Novellus Systems Q1 2007 Earnings Call Transcript

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Novellus Systems, Inc. (NVLS)
Q1 2007 Earnings Call
April 18, 2007 5:00 pm ET

Executives

Robin Yim - IR
Bill Kurtz - CFO
Rick Hill - Chairman and CEO

Analysts

Gary Hsueh - CIBC World Markets
James Covello - Goldman Sachs
Satya Kumar - Credit Suisse
Timothy Arcuri - Citigroup
Steve O'Rourke - Deutsche Bank
Edward White - Lehman Brothers
Mark Fitzgerald - Banc of America Securities
Brett Hodess - Merrill Lynch
Jay Deahna - J.P. Morgan
Harlan Sur - Morgan Stanley
Mahesh Sanganeria - RBC Capital
Ben Pang - Caris & Company
Gavin Duffy - A. G. Edwards

Presentation

Operator

Good day and welcome to Novellus' First Quarter 2007 Earnings Call. As a reminder, this call is being recorded today, April 18, 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, Tom. Good afternoon everyone, and thank you for joining the Novellus Systems' first quarter 2007 earnings conference call. Joining us by phone from Japan is Rick Hill, Chairman and Chief Executive Officer, and with me here in San Jose is Bill Kurtz, Chief Financial Officer.

Financial results for our first quarter 2007 were released on PR Newswire shortly after 1:00 PM Pacific Daylight Time. You can obtain a copy of the news release in the Investor Relations section of our website at www.novellus.com.

Today's earnings call contains forward-looking statements about Novellus' business outlook, the future performance of Novellus, and our products and forecasts of key metrics for the second quarter of 2007. Specific forward-looking statements include, but are not limited to, our expectations regarding semiconductor industry growth and capital equipment spending, the demand for and competitiveness of our products, our expectations that we will continue to maintain our position or grow market share, the forecasted bookings, and shipments volume, revenue, gross margin, operating expense, tax rate, DSOs and earnings per share both on a US GAAP and pro forma basis, our financial models for 2007 and other anticipated 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, including an inaccurate basis for our financial forecast. Information concerning risks that could cause actual results to differ to materially is contained in today's press release, our filings with Securities and Exchange Commission, including our Form 10-K for fiscal 2006 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.

Bill Kurtz will begin today's call with a review of the financial results for the first quarter followed by guidance for the second quarter of 2007. Then Rick Hill will discuss the state of the business and our industry outlook followed by a question-and-answer session.

I'll now turn the call over to Bill.

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Bill Kurtz

Thank you, Robin. As Robin indicated, I will review the first quarter results and then provide the outlook of our key metrics for the second quarter. So, let me start with the summary of Q1. Bookings, revenues, gross margin and EPS for the first quarter were all within guidance range provided on a mid-quarter update on February 28.

Shipments, however, ended up 10 million below guidance due to customer push-outs in the quarter. Bookings came in at $412 million and were down 6.7% sequentially as expected due to the anticipated digestion of capacity by our customers.

By wafer size, bookings were 83%, 300 millimeter and 17%, 200 millimeter. Shipments were about flat with the prior quarter at $389 million as we continued to experience some customer push-ups in the quarter.

Revenues came in within the guidance range at $397 million and were down 9.5% from December as expected. Revenues were also impacted by customer shipment push-outs; however, the shipment push-outs were largely offset by increased tool acceptances to keep us within the guidance range.

Now, first quarter revenues by geographic region are as follows. United States was 22% of revenue, Korea at 26%, Greater China was 36% of revenue, Japan 9% and Europe represented 7% of revenue. Gross margin was at 49% as expected, which is down approximately 2% compared to the fourth quarter due to both product and customer mix.

Turning to operating expenses, operating expenses were about $128 million in the quarter, up as expected by about $3.5 million due to higher employee-related costs, mainly resulting from the absence of year-end shutdown and payable tax savings that lowered the Q4 expenses. In the second quarter, we anticipate that operating expenses will actually increase by approximately another $7 million due to merit increases, higher profit share that's tied to our shipment's P&L and R&D programs to support key product releases.

Our effective tax rate in the quarter was approximately 31.5%, down two points from the prior year due to increased foreign income resulting from the implementation of our new global business structure.

Our first quarter GAAP net income was reported at $53.8 million or $0.42 per diluted share. Excluding the impact of FAS 123(R), EPS for the first quarter was $0.45. There were no special charges recorded in the first quarter.

On a pro forma basis, Q1 EPS would be down from the fourth quarter as expected, and up from the first quarter of 2006. Comparing to the prior year, the increase in earnings over the prior year was driven by higher revenues, higher gross profit and a lower effective tax rate offset by higher operating expenses.

Now, turning to the balance sheet, we ended the quarter with just over $1 billion in cash, short-term investments and restricted stock, which is about flat from the prior quarter. There were no stock buybacks executed in the first quarter.

Net accounts receivable grew by $61 million, and DSOs increased from 67 days at the end of December to 81 days in the first quarter. This increase in both AR and DSO is a result of the distribution of shipments within the quarter, such that a higher proportion ended up in the third month of the quarter, any lower level of factored receivables resulting from Japan. Now, going forward, we expect DSOs to range between 70 and 80 days depending on the timing of factoring and the timing of shipments.

Inventory increased by $36 million on a sequential basis as a result of both customer push-outs and the inventory build required to support our forecasted 16% growth in shipments during the second quarter.

Now, I'll summarize the guidance of our key metrics for the second quarter. First, we expect bookings to be down approximately 10% to 20% sequentially to a range of $330 million to $370 million. Shipments are forecasted to be up 13% to 16% sequentially, with a range of $440 million to $450 million. Revenue is forecasted to be in the range of $410 million to $420 million, up 3% to 6%.

Gross margins are forecasted to increase to approximately 50% in Q2 and earnings per share, including FAS 123(R)-related stock comp expense is expected to be between $0.42 and $0.45. Excluding FAS 123(R), EPS would be expected to be between 45% and 48%.

We expect the tax rate of approximately 32% on an average for the balance of 2007, which incorporates the initial implementation phase of our global business structure. We also anticipate further opportunities to reduce our tax rate in 2008 and beyond, with a full implementation of our new structure.

With that, I would like to turn the conversation now over to Rick, who is in Japan, visiting customers, who will comment on the state of our business. Rick?

Rick Hill

Thank you, Bill, and good afternoon ladies and gentlemen. As Bill just reported, our net sales were down 9.5%, which was on the low side of our estimates for the fourth quarter. But it was within our expectations.

Bookings were also down as we expected, 6.7% and on a year-over-year basis, they were down 1.1%. On a regional basis, the bookings are down both from a standpoint of year-over-year, in all regions except for China. The strength in China was largely driven by bookings for memory products.

We also were helped with our bookings number, with a record bookings period for Peter Walters polishing equipment. We think, which is again, a strong sign of our strength in the polishing technology, as we go forward. We don't expect that the record level of bookings exceeding $70 million and Peter Walters will continue at that level going forward.

What was unexpected to us was a late quarter one push-out. Again, it was driven largely by the memory segment. And you can see by our forecast, we see most of that product shipping in Q2, and we do see this materializing during the month. This push-out did adversely affect our finished goods inventory, which further contributed to some of our growth in assets that we were managing. Going forward, our expectations, as Bill reported, for the second quarter is a further downturn in the industry overall.

Asia in particular, is extremely cautious right now. Japan shows to be flat, but some announced fabs are actually going to occur in Taiwan. One major fab announced the NExT RISC fab will not be a major factor for Novellus, as the technology being used will come from Elpida where we do not have a very, very strong position. So consequently, despite that large announcement, we don't expect that to have a huge impact on our business, and whether or not they occur in the second quarter or not, I am not sure of the timing of those orders at this particular time.

There were no buybacks in the quarter. There was nothing behind those buybacks or having buybacks or not having buybacks. We've articulated before that we view our cash balance as the opportunity to invest before our investors, and that's our current status with buyback.

Bill reported the guidance for bookings down an additional 10% to 20%. This is in line with what we had indicated for the overall year profile. It does mean that we need a strong rebound in bookings in both the third and fourth quarter, which at this particular time, we do start to see signs that this could occur. There is some firming in the Flash memory prices. DRAM demand continues to be robust, and we have to see what transpires during the second quarter to really see the potential impact on a second quarter, but we still tend to feel the second quarter, from a bookings standpoint, will tend to move north.

Our gross margin improvement will come in the second quarter, again due to continued improvement in product performance, our value selling, and there is some adverse mix effect again in the second quarter, as some of our less strong gross margin products do show some growth due to past bookings and revenue recognition during the quarter. Our EPS again will show some improvement potentially, flat to some improvement, on the current revenue forecast due to continued control of expenses and some improvement in gross margin.

So, at this time, I would like to open it up for any questions that you might have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). We'll go first to Gary Hsueh with CIBC World Markets.

Gary Hsueh - CIBC World Markets

Great, thanks for taking my question. I guess my question is around shipments. The only person that's reported in this space is Lam Research. They talked about shipments pull-ins actually into the March quarter. You are talking about the net shipments kind of push-outs. You are both guiding to shipments being up. But could you help me fair it out what's the difference is between perhaps some of your competitors. I think you pointed out that you have limited exposure to RISC chip, but anything else going on there?

Rick Hill

No, I think the shipments were largely memory-driven. We did see some pull-ins from a logic standpoint, but then that was in a negative direction, and it was somewhat of a surprise to us. But it was not as a result of loss of business. And again, we do see it going up in the second quarter.

Gary Hsueh - CIBC World Markets

Okay. And if I could sneak in one last question here to Bill. Bill, on gross margins, you basically talked about hitting 52% to 54% gross margin, I have to assume that that's a much higher kind of revenue run rate. If you kind of bring that back down to the earth at around the $400 million level, what does that translates to in terms of gross margin targets at roughly $400 to $420 million kind of range for the year?

Bill Kurtz

Sure. As we have commented on our current gross margins now running approximately 50% are a function of our current product mix. But we anticipate even after $400 million of being able to improve margins from here, as Rick pointed out, by making further improvements in the product portfolio, getting value differentiation for what we sell. And so, we see an ability to improve gross margin from here, even at the current level. Now, we do get a benefit from higher revenue, but it's not the big driver that gets us to 52% to 54%. The big driver that gets us to 52% to 54% is continuing to invest in the quality of our product portfolio to get differentiation to get the value of that getting to the bottom line.

Gary Hsueh - CIBC World Markets

All right, great. Thanks.

Operator

And we'll take our next question from James Covello with Goldman Sachs.

James Covello - Goldman Sachs

Great, guys, good afternoon and thanks so much. Rick, you have been helpful in the years in helping us think about the fact that most customer investment is tied to customer profitability. So, the kind of environment you are talking about in the second half, can you talk about how you think that relates to what the customers are going to be doing from a profit standpoint? And I guess the question is, are NAND prices just kind of flattening out enough or would we have to see some significant pickup because they are losing a fair amount of money right now?

Rick Hill

Right. I think NAND is about the future market share, and I have articulated several applications that bode well for NAND pricing in the short-term as well as the long-term. And I still do expect to see that trend throughout the rest of the year. And so, now you have the phenomenon of as NAND Flash consumption grows, market share is a function of capacity.

And so, I don't see a large stalling build-out for NAND Flash, okay. And again the driver for Vista is going to continue to support the need for expanded DRAM production. So, while I see a short-term pause in the bookings standpoint, we are still shipping a fair amount of capacity into the memory fabs, and I do expect that that will return in the later part of this year and coming back to --

James Covello - Goldman Sachs

And kind of regardless of customer profitability, just because of some of the longer term trends or just customer profitability from that?

Rick Hill

I think another factor that's going to weigh in on 300 millimeter fabs and then analysts pose the question, what do I think of 200 millimeter fabs in the NAND and memory market? And I don't think in the long-term 200 millimeter fabs can be competitive in the NAND Flash marketplace. So, you will see that capacity switch over to 300 millimeter in the very near term. So, part of the expansion of capacity will be taking out 200 millimeter capacity and putting in 300 millimeter capacity. So, this will bully 300 millimeter expected orders going forward.

In addition to that, we are starting to see the phenomenon, I believe, of some Chinese subsidization of factories in China, which would be a net positive, I believe, from the standpoint of build out of future fabs. And I think that might augment the issue that you're speaking about of the marginal profitability of some of the players in the DRAM and in the NAND Flash business.

You have seen the ability to debt finance some of these fabs in Asia. And so, there does appear to be enough flow of capital to continue to support a moderate if not strong level of investment in memory.

James Covello - Goldman Sachs

And if I could just ask one final follow up, then I will go away. What is it we've been doing for the last few years with all the 300 millimeter capacity that's been added already there? Last year was the record high DRAM investment and NAND investment, isn't a lot of that going to replace the existing facilities already?

Rick Hill

I think it's filling a lot of new demand. When you look at unit demand growth and the expansion of use of NAND Flash, as we've discussed before, the drop in price has had a very positive effect in the utilization of that particular technology. And the advances in technology are promoting further diverse uses of it, albeit, the computer industry is still a major driver. I do have some expectations that beginning middle of this year, there will be some substantially improved consumer products that will attractively price and use NAND Flash technology along with new lower power consumption processors, which I think can have a very, very positive effect on the market.

But again, that's something that's forward-looking and speculative. And when we sit here and look at the business, we have to try to make sure that we are there with our equipment to be able to supply it to our customers when they need it.

There has been some concern in the memory market. There still is some concern in the memory market. But most of the feeling of our customers are that the second half of the year, they are seeing increased demand because of expanding applications. That's my best guess on it, and its host of different inputs, including our own internal marketing.

James Covello - Goldman Sachs

Terrific. Thanks so much.

Rick Hill

All right, Jim.

Operator

We will take our next question from Satya Kumar with Credit Suisse.

Satya Kumar - Credit Suisse

Yeah, hi. Thanks for taking my question. Rick, I think you've reiterated your view of second half recovery, and it's sounding like you are sort of more positive on the Flash memory and there was a lot of discussion on the memory side.

Can you talk a little bit about the logic and foundries? It seems to me that the foundries like UMC and Chartered are running at fairly low utilization levels 50% to 70%, and guidance from chip companies are sort of lukewarm into Q2. What is sort of baked in into your recovery scenario for the back half for the non-memory portion? And what gives you the confidence that those parts would recover not to drive any meaningful recovery?

Rick Hill

Right. Clearly, the foundry model is a very desirable model going forward, as more and more IDMs make the decision to abandon process development and look to the foundries.

Now, part of that phenomenon is going to be them taking existing capacity and transferring that capacity to existing foundries. And so, you are going to see that phenomenon. So, that should be a positive upward pressure. Now, most of these announcements were made at the end of last year and beginning of this year relative to stopping development at 45 nanometer, which while it has a huge effect on the technology going forward, it also has an effect on existing designs, because if you're taking existing design at 65 nanometer and 90 nanometer, you want to have a path to continue to shrink it.

So, my gut tells me that some of the existing 90 nanometer and 65 nanometer designs will start to move to the foundries. So, I think, they will start to see an upward demand for their services, and which I think is on the whole, a net-net good for the industry, because it will create demand for new 300 millimeter products because that's where the investment is.

It has somewhat of a negative suppression effect on what I would call the inefficiency factor. You have to remember is that we've got a whole bunch of guys investing in fabs, competing for the same supply to the marketplace. There is some efficiency and as an equipment company, we benefit. But I think, the net benefit is positive. And while we see some under utilizations within the foundry, I think at the advanced technology node that can be zapped up pretty quickly if designs are transitioned to foundries. It has to do with the qualification cycle.

So, I don't have specific data. I am not giving you any information that comes directly from the foundries. But it's my gut feel, as I survey the overall industry and the trends in the industry and do talk with customers, who are getting out of the business, what I anticipate might be some of the unintended consequences. And so, that's why I am somewhat optimistic on the foundry model as well.

Satya Kumar - Credit Suisse

Rick, if I could have a quick follow-up -- that was useful on the foundry side, but getting back to this memory part. When I look at the memory industry, they tend to add capacity in a large sense. Toshiba is talking about 200,000 wafer start fabs. Really they don't stop it once they start. And one of your competitors last week Lam announced that they are actually increasing their earnings estimates for this year to north of $4.60. Not one of those products has actually contributed to producing any memory yet, and in spite of that you have seen a pretty big decline in memory prices.

In other words, there's a big pipeline of capacity that's still coming for these memory fabs. And you're looking at basically just the initial stages of inflection point in margins for chip companies and you are starting to see push-outs for the very first time. Why should these memory companies really come back in the third or fourth quarter and order ahead of what could be weaker demand once again in the first half of next year? Why couldn't this be a multi-quarter for the long downturn for memory orders?

Rick Hill

Now your key assumption is weaker demand in the first half of next year. And given that assumption, you jumped to the same conclusion. So, you really got to be looking in front of the semiconductor manufactures and try to anticipate whether or not we are going to see more exciting product cycles going forward in order to believe. And I think when you look at the inevitability of Vista, we have talked about this before, it is going to drive incremental demand for DRAM. And I just don't think you could stop that freight train. And so, I think that will be one factor that will be gaining momentum at the end of this year and in the beginning of next year.

So, that drives my thought process. I don't say for a minute that it's absolutely correct, but I am trying to share with you my thought process in looking at the market. And in the NAND Flash arena, it is basically application expansion. And I think the key application expansion is going to be NAND and laptops, professional laptops to start with, consumer laptops quickly following. And if you don't believe in those applications, then I think, we'll have a glide of capacity, and we could see a protracted downturn. But if you believe those applications can have value to the consumer, then I see memory manufacturers competing for that market share and that capacity, which sort of forces an investment cycle. And that's driving my logic, nothing more and nothing less.

Satya Kumar - Credit Suisse

Got it. Thank you so much.

Rick Hill

You're welcome.

Robin Yim

Next?

Operator

We'll take our next question from Timothy Arcuri with Citigroup.

Timothy Arcuri - Citigroup

Hi Rick. Couple of things; number one, if I try to strip out Peter Walters from your bookings and I try to compare what you just booked to what the trough was in 2004, it looks like the core business is not really that far away from the bookings trough back in 2004 yet. There is no other major equipment company that's really anywhere close to that, and you've been saying all along that you haven't been loosing market share. So, I am wondering if you can reconcile that first of all.

Rick Hill

I can only reconcile it from the standpoint of the revenue line. Bookings can tend to be misleading because of the timing of the bookings within the industry. Just as an example of growth, if you don't go this far down in the trough, and you come up and you don't go up as far as everyone else, it doesn't necessarily mean that you've lost market share.

I believe that for the most part in the industry I have commented that we have not lost market share. We have indicated some market share loss in the areas of CMP, not meeting our expectations for market share, and PVD, we believe we're in a position to regain that market share with the performance of the product currently. The delay here is somewhat of a help for us both in a CMP and a PVD standpoint, as it does allow more time for the qualification of our product, which I am sure through your channels you've checked and the performance is quite good. But our core products continue to perform extremely well from the standpoint of PECVD, Tungsten, Electrofill and particularly our strip product is doing extremely well.

We do continue to sell value, greater and greater productivity, which is essential to penetrating from a unit volume standpoint. And we believe that if we can get PVD to yield this year, which we believe it will, and CMP to start to show performance this year, we can have a very, very positive effect on the growth at the top line. And so, commenting on the bookings in any quarter is a difficult thing to do in this business, as you all know.

Timothy Arcuri - Citigroup

Thanks, Rick. If I can just ask just a really quick follow up to that. What would your guidance have been, this is probably tough to answer, but if you had to report a month ago, you are guiding bookings down 10% to 20%. What would that guidance have been one month ago? Has it deteriorated, is it the same, or is it better than it would have been one month ago?

And then to Bill, Bill this is a third straight quarter where you haven't bought back any stock. And I am wondering, what's the specific reason? Is it your outlook on the industry, you think the stock is expensive? It just seems rather it's been three straight quarters. Thanks.

Rick Hill

I think from the first standpoint, from the standpoint of the trend in bookings and we articulated this during the call, it's tended to be more negative, but within the range of what our expectations would have been for the second quarter. And on the stock buyback, we don't comment any further other than we have $600 million left in the buyback, which will be completed by September of, is it '08 or '09?

Bill Kurtz

'09. We have over two years to go on the buyback. And as Rick commented, Tim, we are committed and to use that to the benefit of our long-term shareholders.

Rick Hill

Okay. Thanks.

Timothy Arcuri - Citigroup

Hey, guys. Thanks.

Operator

We will take our next question from Steve O'Rourke with Deutsche Bank.

Steve O'Rourke - Deutsche Bank

Thank you. Were there any cancellations in the quarter, order or shipments?

Rick Hill

No, cancellations, only push-outs.

Steve O'Rourke - Deutsche Bank

Okay. And how much of your backlog is memory? And how much you will ship in the next six months?

Rick Hill

We don't divulge our backlog by product application. So, we just give out one number.

Steve O'Rourke - Deutsche Bank

Okay, fair enough. And Rick, with the recent push-outs that you saw with shipments, what kind of gives you confidence that you may not see more of that during Q2?

Rick Hill

Only that one month is by, some of that stuff is already shipped. So, that's one of the factors on it, but that always could happen. But our conversations and I was spending a lot of time with customers, we believe they are committed to putting in capacity. But everybody has the same question. When you are forecasting the future, it's one of the most difficult things to do. Otherwise, we'd all be in your business.

Steve O'Rourke - Deutsche Bank

Fair enough. One last question Rick, since you are in Japan, how do you see Japanese customers business for you evolving over the rest of the year really?

Rick Hill

We believe that we are positioned in Japan very, very well given the players that have the financial where with all going forward to continue to sustain long-term investment. So, I think we'll participate well in that particular marketplace.

Now, we have areas for improvement. As I articulated on the call, we could improve at Elpida, and that will have sometime positive effect on some of the investments that they are making. And they were very aggressive, and also very capable, okay. When you look at the quality level of Japanese products as quality demands go up, I think that they tend to be fierce competitors. And they are not lying down in the memory business neither the Flash business or the DRAM business. And we've got to do our best to continue to grow our market share. But outside the Sony, Toshiba, Fujitsu area that we talked about, we are somewhat weaker exposure rate to Japan. And we're working on improving that. But that's a relatively long-term process.

Steve O'Rourke - Deutsche Bank

Thank you.

Operator

We'll go next to Edward White with Lehman Brothers.

Edward White - Lehman Brothers

Thanks. Rick, I was wondering if you could talk a little bit about how the mix of business geographically might shift a little bit in the second quarter. There was concentration in Greater China in the first quarter. Would you expect that to shift around a little bit?

Rick Hill

Right. I am surprised, at this juncture, I am starting to see that there is, as I mentioned before, more subsidization regionally within China, which I think could have an effect on the location of putting fabs in Mainland China going forward, a positive effect, because that clearly is what has driven this industry for a long, long period of time.

The one balancing act on that is the loss in our agreement and the limit of the 90 nanometer node technology. So, that would be the counter availing balance in that area. But I think the bias is, at least in the next two quarters, going to be more into the Greater China region. And I think there will be somewhat of a pause, and we are talking bookings now as opposed to shipments and revenue reorganization, somewhat of a shipment away from Korea.

Edward White - Lehman Brothers

Okay. And then secondly, for Peter Walters, why were the bookings particularly strong during the first quarter? And can you talk about some of the dynamics going on there, since that what is the factor in the overall bookings pattern for the quarter?

Rick Hill

I think part of the movement to advance technology has pushed increasing demands on the wafer polishing industry from a quality and performance standpoint. And I think our understanding of that technology of polishing and our ability to be able to provide the type of polishing equipment necessary for wafer manufactures to get the highest value for their wafers led to our strong bump in bookings during the first quarter.

It's also a leading indicator of demand for wafers, advance technology wafers, which I think is sort of a prelude to the next generation of technology that will be coming out of our semiconductor companies. And I think that's the dynamics going on in that particular area. And the quality demands on the polished finish of wafers going forward is doing nothing but increasing. And I think our understanding of that polishing technology is extremely good.

Edward White - Lehman Brothers

And finally, was there any specific reason that the customers that pushed out shipments gave for what was happening, or do you think it was just, I mean normally it's a lot of different things like fabs aren't ready and things like that. Does it seem to be more general, or was there any specific theme behind that that you can discern?

Rick Hill

There has been a theme of delaying somewhat based on current levels of demand and pricing. There has also been somewhat of a shift from DRAM back to NAND, the fungibility there. And so, there are several factors going on.

Edward White - Lehman Brothers

Okay, great. Thank you.

Rick Hill

Thank you, Ed.

Operator

We'll take our next question from Mark Fitzgerald with Banc of America Securities.

Mark Fitzgerald - Banc of America Securities

Great. Two quick product questions. The logic that you had in the Green Peninsula, is there any opportunity this year to lever that into the memory applications?

Rick Hill

I think that, you are talking about from a standpoint of copper applications I assume. And I do believe that you are going to see an acceleration of copper into memories. And I think, our understanding of making this transition is extremely good. And so, I do have some anticipation that there is the ability to leverage that going forward.

Mark Fitzgerald - Banc of America Securities

And is that in '07 or further out?

Rick Hill

It's at end of '07, beginning of '08 type timeframe.

Mark Fitzgerald - Banc of America Securities

Okay. And just on the new VECTOR platform, is that a replacement for the existing platform that is going to move everybody over to that? And can you just --

Rick Hill

It will depend, right. I mean, we are talking about quantitization factors. I think, when you talk about large memory fabs, the throughput and the performance benefits are compelling. In some cases, if the volumes are not as high, it doesn't necessarily mean that everybody will switch the whole house. But I think there will be a predominant movement to Express. And so, both from a standpoint of creditability and new products going forward, there are some significant opportunities for us to enhance our customers' businesses.

Mark Fitzgerald - Banc of America Securities

Thanks.

Operator

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

Brett Hodess - Merrill Lynch

Good afternoon. Rick, with the Peter Walters with the high orders you have, does those products ship fairly quickly or there are long lead times, they spread out over time? And also, does that product line being up have any impact on margin?

Rick Hill

From a standpoint of shipping, we wouldn't recognize and I must say we're going to ship within a year, they do tend to be a little bit longer cycle times than our existing products in the semiconductor business. But these are not likely to go away, we believe. From a standpoint of -- what was the second part of the question again, Brett?

Brett Hodess - Merrill Lynch

Does that have any impact on margins when you're --

Rick Hill

Yeah, I'm sorry. On the margin front, the Peter Walters' margins tend to be less than the semiconductor equipment margins. But I don't think it'll have a huge impact on the gross margins. But it does tend to be negative since it is below the 52% to 54% range.

Bill Kurtz

And this is Bill, and as Rick pointed out, where we are seeing the strength is in the wafer polishing, and the wafer polishing tools are closer to our corporate model. So, the strength in wafer polishing we would not expect to take us off our gross margin expectation.

Brett Hodess - Merrill Lynch

Okay. And then I guess the follow-on is, you said it wouldn't stay at this sort of level, but is this just a one-time bulge through from a wafer manufacturers or do you think that they'll stay at a elevated level relative to, may be not this high, but relative to where they have been in the past?

Rick Hill

We tend to think that it is going to be a growth area in general compared to historical levels, because of the new demands for new technologies and the quality of polished wafers. So, while we're not going to get this by as bulge on a continuing basis, we do expect to see growth in this area.

Brett Hodess - Merrill Lynch

And my last question is to follow-on about the memory adoption of copper. How far are you into the evaluation process with the major memory makers at this point for electroplating in copper PVD? And have you started winning an evaluation here, or is it too soon for that?

Rick Hill

We don't comment on individual customer situations. We have commented that over the next two years, we do see memory transitioning to copper. And that includes both NAND Flash and DRAM. And we do find ourselves engaged in most locations.

Brett Hodess - Merrill Lynch

Thank you.

Operator

We'll go next to Jay Deahna with J.P. Morgan.

Jay Deahna - J.P. Morgan

Thanks, good afternoon. A couple of questions here. First of all, the tone of your call is clearly more negative than what we heard out of ASML and Lam Research. So, I am just kind of wondering, how much of this could potentially be company-specific in the sense that may be there is a limited exposure to Taiwan where there is a lot of demand coming from where you're little bit more exposed to memory in general? That's the first question.

The second question is, assuming you get some sort of a recovery in orders in the third quarter, are you talking about a recovery to 1Q levels or what? What kind of magnitude are you talking about? Those are for Rick.

And then for Bill, in terms of the fluctuation in your shipments going up in 2Q with your orders coming down fairly hard, how is that going to impact the fluctuation in revenues recorded in 3Q, 4Q given your ability to somewhat control revenue recognition? And to what extent are you going to react in OpEx to that?

Rick Hill

Okay. First of all, relative to negative or positive on the tone, I appreciate you're noting my tone, although it's not meant to be negative, it's meant to be factual to try to really give you the same thing we are seeing and what we are making our decisions on. So, it's not meant to send a message of stronger or negative. I am not trying to bolster, I am trying to give information.

I think from a standpoint of Taiwan, aside from the areas that are buying technology from certain key memory manufacturers in Asia or in Japan in particular, where we are not strong, I think that's an adverse effect, and that is possible. That's why our words don't match everybody else's words.

But I think that what we see should be what everyone is seeing. And we will see it unfold. I do know that some people aren't talking bookings anymore, while we are talking more extensively about what we will see the bookings do as we see shipments will follow. And relative to revenue recognition, we have specific rules around that, and so revenue recognition falls the way it does. There is not a lot of control. But I'll turn it over to Bill and let him comment on that.

Bill Kurtz

All right, thanks Rick. As you probably observed in our recent couple of quarters, shipments for the last two quarters have stayed flat at around $390 million. But they are expected to improve in Q2 to go up to somewhere between $440 and $450. We see that as a positive sign. And obviously, revenues would follow that trend as the shipments turn into acceptances. And so, we would expect to see revenues continue to be going up not only in Q2 but continuing in Q3.

Now, the other thing, Jay, as you pointed out, that we monitor very closely is the booking strengths. And so, while we're encouraged by the improvement in shipments, we do look to see bookings improve in the second half of the year. As Rick pointed out, we would expect to see them turnaround in Q3. And that's a key metric that we monitor along with the shipment strength to decide whether we have the right level of expenses. If I look at where the expenses are right now, they are at the right position.

Shipments are growing from Q1 to Q2 by anywhere from 13% to 16% and expenses you're growing about 5.5%. So, we clearly want to always keep expenses below the growth and the top line. And our P&L is primarily driven by the shipments.

As long as we continue to see the positive trends that we pointed out continue, then I think we are fine. If things turn down, then obviously we would make the adjustments to strengthen the Company's balance sheet and give us a lower breakeven point if things turn down. So, we are staying very close to both the leading indicators on bookings, in summary as well as on shipments to mange the business.

Rick Hill

We are not going to comment further on what we might do when the event bookings do turn down.

Jay Deahna - J.P. Morgan

Right. But just not clear Bill. First of all, I wasn't sure what you were saying in terms of the potential magnitude in the bookings recovery in 3Q relative to 1Q. And sometime you have a situation where when things are slow, the customers are a little bit slower to recognize tools, and when things are tight, they recognize them a little bit tighter so that if orders come back in 3Q with relatively quick deliveries, okay. The magnitude of the revenues drop later associated with the order drop in 2Q could be mitigated to a certain extent that happen sometimes, and I am just wondering, at the end of the day, should we be modeling the same revenue volatility out there is what you are seeing in orders in 2Q?

Bill Kurtz

There is no simple --

Rick Hill

Let me take that Bill.

Bill Kurtz

All right.

Rick Hill

Our revenue recognition policies are fairly stringent. And depending upon whether or not we ship multiple systems to a customer of a particular type, you see they are 90/10 or 80/20 recognition. And we tend not to see -- and when you talk about the bulk of that in revenue dollars, they are not contingent upon a customer varying their acceptance criteria. They are pretty specific on what we do. And so, I don't think you can model us accelerating revenue recognition very specifically. And I think that that's a slippery slope to go down.

Jay Deahna - J.P. Morgan

But, if they ask for a quicker delivery date on their order, then that could smooth out the revenue later though, right?

Rick Hill

From the standpoint of if we are able to ship it and we have the capacity to ship it at that particular time and the capacity is largely from a standpoint of material, the revenues will ripple through at about the same rate, and we look at an 8 to 10-week lag time between the bookings and the shipments in general.

Bill Kurtz

Okay.

Jay Deahna - J.P. Morgan

Okay. Thanks.

Rick Hill

Thanks.

Operator

We'll go next to Harlan Sur with Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi. Good afternoon. First question for you, Rick. You mentioned at our conference in early March, your view that global semi-utilizations would bottom here in the first half of this year. Just wondering how has your view changed given what you're seeing here in the March quarter?

Rick Hill

You said global semi-revenues?

Harlan Sur - Morgan Stanley

Utilizations.

Rick Hill

Utilizations. I am sorry.

Harlan Sur - Morgan Stanley

Yeah.

Rick Hill

Yeah, that's my belief. I am in Asia for a while and I will have more data when I return. But at this juncture, I don't see anything that changes that at this juncture.

Harlan Sur - Morgan Stanley

So you are still come bottom here in the first half?

Rick Hill

Yeah, that's what I am tending to see. It is contingent upon the factors I discussed before, and that is the Vista acceptance, NAND Flash finding its way into laptop computers and in more diverse application. Some of those drivers that we talked extensively in past calls are still the major drivers going forward.

Harlan Sur - Morgan Stanley

Okay, great. And then my second question, I know you've talked a little about your views on market share. But, the latest VLSI Research market share data is out today, and it actually shows that Novellus lost market share in pretty much all of its key segments PECVD, HDP, PVD and Strip in 2006. And so, with that in mind, and I know you may not have seen the data, but does this signal that the Company really needs to be more focused on its core CVD business and really think about may be exit strategies for some of its non-performing businesses?

Rick Hill

First of all, I haven't seen the reports, so I can't comment on it at this time. My data tends to suggest otherwise. But we will constantly take a look at that particular data when we see it's available. But I think from a standpoint of growth opportunities, you have to have businesses to grow as well as continue to gain market share in your existing businesses. I think I have discussed various products, where we haven't performed at the level we need to, we're continually trying to perform to that particular level. But we're not making any decisions at this particular juncture to shed product lines. We're investing R&D at somewhat of a fixed level. We're not going to increase that level of expenditure. But we believe that with that level of expenditure and with targeting the 15% after-return, we can deliver these products and provide a better growth vehicle for our shareholders going forward.

Harlan Sur - Morgan Stanley

All right. Thank you.

Operator

And we'll go next to Mahesh Sanganeria with RBC Capital.

Mahesh Sanganeria - RBC Capital

Yes, thank you. I have a question on your booking guidance range. You do provide much narrower guidance range than others in the sector, but it seems like this time your range is much higher than the last time. Does that indicate more uncertainty?

Rick Hill

You can comment Bill, but I don't think that it's much different. A 10 points spread isn't necessarily unusual for us.

Bill Kurtz

No, that's correct. We generally start out the quarter with a 10% range and then at times we narrow it at the mid-quarter to a smaller range. But it is typical for us to have a 10% range as we start a quarter.

Mahesh Sanganeria - RBC Capital

Okay. So, then I have one follow up on -- how do you see foundry orders considering that TSMC has already ordered about $1 billion and they are going to order in June, how does throughout the year, Q1, Q2, Q3, how do you see that trajectory follow orders from foundry?

Rick Hill

As I have said before in foundries in general, I don't comment on any specific customer. I see the foundry model has been extremely attractive model for most companies and that trend is continuing. Sony in Japan, announced discontinuation of 45 nanometers, GI discontinued investment in 45 nanometers. And I articulated sort of the unintended consequences of those decisions in that, when you have new tape-outs for 65 nanometers and 90 nanometers, and you want to be able to extend that technology, you are going to start to put what your big runners would be, where you're going to need cost reductions going forward into the place where you have a technology path, where you might get those cost reductions.

And I think that's a favorable win for the foundry. And so, I see them being able to sustain higher levels of investment going forward. And their profitability models are pretty good, which also are sustained investments. So, that's my feeling about the foundry.

Mahesh Sanganeria - RBC Capital

So, do you expect foundry orders to pick up in the second half?

Rick Hill

I think the foundry, as you've articulated, we're seeing some strengthening now. It's being offset by a much more robust investment in memory, both from a standpoint of Flash and DRAM, which is on somewhat of a low right now. So, I wouldn't expect foundries to grow at the rate that memory investment is growing because the capacity expansion there is not as great as the capacity expansion within the memory business. But clearly, the foundry business is a growth model because of the factors that I just discussed, the shift of IDMs more and more to the outsourcing model.

Mahesh Sanganeria - RBC Capital

Okay. Thank you.

Rick Hill

Thanks.

Operator

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

Ben Pang - Caris & Company

Yeah. Quick question on your PVD. You mentioned that you have I guess some renewed hopes for PVD market share gains in 2007. What applications are there you exactly believe that you can have some momentum? And what are the current insertion points that you see your PVD products gaining some traction?

Rick Hill

I think that PVD is targeted at copper barrier/seed. Although, we do have capability in aluminum, titanium and a host of other materials, but largely it's a copper barrier/seed application, where we think given the technology that we have the defect performance, the throughput of the systems, it's very attractive for businesses that are cost and technology-driven simultaneously.

Ben Pang - Caris & Company

And for the logic companies that are evaluating 45 for making their decisions. What's the percentage of companies that you think have already made the decision on the PVD?

Rick Hill

I think that from a standpoint of our PVD, we had a lot of wins at 90 nanometer. And I believe the extendibility of our technology down to 65 and 45, and even beyond has been confirmed. And so, I think it's attractive at all those nodes.

Ben Pang - Caris & Company

I guess that's where my confusion is in that, your market share is pretty low right now for the copper barrier/seed, but do you actually have a new product that you are pushing at the 45 nanometer for further extendibility beyond that?

Rick Hill

I think that, we don't discuss the technical details of the product. But I think your channel checks can confirm that the performance of the products is such that new application capabilities that we have, have demonstrated the extendibility of our 90 nanometer platform all the way down to 45 nanometer. And while we had a hiccup, a year ago, we have since fixed that hiccup. And as a consequence, I think, we are regaining traction where we had lost it a year ago. And I did articulate the fact that, we didn't meet expectations in 2006, but we are meeting expectations today, and we think it's on a positive vector going forward.

Ben Pang - Caris & Company

And the last question, just a clarification on the R&D expense, should we expect it to be at $60 million level for the rest of the year?

Rick Hill

Bill you might want to comment?

Bill Kurtz

Yeah. We had to take a slight increase in the second quarter as a result of merit increases and some increase in the program spending, and then I would expect to be flat for the rest of the year. That overall expense level by the way, just to comment on it, is in Q2 consistent with our target model, but being on average about 30% of revenue, if you look at it on a shipments basis. So, that's really what gives us confidence.

Rick Hill

That's total operating expense.

Bill Kurtz

The total operating expense, R&D, SG&A included, is about at the 30% level, if you look on the shipments P&L, and that's what gives us comfort that we have the expenses positioned right for the business.

Ben Pang - Caris & Company

Thank you very much.

Operator

And due to time constrains, our final question will come from Gavin Duffy with A. G. Edwards.

Gavin Duffy - A. G. Edwards

Yes, thank you very for taking my question. I just have a couple of housekeeping things. Are we going to see probably the share count go up again or stay around this level?

Bill Kurtz

This is Bill. The share count absent stock repurchases would grow slightly. And then there is always the fact there are stock purchases that will effect the share count.

Gavin Duffy - A. G. Edwards

Okay.

Bill Kurtz

Although, long-term, we expect our share count to come down, as we complete our share repurchase program.

Gavin Duffy - A. G. Edwards

Right. Okay. And I guess this is for Rick, when you seeing like some of the orders you are getting down 10% to 20% for the quarter, I guess I am assuming that these are mostly capacity increase orders while the tech buyers are still pretty healthy?

Rick Hill

Yeah, I tend to think that's the general trend in the industry right now. Yes.

Gavin Duffy - A. G. Edwards

Okay. And I guess last question for Bill, the tax rate in the second half of the year, given your new realignment, is that going to probably stay flat?

Bill Kurtz

Yeah, as I said, over the balance of this year, you should assume a tax rate of approximately 32% or maybe some variation quarter-to-quarter, but approximately 32% for the rest of the year.

Gavin Duffy - A. G. Edwards

Okay. Thank you very much

Bill Kurtz

You're welcome. Okay, Rick, I think that's all the questions we have for today. If you would like to summarize?

Rick Hill

Okay. Thank you very much for joining us for the first quarter conference call. We have a mid-quarter update for quarter two scheduled during May that we'll publish what that exact date is. We believe that the long-term opportunity for the business is very, very positive. And we believe that we are currently operating at a level that balances both growth opportunities and profitability for the future. Thank you very much, and we look forward to seeing you in the next quarter.

Operator

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

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