Investors brought their whips on Tuesday and gave NovellusSystems (NASDAQ:NVLS) a sound lashing, dropping its stock price by 12%. The harsh treatment was in reaction to Novellus reporting third-quarter earnings that were weaker than expected, as well as declining sales and gross margins. Adding to the bad tidings was a disappointing outlook. Sales tallied $339 million, down 18.5% from last year's third quarter. If you have been following the semiconductor equipment industry, you won't be surprised. This industry has been in a downturn all year after a strong 2004, although customers have been investing in certain products like NAND flash memory.

Net income came in at just $23.4 million ($0.17 per diluted share), which was nearly a 30% drop from the second quarter and a whopping 64% below last year's third quarter. If you ignore one-time charges, things look a little better, but still the "earnings" number pops up only to $0.21 per share. According to Novellus management, one reason for the weak earnings results was higher warranty costs that reduced gross margins. Gross margins fell by 5 percentage points from 48.4% in Q3 2004 to 43.4% in Q3 2005. Management said during the conference call that the warranty issues arose with some of the new products, but that this is not uncommon with new products. It hopes the higher warranty costs will last only one more quarter.

Novellus is a hostage to its industry, so I'm not too concerned that its sales have fallen so much since last year. I can even give the company a free pass on its weak earnings -- this time -- although I plan to watch warranty costs in the future.

Two factors are more worrisome. First is the high level of order cancellations -- higher, even, than during the great tech wreck of 2000. CEO Rick Hill said that companies that canceled typically had cash flow problems. This may very well be true, but I wonder if these cancellations also say something about how Novellus' customers feel about the health of end-user semiconductor demand. After all, if these customers felt that the outlook for semiconductor demand was bright, wouldn't they go ahead and make these investments?

The second worrisome factor is the company's competitive position in new products. Novellus is struggling to gain traction in PVD (physical vapor deposition, a method of depositing films) and CMP (chemical mechanical planarization, a technique for making rough surfaces smooth). The company characterized the pricing for PVD products as "intense." With these new products, Novellus is butting heads with industry titan Applied Materials (NASDAQ:AMAT). It's possible that Applied will, um, apply enough pricing pressure to make these products unprofitable for Novellus.

While virtually all semi equipment makers are experiencing lower earnings and revenues this year, some are starting to see brighter times ahead. Lam Research (NASDAQ:LRCX), for example, announced declining financial results last week, but the numbers were better than expected, as was its guidance, which referenced improving customer demand. Lam's stock jumped more than 11% on the news. Lam makes equipment that removes portions of thin films during the manufacture of semiconductors. Novellus' products are concentrated more on the deposition side of the equation, so its products aren't direct competitors with those of Lam. Nevertheless, Novellus should still experience some of the same semiconductor industry dynamics. Whether Novellus will follow in Lam's footsteps and soon signal that better times lie ahead for it is, however, anyone's guess.

For someone who doesn't own the stock, like myself, this quarter was a double-edged sword. I always like buying stocks of companies in cyclical industries at as low a price as possible, so the price drop makes the stock more interesting. In the case of Novellus, though, there are enough worrisome issues to keep me on the sidelines for the time being.

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Dan Bloom doesn't own shares of any stock mentioned in this article.