Novellus Q1 2008 Earnings Call Transcript

Novellus Systems, Inc. (NVLS)

Q1 2008 Earnings Call

April 21, 2008 4:30 pm ET

Executives

Robin Yim - Investor Relations

Jeffrey C. Benzing - Principal Financial Officer, Executive Vice President, Chief Administrative Officer

Richard S. Hill - Chairman of the Board, Chief Executive Officer

Analysts

Gary Huse

James Covello - Goldman Sachs

C.J. Muse - Lehman Brothers

Satya Kumar - Credit Suisse

Brett Hodess - Merrill Lynch

Stephen Chin - UBS Warburg

Edwin Mok - Needham & Company

Mahesh Sanganeria - RBC Capital Markets

Steve O'Rourke - Deutsche Bank

Bill Ong - American Technology Research

Jay Deahna - J.P. Morgan

Patrick Ho - Stifel Nicolaus

Weston Twigg - Pacific Crest Securities

Analyst for Timothy Arcuri - Citigroup

Steven Pelayo - HSBC

Presentation

Operator

Good day and welcome, everyone, to the Novellus first quarter 2008 earnings conference call. As a reminder, today’s call is being recorded today, April 21, 2008. I would now like to turn the program over to Ms. Robin Yim of Novellus Systems. Please go ahead.

Robin Yim

Thank you. Good afternoon, everyone, and thank you for joining the Novellus Systems first quarter 2008 earnings conference call. Joining me on the call today are Rick Hill, Chairman and Chief Executive Officer; and Jeff Benzing, Chief Administrative Officer.

Financial results for our first quarter 2008 were released on PR Newswire shortly after 1:00 P.M. Pacific Daylight Time. You can obtain a copy of the news release in the investor relations section of our website at www.novellus.com.

Today’s earnings call contains forward-looking statements about Novellus' business outlook, the future performance of Novellus, and our products and forecast of key metrics for the second quarter of 2008. Specific forward-looking statements include but are not limited to our expectations regarding the paring down of certain development and evaluation activities related to advanced technology nodes over the next several quarters and additional write-down of related assets; our expectation to continue to evaluate savings opportunities and the resulting non-recurring expenses in the current and future quarters as a result of actions we anticipate to execute; the impact of changes to our effective tax rate related to our international structure resulting from differing levels of profitability than previously forecasted; the forecasted bookings shipment volume revenue, gross margin, operating expense, tax rate, DSOs, and earnings per share, both on a U.S. GAAP and pro forma basis; our ability to forecast results, product mix, and further implement cost reductions; 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 materially is contained in today’s press release, our filings with the SEC, including our Form 10-K for fiscal 2007 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.

Jeff Benzing will begin today’s call with a review of the financial results for the first quarter. Then Rick Hill will discuss the state of the business and our industry outlook, followed by guidance for the second quarter of 2008, and then open the call for the question-and-answer session.

I will now turn the call over to Jeff.

Jeffrey C. Benzing

Thank you, Robin. I’ll start by reviewing the first quarter’s results. Bookings were $297 million, down 13.4% from the fourth quarter of 2007, which was within the low end of the guidance range of flat to down 15. By wafer size, bookings were 92% 300-millimeter and 8% 200-millimeter.

Q1 shipments were 313 million, or 3.7% below the low end of our original guidance range of 325 million to 350 million, but within guidance provided in our conference call on April 8th.

Quarter one revenues were $315 million, down 13.4% from Q4, which falls at the low-end of the guidance range of $315 million to $325 million. As discussed, this was primarily driven by push-outs of customer acceptances in our industrial applications business.

Now, first quarter revenues by geographic region are as follows; in the U.S., 30%; greater China, 30%; Korea, 18%; Japan, 14%; and Europe, 8%. Gross margins for the quarter came in at 46.1%, which was below mid-quarter guidance of approximately 47%. The primary reasons for the lower gross margin was product mix, primarily in our industrial applications business, and lower absorption of fixed overhead costs as shipment volumes weaken and higher-than-forecast write-downs of evaluation systems in our semiconductor business.

Given a weaker outlook in the business and in line with our reduced targets and operating expense, you should continue to see continued paring down of certain research and development activities related to advanced technology nodes over the next several quarters, which may result in additional write-downs of related assets, such as laboratory and other evaluation systems.

First quarter operating expenses totaled $118 million, down $6 million from approximately $124 million in the fourth quarter, excluding the $16.4 million in one-time benefits we had in the fourth quarter. We were able to lower our OpEx quarter to quarter, even with higher employer related costs than those we experienced in the fourth quarter that benefited from the higher shut-down savings and the payroll tax savings that typically reduces our fourth quarter expenses. We accomplished this by managing headcount and R&D spending. In addition, we experienced lower commissions and profit sharing expenses commensurate with a lower volume of shipments and revenue.

In the second quarter, we anticipate that ongoing operational expenses will decrease further as we continue towards our goal of exiting the quarter at a $110 million run-rate for operating expense, excluding the impact of a weakening U.S. dollar.

We continued to evaluate various cost-savings opportunities, especially in the light of the current business environment, and expect to see $10 million to $13 million of non-recurring operating expenses as a result of actions we anticipate to execute on in the quarter.

Our effective tax rate for Q1 before the discrete -- excuse me; our effective tax rate before discrete items for the year has increased to approximately 36% versus the previous guidance of 32%. For Q1, our tax rate came in at 45.3%, 9.3 points over the effective tax rate for the year because of $2.7 million in one-time adjustments to deferred tax and tax reserve accounts.

Additionally, the tax rate was adversely impacted by a decrease in tax exempt interest income as we shifted a larger portion of our investment portfolio into taxable securities which affected the tax rate. Our expected tax rate of 36% for 2008 increased in part because we expect to realize a lower benefit from our international structure.

EPS for the quarter was $0.15 per fully diluted share and within the revised guidance range provided on April 8th versus our mid-quarter guidance range of $0.21 to $0.24. Forecasted EPS was negatively impacted by the issues outlined before.

Turning to the balance sheet, we ended up the quarter with just over $576 million in cash, short-term investment, restricted cash, and long-term investments, which is down $181.5 million from $758 million in the prior quarter. On a cash flow basis, approximately $150 million of cash was used to pay for purchased stock. Actual stock buy-backs in the first quarter totaled $135 million, or 5.8 million shares at an average price of $23.20, which brought our share count to just under $100 million shares.

Cash flow from operations was negative by approximately $32 million, due primarily to lower earnings, a rise in accounts receivable and inventories, and a decrease in accrued liabilities due to payment of annual bonuses.

Net accounts receivable grew by $28 million and DSOs increased from 76 days at the end of December to 94 days in the first quarter. The increase in both ARs and DSOs resulted from slower payments by customers and less than half the amount of factory receivables compared to Q407.

Inventory increased by approximately $30 million on a sequential basis as a result of customer push-outs.

That concludes my remarks for the first quarter. Now I’ll turn the call over to Rick who will comment on the state of the business followed by the guidance of our key metrics for the second quarter.

Richard S. Hill

Thank you, Jeff. Good afternoon, ladies and gentlemen. Quarter one was a disappointing quarter for all of us. While given the economic uncertainty globally, we should have anticipated the results but we didn’t, or we would have projected it during our mid-quarter update. The environment today is quite dynamic.

As we stated two weeks ago, our shortfall in revenue and gross margin were driven primarily by a shortfall in revenue by our industrial product groups and write-downs on some evaluation systems and inventory caused by the termination of R&D programs as we drive to the $110 million operating expense run-rate.

Now, before resetting expectations for the second quarter, I want to share with you the current economic environment we find ourselves dealing with. On the bright side, the PC market is in line with our expectation and as long as it holds, this should provide a good base to drive DRAM and NAND Flash prices up by increasing demand and outstripping the supply, as less and less supply is being brought on.

Prices, however, are below our expectation at this point in the cycle but they are in the right direction upward.

On the negative side, tight credit markets did lead to push-outs at the end of the quarter and we don’t see an immediate end to this. Analysts are predicting more ASP weakness in NAND and DRAM. This will adversely impact the timing of capacity expansion. It will be most affected by what the consumer does and corporate CapEx for IT going forward.

There was a positive data point from Intel last week and a neutral data point from IBM as IBM’s growth was more service than hardware driven.

We can’t control the market but we can control the success of our product and our expenses. On a product basis, we have seen significant wins with new products from both PECVD and HDP. Those two being our largest businesses is a very good sign.

On an expense front, we are on track to exit quarter two at the $110 million operating expense, excluding what I would call a headwind due to exchange rate. There’s about an incremental $1.7 million to $2.2 million of increase in expenses from exchange rate, the devaluation of the dollar, that we are still working with.

In the second quarter, we will achieve that $110 million run-rate but will require an additional $10 million to $13 million of additional write-downs for workforce reductions which are already complete and asset impairment charges as we complete the shutdown of certain R&D projects.

Our break-even point is expected to be in the $245 million to $250 million per quarter range. On a balance sheet front, we saw temporary deterioration on the balance sheet as cash flow from operations was negative for only the third time in 15 years. The cause was a push-out of a major shipment which increased inventory by $30 million and delayed payments that pushed up accounts receivables. Significant portions of that cash has been recovered in quarter two already.

On a customer front, we have seen a dramatic shift in CapEx spending. The top 10 semiconductor companies from a CapEx standpoint spend 71% of the total CapEx and that is up from 52% in 2007. Eight-seven percent of our shipments in Q1 went to those top 10 spenders.

The good news is we are well-positioned in all those companies with all our products.

Now, given that backdrop, I’ll now provide the guidance for the second quarter. Due to weak market conditions and uncertainties to the time of the recovery, we are lowering our revenue, shipment, and EPS guidance to maintain a book-to-bill of one or greater. We are expecting bookings to be down approximately 10% to 25% in the second quarter. Now, at the beginning of the year, we would have expected bookings to be up in the second quarter. Shipments are forecasted to be down sequentially in a range from $235 million to $260 million. Again, our attempt is to maintain a one-to-one book-to-bill ratio and still satisfy customer demand.

Revenue is forecasted to be in the range of $245 million to $260 million. Gross margins are forecasted to remain flat at approximately 46% in Q2.

GAAP earnings will be a minus $0.06 to break-even. Our pro forma EPS should be in the range of $0.01 to $0.05. That’s excluding the anticipated non-recurring charges previously described of between $10 million to $13 million.

That concludes my comments on our guidance for the second quarter. Now I’d like to open it up to any questions that you would have.

Robin Yim

Operator, we’d like to start the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Gary [Huse]. Your line is open. Please go ahead, sir.

Gary Huse

What drives the top end of your booking guidance for Q2 and what drives your bottom end? Is there any kind of scenario between the two?

Jeffrey C. Benzing

Yeah, there’s big scenarios relative to -- it depends what happens largely in the memory marketplace.

Gary Huse

Okay, well let me ask you a question a different way; you talked about delayed payment terms sort of inflating your AR number here on your balance sheet. Have we recognized the bookings on that delayed payment kind of business? Are we seeing that in Q1? Are you guiding to it in Q2?

Richard S. Hill

We didn’t comment on any delayed payments. What we commented on was we had some delayed shipments which increased our accounts receivable, or delayed shipments that happened late in the quarter which increased our accounts receivable.

Gary Huse

Okay and final question here, Rick; if you look at your Q2 order guidance and you just kind of flat line that throughout the rest of this year, we’re looking like we are heading for a down 25% bookings year year over year. What kind of confidence do you have here that Q2 is the bottom and we could see an up-tick here in maybe Q3 and Q4?

Richard S. Hill

Well, I think from a standpoint of supply and demand, Q2 should clearly be a bottom. However, there are other factors that are impacting what’s going to happen going forward; one being fundamental consumer demand and corporate demand as more and more companies have been coming out with weaker and weaker earnings. And the question will be what will they do to their CapEx, which ultimately ripples to us and gives our customers the confidence to bring on capacity.

I am cautiously optimistic but frankly I was -- you know, am quite surprised with the rapidity of the falloff and the rate at which DRAM and NAND Flash prices are coming back are not as strong as I would have anticipated, although they are coming back.

Gary Huse

Great. Thank you.

Operator

Our next question will come from Jim Covello. Please go ahead.

James Covello - Goldman Sachs

Good afternoon, guys. So Rick, if I go through the scenario of the CapEx cuts today that are happening in DRAM and NAND are real healthy for supply/demand in the back half of this year, how many quarters do you think the DRAM and NAND makers need to see ASP improvement before they will come back to order again? Do you think it’s a length of time that they need to see or do you think that it’s an amount of price increase that they need to see before they are going to start to feel comfortable ordering again?

Richard S. Hill

I think it’s a function of the price of DRAM. I think it’s a function of their confidence in the consumer and I think it’s also a function of their ability to get access to capital. Those three things.

James Covello - Goldman Sachs

And you think it’s more the DRAM industry is a little bit more dire than the NAND industry, relative to your discussions?

Richard S. Hill

I would think the answer to that is yes.

James Covello - Goldman Sachs

Okay, and then final follow-up for me; there’s this issue that’s making a bigger -- that’s generating a little more noise in the industry about the ceiling on DRAM in 32-bit operating systems with 32-bits not recognizing more than three or 3.5 gigs of DRAM content per box. Is that anything that’s coming up in the discussion with the DRAM makers or do you have any opinion on that?

Richard S. Hill

I really don’t have an opinion on it and it’s best to ask those guys that question.

James Covello - Goldman Sachs

Thanks very much, Rick.

Operator

Our next question comes from C.J. Muse.

C.J. Muse - Lehman Brothers

Thanks for taking my question. A couple of questions here; I guess first off, there was a lot of moving parts to Q1 but it looks to me like it’s a sharp down-tick in other income that really led to the miss there, so can you help me understand the moving parts there and how we should think about that line item going forward?

Richard S. Hill

Well, the moving parts in other income largely come from the auction rate securities. Our movement of our funds as these things are -- you know, come to their expiration and we sell them, moving them to totally risk-free securities which forced us into a worse tax position because now they are taxable income. But that’s largely the impact and then in addition to that, we reduced cash because we bought back a substantial amount of cash. And Jeff has a comment as well.

Jeffrey C. Benzing

And we also saw a hedge against some of our Japanese bookings, or our bookings to Japan, so we saw a currency hedge of a couple of million dollars in the quarter.

C.J. Muse - Lehman Brothers

Okay. How should we think about that going forward? I mean, $10 million last quarter, $1 million this quarter?

Richard S. Hill

What’s our plan number for -- $5 million going forward is the approximate number going forward.

C.J. Muse - Lehman Brothers

Okay, great. And then in terms of the movement of deferred revenues on the industrial apps side, what kind of magnitude should we think about in terms of the June quarter and can you help us understand what the growth rate or decline for that business should look like in 2008?

Richard S. Hill

That business is planned in 2008 -- I believe the plan has that up slightly, and that’s it with that business.

C.J. Muse - Lehman Brothers

Okay, and final question for me -- where is your headcount today?

Richard S. Hill

An overall headcount is at 3,575. We’ve reduced the semi headcount by 141 heads since January and we have added some heads in our industrial products organization.

C.J. Muse - Lehman Brothers

Great. Thank you.

Operator

Our next question comes from Satya Kumar.

Satya Kumar - Credit Suisse

Have you tried to disaggregate, I’m sure you have, the trend that you are seeing from NAND Flash and DRAM? Is the decline that you are seeing right now, is that predominantly just coming from DRAM and is NAND Flash pretty much holding up without much signs of weakness --

Richard S. Hill

Actually, we’re seeing an increase in both DRAM and NAND. We’re also seeing from a contract standpoint the ability of the customer to raise prices. The question is how long does it last and how much more can they get it up because they are substantially below where I think they need to be in order for it to be long-term economically viable to provide the cash flow from operations and the cash on their balance sheet to continue to expand capacity.

Satya Kumar - Credit Suisse

But I guess my question is if you look out into your June outlook, are you baking in any weakness from NAND Flash customer ordering patterns or is that pretty much not --

Robert H. Swan

No, we’re not. We’re not.

Satya Kumar - Credit Suisse

Okay, and a question on market share; I know you introduced the Vector product at SemiCon last year. The Gardner data shows that the market share might have declined 400 bps in CVD. I am also really concerned that you are scaling back your R&D expenses. How should I think about your ability to gain back the CVD market share in ’08? And along that vein, if you could also help me understand how you are going to prioritize R&D for CMP and strip in ’08, would be great.

Richard S. Hill

I think from a standpoint of R&D, we have de-prioritized small niche markets and have refocused our R&D on larger, more important markets to us. And as you well know, we introduced Vector Extreme and we’ve shipped over 100 units of Vector Express since our introduction in July and we’ve shipped over 10 units of Vector Extreme since the beginning of the year in 2008. So that has been part of our redirection of where a majority of our R&D is going.

There are quite a few niche areas looking beyond into the 32 and beyond environment that we think are so far out as to, given the trend in the industry right now, we need to focus on our core products and that’s exactly what we’ve done and it’s what has allowed us to so dramatically reduce the operating expenses.

Satya Kumar - Credit Suisse

Thank you.

Operator

Our next question comes from Brett Hodess with Merrill Lynch.

Brett Hodess - Merrill Lynch

Two questions; first, just to clarify on the guidance, the pro forma EPS would exclude the operating expense items that could get written down in the quarter and the effects of the exchange rate, is that correct?

Richard S. Hill

No, the operating expense of $110 million would exclude the write-down of between $10 million and $13 million, but it might be slightly above the run-rate of $110 million if exchange rates stay as adverse to the dollar as they are today, although we are continuing to look to lower that.

Jeffrey C. Benzing

Brett, the $0.01 to $0.05 does include any exchange fluctuations in our forecast.

Brett Hodess - Merrill Lynch

Okay, great. And then second question, Rick, I was wondering if you could talk a little bit about the progress that the NAND guys are making on copper right now and if you think that that can give you a differential relative to the market environment you are finding yourself in as they start to adopt that across the course of the year?

Richard S. Hill

Well, I think clearly from a standpoint of copper into NAND, anything that puts copper into DRAM benefits us and we do see that in NAND but we also have to see major expansions of the factory as opposed to pilot line type of numbers. And right now, we are basically waiting for the real full fledged production orders.

Brett Hodess - Merrill Lynch

Thank you.

Operator

Our next question will come from Stephen Chon with UBS Warburg.

Stephen Chin - UBS Warburg

Rick, given the narrower product focus here, is the longer term gross margin target still in that 52% range? Or could we assume that you could target a higher level now, given this narrower focus on key products?

Richard S. Hill

Well, I think that we are still targeted on our 52% to 54% range and it’s based on the fact that while we can narrow our focus on products, there’s also dynamics going on within the market and given the breadth of our product line, we have some products that are competing with international competition, where their profit objectives are substantially less that I don’t think we can get to 50% type gross margins but yet it’s important that we understand how to compete in those markets. We are going to compete with a different model in those product lines by minimizing the amount of R&D and trying to be more efficient from an administration and a structure standpoint, such as our contribution to the company -- so what I tend to see are pressures on gross margins but continued focus on lowering operating expense to deliver the 15% after tax that I believe we can do.

Stephen Chin - UBS Warburg

Thanks for that, Rick. And then for Jeff; Jeff, do you think the days sales outstanding can normalize lower back in Q208 and do you expect the company to be back to cash flow positive from operations in the second quarter?

Jeffrey C. Benzing

I think we saw a confluence of stuff that came together towards the end of the first quarter, which caused the cash situation. But I don’t anticipate repeating itself; at least I have no forecast at this point. The DSOs again are a realization of products that went out late in the quarter and certain systems in our industrial group that didn’t get revenue recognition.

Stephen Chin - UBS Warburg

Okay, thanks. That was helpful.

Operator

Our next question will come from Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company

A question on the foundry side; Rick, what are you seeing on the foundry side? Do you see orders -- any chance of orders improving later on in the year?

Richard S. Hill

So within the first quarter, orders within the foundries were actually quite good. Right now, it appears that there is somewhat of -- there’s a prediction of somewhat of a slow down in the foundries, which leads to part of our caution. Again, given utilization rates, it tends to feel like they should be able to increase capacity and you know, we would believe they need the capacity. The question is can they get access to the capital.

Edwin Mok - Needham & Company

Great. And a question on the balance sheet; you have -- Jeff, there is a long-term investment item that was added. Are those debt facilities or any risk on those facilities being auctioned at a lower rate?

Jeffrey C. Benzing

The addition to long-term was the shift in recognition of our auction rate securities from a current to a long-term.

Edwin Mok - Needham & Company

Is there any risk -- do you worry that the value might actually come in a little bit less than that?

Jeffrey C. Benzing

We don’t believe that there is a risk in the long-term redemption of those. However, we have taken, you’ll notice, an impairment -- a temporary impairment on those of $5.8 million.

Edwin Mok - Needham & Company

Great. Thanks for answering my questions.

Operator

Our next question comes from Mahesh Sanganeria with RBC Capital.

Mahesh Sanganeria - RBC Capital Markets

Rick, with your booking [items], it looks like September is going to be pretty weak, unless there is a huge upside in the December quarter, we are talking about revenues down more than 25% here. So can you help us understand why this sequential year-over-year decline in terms of your three segments? That is, systems orders and services and industrial applications?

If I take them to be down equally, then we are talking about CapEx down in 25% to 30% range. Do you agree with that or not?

Richard S. Hill

Well, I think what you are doing is counting on a weak second half and based on all of the indications we have, you know, we believe that the second half needs to be up. It will be a function of the overall economy and what our customers do and their access to capital but purely from a supply and demand standpoint, the second half should clearly be up.

I think if you are probing at market share loss, I do not believe that we have lost market share in 2008. In fact, beginning at the end of 2007, we actually regained market share in an area of HDP where we have lost market share and I’ve discussed that before.

With the introduction of Vector Extreme, we continue to gain market share in PECVD as well as expand its application base. Now, having said that, let’s put some things in perspective that I think one analyst was pretty sharp in identifying; you know, we fundamentally have taken the productivity of our product from what used to be somewhere in the area of 50 wafers an hour to now where we deliver a Vector Extreme that has throughputs and productivity greater than 100 wafers per hour. And so it requires us to basically win very, very large segments and parts of market share, of which I believe we are doing.

We are still growing the absolute value of our top line in the PECVD business but this is the nature of the business. We have to compete and we are doing it in a way to where we are giving value to the customer and maintaining some of that value in an ability to continue to drive our gross margins up.

So from my perspective, the second half we believe has to be up. Whether the second quarter is the bottom or the third quarter is the bottom, there has to be a bulge in ordering that follows because there is clearly two more quarters of substantial down, there will be a major mismatch between supply and demand unless there is a huge fall-off of consumer demand and corporate demand for IT. Okay?

Mahesh Sanganeria - RBC Capital Markets

Thank you very much. That’s very helpful.

Operator

Our next question comes from Steve O'Rourke with Deutsche Bank.

Steve O'Rourke - Deutsche Bank

Thank you. Rick, just a follow-up on the last question; there have been a couple of announcements about some big banks cutting some IT spending. Maybe that’s the beginning of things but it almost seems like we could be bouncing along a bottom for several quarters now, provided that Q2 is a bottom. I mean, can you comment on how you look at the balance of the year with respect to that? I know you’ve done some of that already here but it just seems like when you handicap things, we could be sitting at a bottom for several quarters.

Richard S. Hill

It’s possible although the reality is given the lead time to put in capacity, we tend to see the demand before you actually see it in the end market. So I think what you see, push-outs and things along those lines, are the result of falling demand last month. Now the question becomes do we start to anticipate a pick-up in demand on the consumer side, on the corporate side, in the third or fourth quarter that our customers will have to start to move to bring in that capacity to anticipate it?

I think it was a very positive surprise for us to see Intel so bullish about the future and certainly they are the front engine of all the IT, and as long as microprocessors are strong, it provides a very, very strong base to provide sort of a floor on the equipment business. And so that’s how we see the market.

You know, it’s difficult enough to forecast the next quarter without trying to forecast three or four quarters down the road. We just can give you indications of what we think. It’s the same data that I use to make decisions on whether I’m cutting expenses or adding expenses, and so that’s what we try to do during the call.

Steve O'Rourke - Deutsche Bank

Thank you. That’s helpful. One other question -- were there any cancellations in the quarter?

Richard S. Hill

No cancellations in the quarter.

Jeffrey C. Benzing

Nothing material, no.

Steve O'Rourke - Deutsche Bank

Thank you.

Operator

Our next question comes from Bill Ong with American Technology.

Bill Ong - American Technology Research

Evaluation tools that went down -- what applications were they targeting?

Richard S. Hill

I’m sorry, I didn’t catch the question.

Bill Ong - American Technology Research

On the evaluation tools that you’ve written down, what applications were they?

Richard S. Hill

Well, they were programs that we had, internal R&D programs and we didn’t disclose them and so we won’t highlight what they were that we killed.

Bill Ong - American Technology Research

Okay, you talked about revitalizing the PECVD and [GAP sales]. Could you just offer some clarity on your other product lines -- CMP, surface cleaning, PVD?

Richard S. Hill

Well, CMP we continued to invest in from a standpoint of we have a success at one customer. We are trying to expand that. Very controlled. We are making some improvements to the system. We are optimistic. It’s a tough market but we believe we can bring the value that the customer needs, especially in this market.

As I’ve said before, we’ll look out a couple of quarters and see what we do with that as we see how the product is accepted in the market place.

PECVD have a strong technological position. It’s a matter of getting the DRAM market and the NAND Flash market to begin to put in significant capacity for copper on the back end in NAND and DRAM.

From a standpoint of strip, I think we are doing an outstanding job -- extremely competitive market but the value we bring to the customer is extremely good. The business has a very solid contribution margin overall to the company. It has a detriment to the gross margin of the company but given the competitive nature of our business, we’ve got to learn to be able to compete with slightly different models with slightly different product lines and I think in the strip one, it’s one where we are learning to really dramatically lower our R&D costs and simultaneously lower -- improve what we offer to the customer, slightly improve gross margin. But we are not going to be able to get them to the 50% level and above, which the majority of our products are at.

So I think in the area of copper electro fill, we dominate, continue to grow there. From a standpoint of tungsten, again it is the preferred system for tungsten. As you know, the applications are shrinking somewhat but given the market share offsets, we still see small growth in that particular product line. So that’s pretty much the waterfront.

And I talked about HDP. We’ve made dramatic improvements of product performance, reliability, particle performance. Had some major wins at year-end, have had several wins since the beginning of the year with the new product that we introduce, so we are feeling pretty good about that product. And PECVD, it should be the dominant PECVD vehicle in the industry because there is unmatched value in the product and given the competitive nature of the business our customers exist in, as more and more devices go to [Damethene], which will include NAND Flash and DRAM, we’ll see increasing applications of Vector tools, which is good for us.

Bill Ong - American Technology Research

Thanks for the update.

Operator

Our next question comes from Jay Deahna with J.P. Morgan.

Jay Deahna - J.P. Morgan

Thanks very much. On the comment that 90 days ago or what have you, you would have expected second quarter orders to be up and now you are guiding what you are guiding. Is that all related to DRAM or is it other types of chip makers just ordering smaller quantities? And then I’ve got a follow-up.

Richard S. Hill

It’s a combination of both, largely memory though, as you’ve observed. But you are absolutely correct; due to the availability of capital, it’s a lot of people ordering less, smaller quantities.

Jay Deahna - J.P. Morgan

Okay, and then shifting gears a tad, what is the -- I know this sounds like a broken record and I apologize for asking but what is the status of CMP? Because for Novellus anyway, that would be considered a niche market at this point in the game. What’s your dedication to that and also [inaudible] strip in terms of this R&D shift you are doing?

Richard S. Hill

So from a standpoint of CMP, CMP would be a niche market but the size of the market is dramatic. There is over $1.5 billion spent on CMP equipment with what I would call marginal productivity and marginal performance for advanced technologies. And the real big question is can we introduce a product that has a unique architecture, a differentiated architecture that gives unparalleled productivity and also world-class results on the wafer?

Now, we believe we are getting world-class results on the polishing of the wafer from the standpoint of dishing and erosion. We have fallen short from a standpoint of the actual clean; what should have been the simplest part was the cleaning of the wafer. We have a plan in place. We are executing on that plan to bring that to world-class levels. Now, once we have it there, if we can get an acceptance by the customer that we can bring them value -- for example, cut their cost of CMP by 30% or 40%, we’ll see if that sells. If it does, it’s a pretty big market that shouldn’t be a niche and it shouldn’t be a stretch for the customer to think that Novellus could bring that product to market and support it which is the difficulty today of companies entering new markets.

And so that’s overall the CMP. Keep being a broken record. I need skeptics and -- but we -- you know, if we can be successful, it has substantial growth opportunities for us.

Now from a standpoint of niche markets I spoke about before, we’ve had a lot of R&D programs that are going after relatively small-sized markets where the markets themselves are only in the magnitude of $50 million to $100 million. And yet you are putting the same amount of R&D into these programs. We’ve really put a kibosh on those. They are attractive sometimes for certain customers but an economic return overall isn’t necessarily attractive for us. So we’ve really put a fine filter on those.

And Jay, you had one more issue -- you mentioned something on strip. What was it you would like to know?

Jay Deahna - J.P. Morgan

Is strip one of the ones that is going to have a reduction in R&D and what are some examples of the ones that you cut back, like ALD or something?

Richard S. Hill

Well, we’ve cut back some ALD but as I mentioned before, I don’t want to go into any specifics on some of the stuff that we did cut back on because they weren’t public to begin with. The one you mentioned happened to be public, but the other ones I don’t want to say anything.

And in the case of strip, it’s not a matter of cutting back on R&D as much as it is doing it differently, where I think we’ve lowered the cost dramatically and we are still able to get the R&D out. We’ll try to do more and more of the in the other product lines. We just won’t leave it with strip.

I think the key to success is how to get a better return on the R&D dollars in a market that’s as competitive as ours. And you’ve identified this yourself many, many times. That’s the key. You’ve got to get the productivity on the R&D. Okay?

Jay Deahna - J.P. Morgan

Thank you.

Operator

Our next question comes from Patrick Ho with Stifel Nicolaus.

Patrick Ho - Stifel Nicolaus

Thanks a lot. Rick, I just wanted a clarification; you said earlier that NAND was in a more dire situation than DRAM. Was that with regard to pricing or was that with regard to the order flow on the equipment side?

Richard S. Hill

I think it was the opposite. DRAM was more dire than NAND.

Patrick Ho - Stifel Nicolaus

And so then I just wanted a clarification on that. All right, fair enough. And in terms of the bookings outlook, when you mean memory do you see incrementally things getting worse for the NAND Flash players or worse for the DRAM?

Richard S. Hill

From a pricing standpoint?

Patrick Ho - Stifel Nicolaus

No, from the equipment order side of things.

Richard S. Hill

I think from the equipment ordering side of the thing, I think it’s getting worse for NAND, substantially worse for NAND and also DRAM, but -- or also both of them, but clearly more for DRAM.

Patrick Ho - Stifel Nicolaus

Okay, so incrementally you think DRAM could worsen more so than NAND going forward?

Richard S. Hill

From a standpoint of shortage of supply.

Patrick Ho - Stifel Nicolaus

Great. Thanks a lot.

Operator

Our next question comes from Weston Twigg with Pacific Crest.

Weston Twigg - Pacific Crest Securities

Just a couple of questions; one, I’m just wondering if you can give us a progress update on your manufacturing consolidation?

Richard S. Hill

Well, I wouldn’t give you an update because I’ve never spoken about manufacturing consolidation.

Weston Twigg - Pacific Crest Securities

Okay. A couple of other questions then; could you give us the value of your current backlog?

Richard S. Hill

We give backlog at the end of the year, one time a year. You should be able to extrapolate it though by -- because we are pretty open on our disclosures of bookings and shipments, so you can figure that one out pretty easily.

Weston Twigg - Pacific Crest Securities

Yeah, I’ve done that. I just was hoping for an update on that. And then on the tax rate piece, you mentioned 36% for the year. Is that a moving forward rate or is that the average for the year?

Jeffrey C. Benzing

That’s the moving forward effective rate.

Weston Twigg - Pacific Crest Securities

Okay. Thank you.

Operator

Our next question comes from Timothy Arcuri with Citigroup.

Analyst for Timothy Arcuri - Citigroup

-- calling in for Tim. Most of my questions have been answered but I had a quick follow-up to some of the earlier questions on NAND. If I look at the comments you’ve made on the tight credit environment and sort of look at this capacity situation that we have in NAND and take all those together, is it fair to assume that you guys are actually seeing somewhat of a slowdown in how fast your NAND customers are shrinking to the next technology node?

Richard S. Hill

Well, I think that that is sort of well-known, that it’s becoming tougher and tougher to shrink. But I don’t think that’s it at all. I think the major factor is the market has been somewhat soft and except for one case, the suppliers of NAND are typically also DRAM suppliers, and so they have to balance capacity of DRAM capacity with NAND and their overall budget to add that capacity. And when you look at all the players and you look at the cash flow from those players, I think you can see that the credit markets would affect a majority of them on how much absolute CapEx they can spend. There is one supplier who is pretty much uninhibited, can do anything they want and they continue to do anything they want and very, very effectively. But the others are limited by their availability to capital.

Analyst for Timothy Arcuri - Citigroup

Okay, so I guess you wouldn’t say that you’ve seen any meaningful change outside of that top player -- at the others, you haven’t seen any meaningful change in kind of how fast these guys are shrinking?

Richard S. Hill

Not meaningful, no.

Analyst for Timothy Arcuri - Citigroup

Okay, thanks a lot.

Operator

Our next question comes from Steven Pelayo with HSBC.

Steven Pelayo - HSBC

Rick, when you answered the question specific to the foundries, you mentioned about their -- can they get access to capital as well. I think most of us would assume that the tight money environment was more related to some of these DRAM guys with negative 50% operating margins right now. Are you seeing funding issues coming from all segments as well?

Richard S. Hill

I think it comes from more than just the large memory manufacturers. I think the ability to be able to fund large capital expenditures right now, even with sound programs is a more arduous process than it was three months ago, or four months ago. And I think it does affect more than just the memory players.

Steven Pelayo - HSBC

Fair enough. Thanks a lot.

Operator

And that would conclude our question-and-answer session. At this time, I would like to turn the program back to our speakers for any additional or closing remarks.

Richard S. Hill

Well, thank you very much for joining us for the first quarter update. We look forward to talking to you at the mid-quarter and we hope that the market environment and the opportunities will continue to improve. Thank you.

Operator

Thank you, everyone, for your participation in today’s program and you may disconnect at this time.

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