Novellus Systems Inc. Q1 2006 Earnings Conference Call Transcript (NVLS)

Novellus Systems Inc. (NVLS)
Q1 2006 Earnings Conference Call
April 19th 2006, 4:30 PM.

Executives:

Robin Yim, Vice President, Treasurer
William Kurtz, Chief Financial Officer and Executive Vice President
Richard Hill, Chairman and Chief Executive Officer

Analysts:

Stuart Muter, RBC Capital
James Covello, Goldman Sachs
Timothy Arcuri, Citigroup
Jay Deahna, JP Morgan
Steve O'Rourke, Deutsche Bank
Brett Hodess, Merrill Lynch
Mark FitzGerald, Banc of America
Robert Maire, Needham & Company
Timm Schulze-Melander, Morgan Stanley
Ben Pang, Prudential
Michael O'Brien, Bear Stearns
Mark Bachman, Pacific Crest
Vishal Shah, Lehman Brothers
Shekhar Pramanick, Moors & Cabot
Stephen Chin, UBS
Patrick Ho, Stifel Nicolaus
Gary Hsueh, CIBC World Markets
Suresh Balaraman, ThinkEquity
Satya Kumar, Credit Suisse
David Duley, Merriman
Steven Pelayo, Soleil Fulcrum
Tim Summers, Stanford Financial Group

Presentation

Operator

Welcome to Novellus Systems First Quarter 2006 Earnings Release Conference Call. Operator Instructions. As a reminder, this conference is being recorded today, April 19, 2006. I would now like to turn the call over to Ms. Robin Yim with Investor Relations of Novellus Systems. Please go ahead Robin.

Robin Yim, Vice President, Treasurer

Thank you, Jimmy. Good afternoon, everyone, and thank you for joining the Novellus Systems first quarter 2006 earnings conference call. With me today on the call in San Jose is Bill Kurtz, Chief Financial Officer, and joining us by phone is Rick Hill, Chairman and Chief Executive Officer.

Financial results for our first quarter 2006 were released on PR Newswire shortly after 1 pm Pacific Time. You can obtain a copy of the news release in the investor relations section of our Website at www.Novellus.com.

Today's earnings call contains forward-looking statements about Novellus' business outlook, the future performance of Novellus and our products and forecast of key metrics for the second quarter of 2006. Specific forward-looking statements include, but are not limited to our expectations regarding semiconductor industry growth and capital equipment spending. The demand for and competitiveness of our products, our expectations that we will continue to maintain our position or grow market share, the forecasted shipment volume, revenue, gross margin, operating expense, tax rate and earnings per share; our financial model for 2006, and other anticipated future events. We caution you that forward-looking statements are projections, and expectations regarding future events may involve risks and uncertainties that could cause actual results to differ materially from the results contemplated, including inaccurate bases 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 Securities and Exchange Commission, including our Form 10-K for fiscal 2005, 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 such 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 2006. Rick Hill will then discuss the state of the business, and then we’ll open up the conference call for questions. I will now turn the call over to Bill.

William Kurtz, Chief Financial Officer and Executive Vice President

Thank you, Robin. As Robin indicated, I will review the first-quarter financial results and then also provide an outlook of our key metrics for the second quarter of 2006.

Let me begin. Bookings and shipments for the first quarter were within the guidance range provided on the mid-quarter update on March 2, while revenue, gross margins and earnings per share all exceeded guidance. Bookings came in at 417 million and were up 19% sequentially, driven primarily by increased demand for memory customers. By wafer size, bookings were 62% 300 millimeter and 38% 200 millimeter. Shipments grew 12% sequentially to 354 million. Revenues of 366 million exceeded our guidance and were up 10% from the December quarter.

Now, first quarter revenues by geographic region are as follows. United States represented 34% of our revenues, Korea 29%, Greater China and Southeast Asia combined, 15%, Japan 14%, and Europe 8%. You may note that in prior periods we had separate reporting for Taiwan, China and Southeast Asia, but we have decided to combine them into one category for competitive reasons.

Turning to gross margin, I'm very pleased to report that we met our goal to improve gross margins in Q1. Gross margin increased from 42.3% in the December quarter to 45.8% in the first quarter. Now, it's important to point out that a small portion of the improvement in Q1 was due to the impact of the adoption of FAS 151, which contributed 0.7% to gross margin in the first quarter. Now, excluding this impact, gross margin would have been 45.1%, which is on track with the gross margin goal we set to achieve in Q1, and reflects the expected improvements in warranty costs and a normalized level of SAB 104 impact for the quarter.

Now, as we look forward for Q2, we expect gross margin to improve further on an operational basis to 47%, as a result of continued improvements in the installation and warranty costs and a more favorable product mix. We also expect an additional point of improvement in Q2 gross margins from higher-than-normal level of SAB 104 impact; therefore, we're forecasting a total gross margin of approximately 48% for Q2. That is 47% from operational improvement; an additional 1 point is the timing of SAB 104, resulting in a forecast of 48% for Q2. Also I should note the sale of previously reserved inventory was insignificant in the quarter.

Now turning to operating expenses. Operating expenses were 122 million and up 10 million from the prior quarter. Now, this increase is primarily attributable to higher employee-related costs, most importantly due to the implementation of FAS 123R, which added 7 million of incremental compensation expense in our Q1 results. For Q2, we anticipate operating expenses will increase approximately 6% on a sequential basis, due to higher profit share and the effect of annual merit increases. Our first-quarter results also reflect net pre-tax restructuring and other charges of 13 million, as spelled out in our press release. Of this amount, 9 million is related to an impairment charge taken for two buildings in connection with our previously announced plan to sell excess real estate assets. Now we also expect to sell a third building for a gain, and would therefore anticipate reporting a gain in other income in a future period.

During the first quarter we also completed our previously announced CMP restructuring plan, the net change in estimate of a previously recorded restructuring accrual. As a result, we recorded net restructuring charges of 4 million in the quarter. The incremental savings resulting from the real estate asset sale and the completion of the CMP restructuring plan is expected to be an incremental 1 million per quarter, bringing the cumulative impact of our actions to date from restructuring of real estate to 2 million per quarter. Our effective tax rate in the quarter was 33.7% on a GAAP basis and 34.7 on a pro forma basis. Our effective tax rate for Q2 is expected to be approximately 34% to 35%.

Now in light of the impact that restructuring charges and the implementation of FAS 123R had on our reported EPS for Q1, I will walk through a number of EPS comparisons so that you can both understand our reported and pro forma results to gain a clear understanding of our operational trends. Our first quarter GAAP net income was reported at 27 million, or $0.20 a share. That is an increase from our fourth-quarter GAAP net income of 23 million, or $0.17 a share. Now excluding certain restructuring and other onetime charges and benefits as outlined in today's press release, first quarter net income was 34 million, or $0.25 a share, which both exceeded our guidance range and was above the published First Call estimate of $0.21 a share. The increase over guidance and the First Call estimate is the result of both higher revenues and higher gross margin.

Finally, if I were to exclude the $3.5 cent impact associated with the implementation of FAS 123R, our Q1 pro forma EPS would be approximately $0.29, which represents a sequential increase of $0.09, or 45%, from the $0.20 we reported on a similar basis in the fourth quarter. It's important to note this 45% increase is the best way for you to understand the operational trends on our business on an apples-to-apples basis. The significant increase in operational earnings is primarily a result of growing revenues by 10% on a sequential basis, combined with the increase in operating margin leverage realized by a 3.6 point sequential improvement in gross margin.

Now turning to the balance sheet, we ended the quarter with 754 million of cash, short-term investments and restricted stock -- restricted cash, which was a decrease of approximately 36 million over the prior quarter. This decrease is primarily due to the repurchase of common stock for 68 million, offset by positive cash flow from operations. Net accounts receivable of 416 million grew by 18 million. DSOs remained unchanged at 99 days from the end of the December quarter. Inventory did increase by 30 million on a sequential basis to support our forecasted growth in shipments during the second quarter.

Now we'll summarize the outlook of our key metrics for the second quarter of 2006. We expect bookings to be flat to up 7% sequentially. Shipments are forecasted to be up sequentially, with a range of 420 to 440 million. Revenue is forecasted to be in the range of 370 million to 380 million. Gross margins are forecasted to be approximately 48%. And earnings per share, including all stock comp expense, is expected to be between $0.26 and $0.28. Excluding FAS 123R related stock comp expense, EPS is expected to be $0.29 to $0.31.

Now with that as a summary, I would like to turn the conversation over to Rick, who will comment on the state of our business. Rick?

Richard Hill, Chairman and Chief Executive Officer

Thank you very much, Bill. I'm happy to report that we had a good first quarter, and I'm looking forward to continuous improvement in the business. We had strong bookings across all regions -- U.S., Japan, Europe, Korea, Greater China, and Southeast Asia. Given the fiscal year within Japan ending on March 31, we are expecting somewhat of a slowdown during our second quarter, Japan's first quarter, but we predict that there will be resumption in Japan's spending in the September time period.

The major drivers for this growth in capacity is been Flash and DRAM expenditures. In addition to that, in the United States, certainly the expansion for microprocessor capacity has been a big factor. The foundries up until now have had modest expansion, but we do expect to see that increase. We have seen a resurgence of some 8 inch business, particularly in China. Now there was recently released survey results by both VLSI and Dataquest, where it confirmed that we had gained market share in all of our product lines. That is consistent with our view; however, I might add that our gains in PVD and CMP have not met our own internal expectations, but have in fact grown relatively to our competitor. And we anticipate that, pending resolution of some small issues, we should be able to increase that rate of growth.

Still seeing rational deployment of capital within the industry is the word of the day. Our customers are clearly focused on their returns, and because depreciation is such a big factor on their financial statements, certainly their decision to expand capacity is greatly determined by their own profitability and the ability to fund that growth internally. Because of that, we don't see orders accelerating dramatically. And by the same token, we don't see a precipitous drop-off of orders at present. Our product quality and performance is continuing to improve at an accelerating rate, which we believe will help us to continue to gain market share across all our product lines. Operationally, we are reducing our fixed costs, attacking product material costs, and controlling R&D and SG&A expenses, which we believe will continue to further our ability to fund the growth that we are expecting to see. We have significant opportunities to grow in front of us, and we believe we can do that.

Now while that is true, it won't be without challenges, but they are challenges that we believe we can overcome. You can see our confidence in our continued share buyback program. We bought back approximately 2.7 million shares in the first quarter. Our asset management is improving. Despite that increase in inventory, the inventory increase, as Bill reported, was due to be able to meet a large shipment period in Q2. In fact, we will approach a record level of shipments during Q2. Now, with that, I'd like to open it up to any questions you might have.

Questions & Answers

Operator

Operator Instructions. We’ll take our first question from Stuart Muter with RBC Capital.

Q - Stuart Muter

Yeah, thanks for taking my question. I guess first question for Rick is bookings were up nicely in Q1 and shipments up strongly. Why are revenues kind of not growing that much for Q2 and your shipments are very strong? Is this an impact of SAB 101, or could you elaborate on what's going on there?

A - William Hill

It is a factor of a large number of shipments that go to Japan, which are recognized on acceptance and given the customs within Japan, that tends to be more than a three-month period of time. That is one factor. And the other factors are just largely due to the period of acceptance.

Q - Stuart Muter

Okay that's helpful. A quick follow-up question. In terms of the mix of IDM versus foundry and memory, could you talk a little bit about how that mix was in Q1 in terms of the bookings, and how you see that changing in Q2? Thanks very much.

A - Richard Hill

We don't break that out individually, although from the numbers that Bill gave you relative to the shipments, I think you can see that, clearly, DRAM and Flash memory were a major driver from a standpoint of bookings within the first quarter.

Operator

And we’ll take our next question from Jim Covello with Goldman Sachs.

Q - James Covello

Hi Rick. Thanks so much for taking the call; I appreciate it. Question around the consensus that there's been very rational capital spending by the customers this cycle. And I guess the question -- and you were the first person to point out that declines in NAND Flash pricing will drive elasticity in the market. But how much is too much, in terms of a decline in pricing there, before these guys get their margins eaten into such that they have to reduce their capital spending? So, Flash is one question; the other one is microprocessors. Obviously, we see Intel tonight scale back on their CapEx plans. But what are the -- how comfortable do you feel that customers maintain rationality of spending, given the price declines we've seen in those two markets, and then what Intel has done with their CapEx tonight?

A - Richard Hill

Good question, Jim. You notice we forecast bookings zero -- flat to up 7. We do believe that a lot of capital has been put in place that needs to be basically absorbed into the system. And I think that margins on the whole for Flash are still very, very attractive, and so I don't see an immediate slowdown in Flash. It's only a question of how quickly the applications proliferate in order to consume it. I think that, as we all know, with Vista coming out and the instant-on drives going into the next generation of corporate PCs, that will be a major consumer of Flash memory within those drives. So that's a positive. We don't know how that's going to play out. We do know that because of the delay of the consumer version, we're going to see some of that demand push out a little bit. So, I think that could cause people to pull their horns in slightly relative to Flash. But I think overall, as applications catch up, the Flash market is still very, very attractive. Now, having said that, there's been a lot of conversion of DRAM capacity over to Flash capacity. And consequently, we've seen somewhat of an uptick in the price of DRAM. And that uptick, of course, makes that profitability better, and of course, another source of capital to invest in capacity expansion. The thing we know for sure is unit consumption seems to be monotonic and up to the right. And you've got to buy equipment to be able to produce it.

Q - James Covello

Rick, thanks so much for that, I really appreciate it.

A - Richard Hill

Okay.

Operator

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

Q - Timothy Arcuri

Actually, I had two things. Number one, does the gross margin guidance include any benefit from material cost reduction, or is that another lever where you can see more gross margin improvement during the back half of this year? And then I had a --

A - Richard Hill

Bill, why don't you -- you've probably got the numbers in front of you.

A - William Kurtz

Yeah, Tim this is Bill. The improvement that we're forecasting in Q2, I said, had an operational flavor to it. That operational flavor includes the impact of further improvements in warranty, as well as some improvement in material cost reduction, as well as some favorable change in product mix. Now we’ve also stated that we are driving for 48% on an operational basis by the fourth quarter. So, realizing our goal in Q2 of getting to 47% on an operational basis, we still have another point to go to get to our goal by Q4. So, we do expect further improvement through the balance of the year.

Q - Timothy Arcuri

Okay and then I guess as a quick follow-on, given the gap here between shipments and revenue in the June quarter, is there any way to gauge what kind of the spot gross margin is on the revenue that's going to be recognized in future quarters? So, in other words, is the reported gross margin in June, is it artificially low in some way because it doesn't fully reflect all the installation and warranty benefit gains?

A - William Kurtz

No, because let's take the example of Japan acceptance, which is primarily the factor that's causing the delay in revenue recognition. For the Japan, it's 100% deferral upon acceptance. So, we don't recognize any cost or revenue until we complete the acceptance. So, there's no gross margin impact due to that acceptance timing. In the case of bifurcation, where there is some impact, I'm pointing that out separately to you. And that's why I commented that in Q2 we actually have a 1 point favorable impact due to the higher level of bifurcation acceptances in Q2.

Q - Timothy Arcuri

Yeah, okay thanks.

A - William Kurtz

And I'll continue to point those out as we complete the rest of the year, such that you can understand if they cause a fluctuation in the margins for the quarter.

Operator

We’ll take our next question from Jay Deahna with JP Morgan.

Q - Jay Deahna

Thank you and afternoon. First question on Japan, it looks like Lam had a weak quarter for orders in Japan in the March quarter. You had a strong quarter. Is it possible that Novellus and Lam would be on different quarters in terms of recognizing orders from Japan? That would be number one because I'm under the impression your leadtimes are rather similar. And then the second question -- Rick, you mentioned something about the possibility of orders maybe re-accelerating in the September quarter, if I heard that correctly in your prepared comments. I just want to get some clarity on that one. And last but not least, I think you've been quoted as saying in like a lion and out like a bobcat. I'm wondering where you're at with that now.

A - Richard Hill

I'm still in like a lion and out like a bobcat. I did make the comment that I see that in our second quarter, which would be the Japan Inc. first quarter, I would expect bookings to fall off somewhat. I would expect that across the board. But I do see Japan still committed to semiconductors and capacity expansion. And I would tend to see that come back in what would be our third quarter, Japan's second quarter. So, that is what I said in my comments. And what was the other question, Jay?

Q - Jay Deahna

You sort of got them all. But if we are in like a lion and out like a bobcat, if orders re-accelerate in 3Q, does that imply that they decelerate in 4Q sequentially?

A - Richard Hill

What I said was that Japan in particular, I thought, would decelerate in Q2.

Q - Jay Deahna

Right.

A - Richard Hill

Okay, I didn't comment on any other region other than Japan.

Q - Jay Deahna

Okay, but then if you look at the overall enterprise, you're -- what'd you say -- flat to up 7%, or something like that?

A - Richard Hill

That's correct.

Q - Jay Deahna

Okay, for the overall enterprise in 3Q you expect some sort of re-acceleration. Is that what you're saying?

A - Richard Hill

I didn't comment on quarter three, other than with Japan. I always tell you what I think the next quarter is going to do.

Q - Jay Deahna

Okay, so that was Japan-centric. Okay, just wanted to be clear on that. Then last but not least, you did say something about you expect foundries to pick up. Wondering --

A - Richard Hill

I think foundries have not added as much capacity as have the Flash and DRAM people, as well as microprocessor expansion. And so, therefore, I think it has lagged somewhat. Utilization levels are high. And it would be my anticipation that we'd begin to see a little bit of a growth in that particular area.

Q - Jay Deahna

Got it, okay, thank you.

Operator

Next from Deutsche Bank, we’ll hear from Steve O'Rourke.

Q - Steve O'Rourke

Thank you, good afternoon. Rick, just as a follow-on to that question, do you think the foundries are under-spending as many claim, or are they actually spending very rationally, we should expect that to continue?

A - Richard Hill

I think they're spending very, very rationally. And as a consequence, their profitability is showing it. And I would expect that to continue. Having said that, at the high level of utilization that they're at, and the changes in technology nodes, it would be my anticipation that a little bit of a burp in spending has to occur here in the not-too-distant future.

Q - Steve O'Rourke

Okay and then another question on a separate issue. I think in your prepared comments you mentioned that there were some small issues that needed to be resolved with respect to PVD in order to kind of accelerate some share gains.

A - Richard Hill

Well, first of all, they weren't prepared comments they were actually what I was telling you as part of my thought process for you understanding the business.

Q - Steve O'Rourke

Okay.

A - Richard Hill

I said that we have challenges that we could overcome. And with that, we would not -- we would accelerate our ability to gain market share in those areas.

Q - Steve O'Rourke

When would you expect those issues to be overcome? Is that very near-term or is it later in '06?

A - Richard Hill

I would say it's very imminent.

Q - Steve O'Rourke

Fair enough, thank you.

Operator

Our next question will come from Brett Hodess with Merrill Lynch.

Q - Brett Hodess

Hi, two questions. First, as the warranty issues get resolved, as you noted, the costs would come down in the coming quarter. Is that one of the items that's improving your competitive position for some of the newer products? And do you see that, as you said, imminent? Does that mean that customers are responding favorably already to improvements in those types of areas?

A - Richard Hill

I think, Brett, you hit the nail on the head. Installation and warranty are real costs. They're also costs, sometimes non-monetary costs, to the customer, in that you take too long to install. And as a consequence, that affects their attitude. And the answer to the question is yes. They're coming down across all product lines. And we believe, from a standpoint of quality and reputation that Novellus has had for a long time, we're back on track to demonstrating our ability to deliver high-quality products with low cost of ownership. And we will continue to drive that going forward.

Q - Brett Hodess

The quick follow-on I had is -- Lam had noted that their acceptance times had been declining in helping them recognize revenues more quickly. Have you seen any change in how long it's taking your products to get accepted, and would that have any impact on revenue ramp rate later in the year?

A - Richard Hill

Bill, you want to take that?

A - William Kurtz

Yeah sure. The basic timeframe for acceptance has not changed, as we look at the individual customers and then the individual regions that have different acceptance periods. What you're seeing from us is a function of the mix of our business. And that mix, as we pointed out, is somewhat influenced by Japan, causing a further delay in the acceptance of revenue. But those acceptances are still occurring within the timeframes that we are accustomed to for those customer sets.

Q - Brett Hodess

Thank you.

A - Richard Hill

All right.

Operator

And Mark FitzGerald with Banc of America has our next question.

Q - Mark FitzGerald

Rick, could you give us a quick update here on the CMP tool and where it stands, and where the opportunity is from a revenue point of view?

A - Richard Hill

I think we've made tremendous progress in the area of CMP. I'm very, very pleased with the demonstrated reliability level that the product is currently performing at. We have had significant technological success in polishing wafers at very, very small geometries with minimum dishing and erosion. And so I'm optimistic. Now we have a very, very focused approach in CMP. I think we have a team on it that's extremely capable, and have been very good at executing to their plan. We are not ready at this point in time to project what's going to happen in CMP. But I will tell you that based on the results, the customer interest to pull it into them is very, very great. It has been resisted by us because we do not want to trip when we put the next systems into the next customers.

Q - Mark FitzGerald

Is Peter Walters growing at all in terms of percent of the sales?

A - Richard Hill

In an overall standpoint they have grown, but they have not outgrown the semiconductor business. We did make an acquisition that -- of (indiscernible), which brought their revenues north -- and it's in the 10-K -- up to about a 120 million. So, there is that growth in there. But they're not by any stretch of the imagination distorting the overall growth of the Company, which is largely reflected in the semiconductor business.

Q - Mark FitzGerald

Thank you.

Operator

And Robert Maire with Needham & Company has our next question.

Q - Robert Maire

How do you see the remainder of the year filling out in terms of foundry versus memory? Some other manufacturers have suggested that we'll see memory slow down as a percentage as the foundries pickup. What is your sort of expectation going forward, just how do you see them mix changing or staying the same, or Flash versus DRAM within the memory sector?

A - Richard Hill

It's always a tough one to project. But again, I'm still very, very bullish on Flash. And while I see a somewhat downward pressure on the price, I have a fairly good idea of the type of profit levels on those devices. And so, there's plenty of economic value being gained in the Flash arena. There is also a tremendous number of applications that are in the works that, I think, are going to stimulate demand for units. And so I can't imagine that at this juncture, you're going to get to a point where foundries are going to overwhelm memory -- memory meaning DRAM and Flash capacity expansion. I just can't see that happening, not in the near-term. Now, they can become a more significant piece and layer on top of the growth that we're seeing. I think that's what leads me to believe that we're not going to go out like a lamb, we will go out like a bobcat. I mean, it's not going to drop off and dry up for two years as it did in 2000. So, that's the best flavor I can give to you, Robert.

Q - Robert Maire

Just a follow-on to that. In your guidance of flat up 7%, is there any particular part of that that makes you more conservative? Do you think that we will see a flattening of memory spending? Or what is it that makes you perhaps a little more conservative than you were last quarter?

A - Richard Hill

I think it's more the cycles of spending that I have observed over the years, both from a regional standpoint and a certain customer standpoint.

Q - Robert Maire

Okay and this has been reflective of customer activity, I take it?

A - Richard Hill

Over long periods of time, yes.

Q - Robert Maire

I mean recently. So, you've seen already a slowing --

A - Richard Hill

Again, we are like any company, right. We have a funnel, and we have salespeople who have one view of the world that everything maybe going to happen today. And yet we have a lot of us who have been around for a long period of time and have observed how customers behave, and when they're likely to buy, when they're not likely to buy. And so, we take this raw data, and to the best of our ability, try to put some perspective into it and say, okay, what's likely to happen given all this roll up of a funnel that we have. And then we come up with those numbers. And as I said, I gave a little bit of insight that I felt Japan couldn't maintain the kind of booking strength that they demonstrated in the first quarter. So I suggested that that booking level would come down somewhat, causing somewhat of a muting of the growth between quarter one and quarter two. And there are a couple of other things in there that we know that we look at as sort of our lever in trying to efficiently match our costs with our revenues. And I tried to give you an idea of what we think it will really be. And hence, we said flat to 7.

Q - Robert Maire

Okay, great. Thank you that helps.

Operator

We’ll take our next question from Timm Schulze-Melander with Morgan Stanley.

Q - Timm Schulze-Melander

Hi, good afternoon Rick and Bill. Two questions, if I could. The first for you, Rick. Just on the 200 millimeter China order booking strength, could you just give us some sense as to what design node and maybe sort of what application that is going in, and whether there's any material difference in margin? And then secondly, Bill, just with respect to the warranty expenses, could you maybe give us a little bit of color? I know when some of these warranty -- unexpected warranty expenses first started coming through, you gave us an indication that they decline over time. Could you just give us a sense as to what they were in the quarter? Thank you.

A - Richard Hill

First of all, relative to the 200 millimeter business, yes, it's largely been driven by China. I don't think there's been any detrimental effect to gross margin whatsoever, and I think that it's been a combination of used and refurbish equipment as well as new equipment.

A - William Kurtz

Okay Tim, this is Bill. In terms of the quarter-to-quarter impact, as we looked at the change in gross margin from Q4 to Q1, the improvement in warranty -- that is the reduction of warranty costs -- accounted for about 1.9 points of gross margin improvement. So, we clearly did see, as Rick pointed out, a substantial improvement that not only has helped our financial performance but has improved our customer experience. I pointed out earlier that we had about a total three point impact negative as we went through last year, and so we are now roughly two out of three. We have another point to go before we get to where we intend to be by the end of the year.

Q - Timm Schulze-Melander

Great, that’s very helpful thank you.

A - Richard Hill

You’re welcome.

Operator

We’ll take our next question from Ben Pang with Prudential.

Q - Ben Pang

Yeah, just a quick follow-on on the 200 millimeter business. Did this surprise you guys in terms of how strong China was for 200 millimeter? And also, are you guys actually selling some of your own, I guess refurbished equipment there? Thank you very much.

A - Richard Hill

First of all, it didn't surprise us whatsoever. We're very in touch with what's going on within the market. The second thing is, yes, we do in fact refurbish our own equipment only. We're really not selling anyone else's equipment. The difficulty we have, and the reason it's not just used equipment, it's also new equipment, is given the quality of Novellus Systems and the life of those systems, we don't have this reserve of cores around, or old engines, as you might say, that some other people have. The characteristic of the equipment for Novellus is it lasts really a long time, and people run it for multiple generations. And that's one of the reasons we've been as successful as we have been. But to the extent that we can use parts that are refurbished and other inventory that we might accumulate that have a lower cost basis and still provide our customers with a better value but similar performance characteristics, we do that. And I think it's been well accepted. And what's happened now is you see a strong core 3908 of 200 millimeter Novellus products building within China. And I think they recognize the quality and the capability of the equipment, and I think that's good for us long-term.

Q - Ben Pang

What's your expectation for the 200 millimeter business? How does it trend through the rest of the year?

A - Richard Hill

I don't expect 200 millimeters to trend continue to trend upward. The reality is the economic winds are in favor of 300 millimeters. I mean, most of our customers realize that 300 mm has been a big boon to the semiconductor industry. In fact, there are some that would like to see it jump immediately to 450 millimeter, which is not likely to happen. But the fact is, it's very, very economical. And those that have made that shift to 300 millimeter have a competitive advantage, as most of the people who are at 200 millimeters recognized. But 200 millimeter does offer, particularly in China, a vehicle to begin to help develop the entire infrastructure required to manufacture semiconductors in China. And as there are some technology restrictions, 200 millimeter largely circumvent those technology restrictions. And so China, by investing at 200 millimeter geometries, and beginning to supply more and more of the China domestic demand, they not only reduce their cost, they also have the added advantage of driving demand for people and technology, education within the country, which is something that they want to do. So, it sort of dovetail. But I don't see it being the predominant mechanism for bringing China to the state-of-the art in semiconductors. That ship left the dock a long time ago.

Q - Ben Pang

Thank you very much.

A - William Kurtz

Yeah in fact, this is Bill let me just add on to Rick's comments. For the year, we still expect our split between 300 millimeter and 200 millimeter to be 75/25. So, there will be periods where there is some movement between those two. But on the aggregate, we would expect the year to still be 75 300 millimeter, 25 200 millimeter.

Q - Ben Pang

Oh that’s very helpful.

Operator

We will take our next question from Michael O'Brien with Bear Stearns.

Q - Michael O'Brien

Yeah thanks a lot. Maybe just a little bit more on foundries and memory. Specifically on foundries, did you think that there's going to be a burp in spending? Can you quantify? Is it one quarter, two or three quarter, that trend that you would expect from foundries? And with regard to Flash, some of the big Flash players have talked about front-end loaded CapEx. So, would you expect orders to be down substantially for Flash in the second half of the year, or do you think others will fill in? Thanks.

A - Richard Hill

I think that when we talk about foundries, I think you have multiple successful foundries, all of who have to, are at highly, fairly high levels of utilization. And they're at the point where, I think, they need to add capacity to the next level. And so that's going to go on. It's going to be over several quarters. In the case of Flash, I don't think that anybody is going to bow out of the market at this point in time. I think that the engine driving Flash density is continuing to churn. And anybody who wants to participate in that market is going to have to be on that density transition curve, which is going to drive new equipment. So, I don't see that to be a big dip, but I'm only giving you perspective. I don't have any information that you probably can't glean yourself. It's just the perspective I'm giving you.

Q - Michael O'Brien

Thank you very much.

Operator

Our next question will come from Mark Bachman with Pacific Crest.

Q - Mark Bachman

Hi bill, I was wondering if you might be able to tell us about the cash flows from operations here in the current quarter. And then, just kind of expand on that, and talk about Novellus' ability here to generate cash flow from operations with regard to your approved business model, and maybe specifically so at whatever you consider might be a trough revenue level for you.

A - William Kurtz

Sure, this quarter, as I pointed out, we did have positive cash flow from operations, which offset to some extent the impact of our stock buyback. On an annualized basis, its probably good to look at it on an annualized basis, because there are quarterly fluctuations, depending on the timing of inventory and receivables. On an annualized basis, we would expect operating cash flow in the range of 280 to 300 million. So, you can divide that by four and get a quarterly rate that you should see during the year.

Q - Mark Bachman

Okay, you sound pretty confident here with your business model, and I think your outlook here for strong cash flow is pretty encouraging. So, I guess my question is, do you really think that Novellus' optimal capital structure here is being financed with 100% equity?

A - William Kurtz

Well as we discussed, we continue to, in other calls, we continue to evaluate our capital structure and look for ways to improve long-term shareholder value. Right now, we're focused on taking the excess cash that's being generated by our strong operating performance and putting it to use to reduce the share count to reward the long-term investors. Now, that will have a benefit, as you know, of increasing the return to our equity shareholders. Doing something more significant to the capital structure, we always look at that, but we haven't at this point seen a compelling reason to make that change.

A - Richard Hill

The fact is this is a very, very cyclical marketplace. And as a consequence, it's also one that is very dependent upon having good technology. And I think that given a downturn, one has to have the economic resources available to continue to invest, and during the up cycles, generate the cash necessary to be able to fund it in good times and in bad. Recognizing that the growth of the overall industry has slowed down, we are taking advantage of that opportunity to pull in some of the equity. Now that's our strategy at this point in time. Other than that, we won't discuss anything more relative to our capital structure. Thanks.

Q - Mark Bachman

I appreciate that, both Rick and Bill. I just wondered if you could just comment on PVD real quick. As your sales pick up here and your copper barrier seed PVD product, will gross margin be negatively impacted?

A - Richard Hill

That's directed to me, Rick Hill?

Q - Mark Bachman

Rick or Bill, whoever wants to take it.

A - Richard Hill

I think that going forward, PVD should not be a drag on our gross margin.

Q - Mark Bachman

Okay thanks Rick, thanks Bill.

Operator

We will take our next question from Vishal Shah with Lehman Brothers.

Q - Vishal Shah

Hi, with the recent CapEx solutions by AMD, Micron and Intel, what is your outlook for the equipment industry revenue growth in '06? And it seems in the past you have been able to outperform the industry. So, what is your growth expectation relative to the industry this year? Thank you.

A - Richard Hill

First, I you know, the outlook for the industry and I'll only talk the industry, not Novellus. I think the outlook is nothing but positive. And I'm not trying to do that to hype the industry. The reality is semiconductors continue to become pervasive. Now they are driven by one fundamental, and that is continually driving down the cost, or increasing the functionality per unit of cost. And that is becoming more and more difficult. It used to happen in a lot of different ways. It happened through technology shrink. It happened through increases in wafer size. And the reality is we are coming to technological walls, although we continue to knock them down. But it's becoming more and more cost-sensitive. And as a consequence, our ability to provide greater and greater throughput on our equipment sometimes takes the number of units that we used to sell down. And that's another area where we have to be able to expand the market in a different way, A, take market share, something we have always done and we'll continue to do, in order to continue to grow. So I think that's the opportunity in front of us. We think it's a good industry. It's certainly not looking at 2000 any longer. But when you have an industry that on the whole is going to grow 10%, 14%, that's not too bad.

Q - Vishal Shah

Its 10% to 14% is your outlook for CapEx growth or equipment industry?

A - Richard Hill

Overall equipment industry growth.

Q - Vishal Shah

Okay great thank you.

Operator

We will take our next question from Shekhar Pramanick with Moors & Cabot.

Q - Shekhar Pramanick

Yeah hi, good afternoon. Rick, two questions. One, you gave a flavor in the Japan. First of all, is my assertion correct that in Korea, Korea is very active in Q2 in terms of orders, and then they take somewhat of an air pocket in Q3? And my second part of the question is one of the big Korean players who had previously when used to book orders, you mean then the escrow account and cash needed to transfer into the escrow account. Is that the practice still today, or has the practice changed, how you book the order there?

A - Richard Hill

First of all, I wouldn't comment on any specific company one way or the other. But I think that our, certainly Korea is particularly strong in DRAM and in Flash. And there is more than one company that's strong in that particular area. And I don't see any weakness from any of the players within Korea. They have the financial backing. They have demonstrated their ability to generate internal cash flow and grow. And as a consequence, I think that that's a recipe for success there. So, I think they're going to continue to be tough. And only I'm telling you that during the second quarter, we're flat to up 7, and we expect to see ordering from all the regions albeit I did say that I thought Japan would cool off a little bit. That's the only specifics I gave.

Q - Shekhar Pramanick

Thank you Rick.

Operator

We will take our next question from Stephen Chin with UBS.

Q - Stephen Chin

Great thank you. Hey Rick and Bill. Just staying on the topic of the orders by geography, I don't think I heard you call out Taiwan as a region of strength in the quarters. So, I'm kind of assuming it did not meet your expectations. If that was true, was there a specific customer type that caused this, or were there potential market share losses that may have led to this region's underperformance in the quarter?

A - Richard Hill

We are agglomerated -- we agglomerate Taiwan, China and Southeast Asia for competitive reasons. So we don't call that region out.

Q - Stephen Chin

Okay so nothing specifically different happened in Taiwan no like that?

A - Richard Hill

No.

Q - Stephen Chin

Okay, thank you.

Operator

Our next question will come from Patrick Ho with Stifel Nicolaus.

Q - Patrick Ho

Thanks a lot, two questions. First, one for Bill. On the stocks options going forward, is 8.8 million per quarter kind of what we can trend for the rest of the year?

A - William Kurtz

I'd say that's a good run rate at this point for the year.

A - William Kurtz

Sure.

Q - Patrick Ho

Okay great and maybe for both Rick and you Bill, with the order trends picking up over the last few quarters in terms of your supply chain can you comment how that’s been going in terms of the ramp and whether you can streamline it further to help your margin expansion down the road?

A - William Kurtz

Sure Rick would you like me to address that?

A - Richard Hill

Yes, please.

A - William Kurtz

All right. Yeah we do see the opportunity to continue to streamline our supply chain. We have done quite a bit actually over the past year to put in place lean inventory management and to improve our throughput and cycle times in our factory. That we have done that with our suppliers. You saw that probably most clearly in the reduction in inventory over the past 12 months, as well as in the gradual impact in our margins. Now, there were a lot of offsetting factors to our margins last year, in particular warranty, where you didn't see this as clearly come through. But nonetheless, we still see further opportunity to streamline our supply chain, reduce inventory levels, and contribute to further improvements in cost and improvements to margin as we go forward.

Q - Patrick Ho

Great thank you.

Operator

We will take our next question from Gary Hsueh with CIBC World Markets.

Q - Gary Hsueh

Hi Rick, I wanted to clarify. Your comment about chipmakers absorbing capacity that they had to put in place in the first half was that one in the same comment as Japan sort of subsiding a little bit here in terms of orders in Q2?

A - Richard Hill

Well I think, characteristically, Japan at the end of their fiscal year goes into a planning phase in the beginning of the next fiscal year. Those two are unrelated.

Q - Gary Hsueh

Okay and relative to timing of this absorption of capacity, did you mean Q2 or Q3? What's the extent of timing there?

A - Richard Hill

We forecasted it to be flat to up 7%, as opposed to what it was in the last quarter, which was up nearly 20%.

Q - Gary Hsueh

Okay so, relative to Q2, not Q3. Okay. And is Japan coming back in terms of orders in Q3, the highlight in Q3? In your mind, if you're going out the year like a bobcat, what's kind of holding you back in terms of the order outlook in Q3, if Japan is the highlight?

A - Richard Hill

Well, you have to have the unit growth and you have to have the end demand. And I think we talked about that the corporate Vista is coming out. We're very positive about that. We talked about the fact that the consumer version of that has been delayed until after the Christmas season. That's something to give us a little bit of pause. I'm not capable of predicting the future. I can only tell you what I tried to assimilate in planning the capacity we put in place to the best of our ability. So, I'm not trying to, whenever you do, don't assume that I have some magic glass ball that forecasts the future. I'm just trying to give you a sense of the elements we look at, and then what we think that will do to demand on us. And integrating all those factors that I've discussed multiple times, it came in very, very strong. I expect it then to flatten out going out the end of the year, but I don't expect it to fall off a cliff. And that's the net, net of it.

Q - Gary Hsueh

Okay I can appreciate. Let me squeeze in one more question. One of your peers reported and talked about pricing pressure on spare parts in Q1. I don't see that in your gross margin line. Are you seeing that in the field in either Q1 or Q2? And if you're not, can you hypothesize why one company may be and why you're not?

A - Richard Hill

Well, to say, we all see pricing pressure. I mean everybody in this industry does, starting with our customers, starting with you guys when you go out and buy something at the store and you don't like the price. Even the store clerk is dealing with it. We all deal with price pressure. And in some cases, we are ahead of the curve from the standpoint of we're reducing costs internally, and therefore our price is continuing to go down. In other instances we don't have the volume; our prices are going up. We do not have as large a consumable business as, I think, the company you're referring to has. And as a consequence, our spares are not of that nature. And so that would be the only reason that I would have a difference, I guess.

Q - Gary Hsueh

Okay good answer thanks so much Rick.

Operator

We will take our next question from Suresh Balaraman with ThinkEquity.

Q - Suresh Balaraman

Thanks, Rick just a clarification on the PVD. You said the growth was less than your internal projections. Was this a result of the customers not starting to spend after designing utilization or was it a fact of not getting as many design wins as you had expected? And also, just a follow-up on your comment that you expect PVD not to be a drag on margins. Would you expect that segment to significantly outgrow your overall equipment revenues this year? Thanks.

A - Richard Hill

First of all, from a standpoint of the design wins, I've had more design wins than I want. The worst business you could have is a design win. I think the key disappointment for us has been not ramping the volume as quickly. Okay, I think that we have technologically proven to the world the extendibility of PVD technology. Our competitor has been entrenched with existing capacity that they're capable of upgrading, and they're very adept and are fast followers. And as a result, have caused us not to win as many as we would have liked to have won. And I think that's the tenor of that business. I think, though, that when we look at our overall design and capability, and the fundamentals we have relative to extendibility, particularly in a couple of areas, we think that we will be able to demonstrate to customers some performance characteristics that are going to be critical at 65 and 45 nanometer nodes that they're not seeing yet, because they're only in development. And I think that that will bode well for us as we lay that out to customers in the months to come. Okay?

Q - Suresh Balaraman

Great thanks.

Operator

Next we have from Satya Kumar with Credit Suisse.

Q - Satya Kumar

Yeah hi, thanks for taking my call just to get back to this gross margin point, to make sure I understand this. In 2Q, the 48% gross margin is helped by that 100 basis points from acceptances. And you're still maintaining your 48% gross margin target for the rest of the year.

A - William Kurtz

That's correct.

Q - Satya Kumar

So, does that mean that in terms of a reported basis, gross margins could actually be down a little bit in 3Q, or some of these restructurings could potentially help you guys out to keep it more flat in the second half?

A - William Kurtz

Well again, let me restate the facts for you. I think you have it right, but I'm just going to restate it to be sure that you do. What I'm trying to point out to you is that from an operational improvement level, we've been able to get to 47% by Q2. Now, there are fluctuations, as you recognized, and the recognition of SAB 104 bifurcation. In some quarters it will cause a downward impact on gross margin that is negative, like it did in Q4. In some quarters, like Q2, it will cause a positive impact. I'm trying to separate those for you so that you can follow the operational trends. The operational objective that we set for Q4 is 48% on an operational basis, given an average level of SAB 104. So, all things being equal, we would expect the reported numbers in Q4, without any variation on SAB 104, to be 48%. The operational improvement between Q2 and Q4 is another 100 basis points of operational improvement. Does that clarify it for you?

Q - Satya Kumar

That's perfect. Also, just in terms of coming back to this revenue versus shipment discrepancy, is Japan sort of the, what's driving the big delta? You mentioned that Japan is driving that, but it just seems like a little bit large. Is that one geography? (multiple speakers).

A - Richard Hill

It's purely a function of terms and conditions which are typical in Japan that we have. We (multiple speakers) we modify those going forward that will change. But it has been a custom in the way of doing business within Japan. I think that as we go forward, we're doing our best to eliminate that.

Q - Satya Kumar

So, it's completely accounting-related stuff. So your revenues should come back up in 3Q from these deferred shipments?

A - Richard Hill

I would certainly hope so.

A - William Kurtz

The revenue over the balance of the year between Q3 and Q4 will be realized from those shipments.

Q - Satya Kumar

Got it. Okay one final question, if I may. I noticed that your operating margins from industry products segments was somewhat low in the December quarter, and has declined for a couple of quarters. Is there something going on in terms of product mix, or should we expect that to come back up?

A - William Kurtz

On the operating margins, in Q4, as you pointed out, they were low. The principal reason for the decline was the decline in gross margin, which, as you noticed, in Q4 gross margin went down to 42%. Now, as I pointed out in Q1, we had a significant improvement in our operating margins. They've gone up on a basis, excluding the option related expense, to a pre-tax profit now of about 16%, for an operating profit of 14%. That's a significant improvement from where we were in Q4. Our longer-term model is to get to a point to where our operating profit gets to 20 to 22%. So, we still have room for improvement to get to our long-term model, but we clearly have made a significant improvement from Q4, as the result of growing revenue sequentially, holding expenses relatively flat, and then improving gross margins by 3.6 points.

Q - Satya Kumar

Okay, but in terms of looking at your operational gross margin improvement from 47 in June to 48 by the end of the year, can we pretty much assume that Peter Walters is not a big factor we should worry about?

A - Richard Hill

That's right.

Q - Satya Kumar

Okay got it, thank you very much.

A - Richard Hill

You are welcome.

Operator

We will take our next question from David Duley with Merriman.

Q - David Duley

Thanks for taking my question. Hey, I was just as wondering if you'd comment on the warranty expense issues. You mentioned that you didn't think that PVD would be a drag on margins going forward. I'm assuming that you've solved your warranty expense issues. What did you do internally to fix this problem, and what's to make us think it doesn't arise again at a different customer site?

A - Richard Hill

First of all, it will always arise with new products as they come out. So I can never tell you that it would not arise again. Okay the second thing is, what causes it to arise usually is the fact that you put out a product, and in our business the technology is changing so rapidly, sometimes you can't nail down the specifications as tightly as you would like. And because we work so closely with our customer, and our first concern is their satisfaction, a lot of times we don't worry about whose fault it is and we end up supplying that to the customer as part of a warranty expense. And some people are more lenient, some aren't more lenient. Now, we're getting a little bit more rigid on what's warranty and what's a change in what we were promised to deliver. But, you know, unless we can make our customers successful, we won't be successful. So we're not deviating very much from that policy. The business we're in requires has a lot of risk associated with it. We are in it with our customers. We want to support them. That's the values of Novellus. There is no way that I could promise you that that would never happen again. But I do believe we have a focus on it. We track it. We put in action plans to continue to drive it back to where we want it to. But will it fluctuate from time to time? Yes, it will. And when you look at all the new products that we have from all the R&D expense we have, we'll probably trip again somewhere. But in the meantime, we're going to continue to grow that topline and contribute to enhance shareholder value, albeit sometimes slower than we would like.

Q - David Duley

So, kind of to summarize, you may not be you may be promising less to customers, because it sounds like you kind of over promised and underperformed, and now you've gotten a little smarter about that strategy.

A - Richard Hill

Well no, not necessarily, okay? Not necessarily at all. I didn't say that. First of all, whatever we say to the customer, we deliver. Okay? Sometimes the customer isn't good at articulating what they want. But they're our customer.

Q - David Duley

Okay Final thing for me you did condense I think you used the word glomerate; I'm not sure what that means but you condensed Southeast Asia, Taiwan and China. I was just wondering why you chose to do that, particularly now, what the competitive issues are that would cause you to stop giving us the breakout of those regions.

A - Richard Hill

We used to always call it Greater China. And that's how we used to break it out. Bill joined us, and it came out and broke it out. And I prefer to not have it broke out. So, that's it.

Q - David Duley

Okay thank you.

Operator

Next we have from Steven Pelayo with Soleil Fulcrum.

Q - Steven Pelayo

Great can you hear me guys?

A - Richard Hill

Yes.

Q - Steven Pelayo

One clarification first of all. If I remember, 90 days ago, I think you guys were talking about 48% gross margin by the end of the year, primarily due to the warranty issues coming off. But now I'm looking at your guide to a shipment number that perhaps is as high as 440 million. And I have to see what that translates into revenue at some point. The volume, it certainly around for something higher than the 48% gross margin as well. Did I just misunderstand you 90 days ago, or are there really no volume impacts here? What how should I look at gross margin in light of volume versus warranty issues?

A - William Kurtz

Yeah this is Bill. I realize there's a few moving parts here to the gross margin calculation. At the time that we made that set that goal, we set that goal based on about a $400 million level of revenue. So, in line with that, we given that that number stands still, we would expect to realize 48% gross margin, once we complete all of the operational improvements that we have underway. Just a point of clarification. While we have gained a significant improvement in Q1, and have projected further improvements in Q2, we are not finished at the end of Q2 with our operational improvements. We still have more to achieve by the end of the year to hit that target. Now, as we get above 400, there is about there is some additional utilization of our overhead that is equivalent to roughly a quarter-point for each 25 million on a quarterly basis that you could expect.

Q - Steven Pelayo

Okay great. And one more clarification, just on the operating expenses. Great gross margins pointing in the right direction here. But operating expenses up 6% this quarter, when revenue is kind of flat to up maybe 5% or (multiple speakers) it looks like here. What does that is that just a onetime thing? I understand the merit raises and things like that. Can I expect operating expenses to then be down sequentially in the third quarter, as you start then recognizing revenue on these shipments and have revenues up?

A - Richard Hill

Let me point out to you that, there is two components to the operating expense increase, the largest of which is the increase in profit share. And our profit share is tied to our shipments-based P&L, and so you have somewhat of a timing effect, in that shipments are growing at this point faster than revenue. Those will eventually catch up with each other. But that's why you're seeing in Q2 a faster growth in expenses, which is being driven by the profit share tied to our shipments, than you are seeing on a pure revenue basis. But as I said, that will equal itself out before the end of the year.

Q - Steven Pelayo

Okay so, the bottom line is you would expect operating expenses would likely still increase in the third quarter, but finally revenue growth would outpace that?

A - William Kurtz

Well revenue growth will eventually will clearly outpace that. And I would not expect a significant change after Q2 for the balance of the year, because at that point we would have realized the merit increases, and we would have the majority of the profit share into our run rate.

Q - Steven Pelayo

All right last question for me was just on another clarification. You're guiding bookings up to almost another 7%, up to almost 450 million or so; hints that maybe shipments can stay up in this 430 range for a couple of quarters or so. How do I start thinking about you guys are probably building the biggest amount of deferred revenues, or shipment versus revenue numbers next quarter; that's probably the largest gap that it's been in a while. So how do I think about that deferred revenue transitioning into real topline revenue in the third and fourth quarter?

A - Richard Hill

Well I think the reality is we're focused on trying to reduce deferred revenue and keep it at an appropriate level. I think it is a little bit high. My anticipation is to drive it down from where it is. As Bill articulated, Japan was one area that, because of our success in Japan, we got this big deferred revenue piece that we're not going to see ripple through for a while. But on the whole, we should see that starting to ratchet down.

A - William Kurtz

While it's difficult to give you a precise quarter-by-quarter buildup, we would expect that by the end of the year we would be back down to a more normalized level of deferred revenue. Okay. The last question are we on?

Q - Steven Pelayo

Okay thanks.

A - William Kurtz

All right.

A - Richard Hill

Okay last question William.

A - William Kurtz

I think so, Rick. This is, we should make this the last question.

Operator

We will take our final question Tim Summers with Stanford Financial Group.

Q - Tim Summers

Thanks for taking my question just a couple of housekeeping points. Number one Bill, what drove the revenue upside in the quarter, given that shipments and orders were kind of in line with guidance? And secondly, given the amount of cash that you have, is there any thought about increasing the rate of stock buyback? Thanks.

A - William Kurtz

Sure we had forecasted revenue to be somewhere in the range of 345 to 355. We came in about $10 or $11 million above that. I wouldn't say that there was one or two specific events. As you know, a few tools on either side of that could make a big difference. So, there were some acceptances that occurred earlier than expected, and it's nothing that indicates any significant change in trends that I would have you model for the business. I'm sorry, what was your second question?

Q - Tim Summers

Is there any thought about that changing?

A - William Kurtz

Oh, further stock buyback?

Q - Tim Summers

Stock buyback program, yeah.

A - William Kurtz

Well, as Rick pointed out, we are focused on making sure that we improve our shareholder equity. And one way that we can do that, in addition to growing earnings, is to reduce the share base. We have an annual cash flow that I estimate at between 250 to 300 million, and we would certainly want to operate somewhere within that range, so that we are consistent with the cash flow of the business. So, given that we bought back somewhere around 68 to 69 million, that's pretty close to the run rate for the year, unless we see an opportunity to that really compels us to accelerate that pace.

Q - Tim Summers

All right thanks.

Richard Hill, Chairman and Chief Executive Officer

Okay, thank you very much for joining us for the first-quarter conference call. We look forward to speaking with you at the end of the second quarter, and we hope we can continue the improvement in operating performance, as well as continued growth in revenue and in market share. Thank you very much.

Operator

And that does conclude our conference. Again, thank you all for your participation. We hope you enjoy the rest of your day.

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