memory, nonvolatile memory, which is insatiable, I think that as we get the density up, and we get the cost per bit down, you're going to see nothing but growth and expansion. And then in areas where we can't shrink, you can't afford the process technology cost increases, I think you're going to start to see people get the density by going vertical. Year and a half ago, we came out with the vertical reality. We see TSV's becoming a more important part of the designers' tool bag and instead of looking at bit density -- or gate density from an area function, look at it from a volumetric function. And that's what TSV enables, and I think that's another avenue to continue to get those transistor cost per unit area down, which will keep this technology moving.

And so yes, you can look at it any one way and say, gee, the glass is half empty, but I think really that glass is half full. And the creativity of the mind of the engineer and people, that hasn't been shut off, and so therefore, what we design hasn't been shut off, and so I think the prognosis is pretty good overall for the semiconductor industry.

Operator

We'll take our next question from Chris Blansett with JPMorgan.

Christopher Blansett - JP Morgan Chase & Co, Research Division

Rick, I have asked about the continued share repurchase for you, when you think you that actually gets to low share count that you may have to start using alternative methods versus the dividend in order to keep the cost look good?

Richard Hill

Chris, I haven't decided what that is yet, so no sense speculating on it now.

Christopher Blansett - JP Morgan Chase & Co, Research Division

And then I guess the second – well I guess, along those lines though, when you've talked about investor and you've mentioned dividend versus share repurchase, have you found that the share repurchase is vastly more preferred than dividends or do those investors really care?

Richard Hill

I think they recognize just as I do, as the tax efficiency associated with the share buyback, which is better than the dividend. And that's only going to get better going forward, based on every indication of where taxes are going. And so everybody is in line with that. If people want a dividend, they can always go and buy to convert, and they, in essence, have the dividend and the stock. So we offer 2 vehicles for return.

[

:p id="27631090" name="Christopher Blansett" />

And then the other question I want to ask about was in the vertical NAND area. And when do you think you'll start to see some equipment purchases related to that? And kind of tied to that, do you think that some of the existing NAND fab flashes will backfill for vNAND process, which could kind of give another big burst or a boost to CVD equipment sales for a period of time?

Richard Hill

Well, I think in the vertical NAND arena, the big advantage is they will be able to backfill and that capacity and not just do greenfield fabs. And it will also basically to -- it will reduce the demands for advanced lithography to lower overall cost. So I think vNAND is very, very viable, and I would suspect in 2012, you'll begin to see capacity come online.

Operator

We'll take our next question from Ben Pang with Caris & Company.

Benedict Pang - Caris & Company, Inc., Research Division

On the order guidance, your original third quarter order guidance has been a bit higher and then it got pushed out at the mid-quarter. Is order strength you expect in the fourth quarter pretty much exactly those the same orders that were kind of pushed out of the third quarter or is the mix changing?

Richard Hill

No, clearly as we said when we pushed the numbers out, we said they'll either fall in the third quarter or the fourth quarter. And we're not doing back hand springs to bring them into any one quarter. We're just reporting.

Benedict Pang - Caris & Company, Inc., Research Division

Okay. And then to follow up on the earlier comment you made regarding the potential of growth driver, I think you made the analogy to the previous cycle and the interconnect levels are growing and really benefiting CVD. What's the specific application that you see, going forward, that would drive the same type of outgrowth for our CVD?

Richard Hill

Well, I think the major 2 applications that will drive more and more deposition is certainly vertical NAND technology will drive the more and more deposition. Our move into the packaging will drive more volume of deposition, meaning, the structure sizes are so much larger. We're going to be putting down a lot more material. And then also double patterning, quadruple patterning of conformal films is another opportunity in order to expand deposition opportunities, because clearly, it's becoming clear that it's not a slam-dunk to go to EUV. The costs are high, the throughputs are less, the market is craving alternatives and the creativity of our engineers isn't that -- we're all striving to figure out how we can take a chunk out of that opportunity. And so I think all of those things play into better opportunity for deposition going forward.

Operator

We'll take our next question from Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company, LLC, Research Division

For my question Rick. First question actually related to bookings versus your shipment and revenue, I noticed that booking has been below shipment or revenue for the last 3 quarters. I'm not asking you to project the first quarter, but is it possible that in the first quarter you might actually have a lower level of shipment even if bookings continually recover?

Richard Hill

I would hope not to plan that. That's not -- I mean, not likely.

Edwin Mok - Needham & Company, LLC, Research Division

What about timing of revenue? Is that any type of revenue recognition timing that might impact your...

Richard Hill

The only thing that's potential is revenue recognition, because we are shipping some first time products that are coming out. And we do have the legacy of having to ship 2 products into one location, before we can recognize revenue 90-10. I mean, it's complex. I wish it weren't, but it is. And there's no sense changing that.

Edwin Mok - Needham & Company, LLC, Research Division

Great. I just wanted to get that clarification. And then one question I have regarding your booking, high booking on the fourth quarter. I was wondering are you seeing that across the board among your customer? Are you seeing mainly just from 1 or 2 leading customer that's starting to drive the high bookings?

Richard Hill

We don't really tie it to any single customer, as you well know, but it was nice asking. I gave in my commentary what I saw were the drivers of the business and then so you can sort to deduce where it's coming from, from there.

Edwin Mok - Needham & Company, LLC, Research Division

I see. That's very helpful. And one last question I have for you, Rick. Just on the TSV side. Do you still believe that TSV will start to see more meaningful adoption in the coming year and that, that will be a driver for your revenue incoming?

Richard Hill

I think it's one of the most underutilized tools in the tool bag of designers. And as it becomes more apparent, its capabilities, its performance advantages, I think -- in other words, I want you to remember what I said about the transistor density being volumetric rather than just area, because that's where the world is going to go.

Operator

And we'll take our next question from Patrick Ho with Stifel, Nicolaus.

Patrick J. Ho - Stifel, Nicolaus & Co., Inc., Research Division

Rick, as you look at the DRAM industry and obviously a lot of the moving parts and the variables there. Can you give a little bit of color from your standpoint if the DRAM as an industry from a CapEx perspective, whether they're reaching some kind of threshold where we use it's [ph] point to become as prevalent and as we get down to the 2x node. And what you see as the potential catalyst for DRAM to start adding capacity in addition to just the big growth. When do you see, I guess, that inflection point where new processes and technologies create the need for new capacity buys?

Richard Hill

So DRAM is the one area where in the semiconductor business, there tends to be more headwinds than tailwinds. And what I mean by that is, as I've always said in the past, DRAM is an application follower, it's not an application generator. Think of NAND Flash as the ability to have nonvolatile memory, drives unbelievable number of applications that can be done, because of the ability to hold these bits permanently. DRAM has always been driven by PC technology and the microprocessor needing to address a certain amount of DRAM based on its word size or its speed because of the clock rate of the microprocessor. And what you see today is in the microprocessor arena, you see the movement towards a reduced instruction set processor, which again tends to be a little bit of headwind to DRAM. You don't see the expansion of the bit size or the word size growing as rapidly as it has in the past, okay? Now you see multicore applications, which tends to be a little bit of a tailwind for it, but from a standpoint of the actual drivers themselves, there tends to be more headwinds on DRAM. So what you see happening is specialized DRAM. DRAM that goes into mobile applications, where you're very sensitive to power or you're really sensitive to speed application. And so that's how the DRAM market is starting to evolve, which then is going to push it more and more into technological capabilities that may exist in one company and not exist in another company until, of course, someone can figure out how to move at infinite speed and 0 power, which I don't think can occur the last time I checked. And so as a result, DRAM tends to be a headwind, and I think majority of the expansion of capacity and everything is going to revolve around nonvolatile memory.

James Covello - Goldman Sachs Group Inc., Research Division

That's great, Rick. Maybe a question for John in terms of OpEx since didn't give a lot of granularity. Can you discuss a little bit maybe at a high level the type of investment you're going to be making particularly with whether it's TSV or some of the vertical NAND discussion that you mentioned, and could we assume that it's going to track higher on an absolute level as these investments go in?

John D. Hertz

Well, I wouldn't necessarily say that we deviate from our model. So we make pretty disciplined trade-off decisions with our OpEx and where we invest. And so I wouldn't expect these investments in TSV or vertical NAND are going to cause us to be outside of our model from OpEx standpoint.

Patrick J. Ho - Stifel, Nicolaus & Co., Inc., Research Division

And maybe one final follow-up off of that. Given that it's still at the early stages of 450, is that something that's not going to have a big impact one way or another for you guys again on the OpEx line?

John D. Hertz

Well, definitely not in the next -- in the near term, say, the next year. I think as we get farther out in time that will become a bigger impact.

Operator

We'll take our next question from Weston Twigg with Pacific Crest.

Weston Twigg - Pacific Crest Securities, Inc., Research Division

I just wanted to follow up on the packaging piece. Just wondering if you can update us on the rate of advanced packaging solutions like TSV or wafer level packaging over the next few years. And I'm wondering how much of that could be impacted by the current downturn? And also in terms of revenue dollars, what do you expect from advanced packaging solutions in 2011? And how much do you think that will grow in 2012?

Richard Hill

Well, Weston, we don't break that out here in the call. We really try to focus on the financials and then I talk a little bit about the color of the market. And as I said previously, the attractiveness of advanced packaging comes with bringing a new capability set to the packaging company such that they have more to offer their customers, higher packaging pin density, lower-cost, getting rid of gold wire bonding capability, getting greater transistor density through vertical integration of devices, and I think those are the things that play out with advanced packaging. So those are real tailwind. I'm trying to accelerate these advanced packaging into the OSATs as well as the top players in the industry making sure they have in-house capabilities that no one else has. And so you got both of those horses going on right now. And therefore, it's a pretty attractive market right now. And what we like about it is as an example in copper volumetrically, when we're doing deposition of copper, the volume of copper we have to put down is dramatically greater than what we do in the back end and the front end if you will, in the interconnect to the IC, it's minute volumes compared to the back end packaging wafer-level packaging, so there again, it's a very attractive market.

Weston Twigg - Pacific Crest Securities, Inc., Research Division

I think it's Semicon West who you had mentioned that you're expected to be [indiscernible] to around 400 million? Is that right? And then I guess maybe another way just to ask on the growth in 2012, do you think that TAM actually does grow in 2012 toward that, aside from what [ph] you mentioned?

Richard Hill

And the answer is yes. Yes, it does.

Operator

We'll take our next question, our final question today, from Mehdi Hosseini with Susquehanna.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Rick, when I look at the past decade, the average peak to trough contraction in booking for the front end equipment companies has averaged about 40%. And if I were to look at your just-reported quarter, I get a peak to trough booking contraction of 45%, and given your guidance, does that mean that we have already hit to bottom in the current downturn?

Richard Hill

Well, I think I mentioned either in the mid-quarter update or at the end of the mid-quarter update that I felt like we had bottomed out. And that we were at the bottom, because I had some indication of the order strength in the fourth quarter at that juncture. So I tried to give people as much information as I possibly could, and we've seen more positive feedback since that point in time.

To me, the cloud on the horizon is the macro, not the micro. I could talk in raptures about where technology is going and why it's great. And there's no way semiconductors are going away anytime soon or our semiconductor capital equipment company is going away anytime soon. But you still have the fundamental irresponsibilities of sovereign nations, including our own, relative to our inability to rein in spending and with that, that presents headwinds for all of us who are in free enterprise, where we don't have a printing press to print money. We have to go out and make it the old-fashioned way, earn it. And I think that's the only cloud on the horizon, frankly.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

And then on the new opportunities, packaging. Given the different kind of customer mix, doesn't that imply that there may be lower margin profile opportunities?

Richard Hill

Well, Mehdi, you have to remember that we have -- it would be lower margin if we couldn't deliver dramatic cost of ownership and technological advances. We've recognized a long time ago, we can't charge very much for a product that doesn't enhance the value to our customers. And we're focused on that. And I am convinced that in this packaging arena, the front end technology we're so good at that we can bring to the back end with our new SABRE 3D with our 3D capability, with our strip products, are so significant from a yield standpoint, from a quality of what we're putting down that it's offering that will ultimately dramatically lower the cost of packaging and, simultaneously, we'll be able to get higher margins.

Operator

And at this time, I'd like to turn the call back to Mr. Hill for any closing remarks.

Richard Hill

Thank you very much for joining us for the third quarter. I'm happy I could bring just a small amount of good news with that booking forecast of up 10% to 30%. Again, I do appreciate all the difficulties you all have in this tough, turbulent markets that we have and I appreciate your support of Novellus and you're participating in our call and I look forward to our mid-quarter update. So thanks very much and I look forward to talking with you in the future.

Operator

And this does conclude today's conference. We appreciate your participation. You may disconnect at this time.

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