Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand Aviat Networks, Inc.’s (“Aviat”, the “Company”, “we”, “us”, or “our”) results of operations and financial condition during the two-year period ended June 28, 2024. MD&A is provided as a supplement to, and should be read in conjunction with, the Company’s consolidated financial statements and accompanying notes. In the discussion herein, the fiscal years ended June 28, 2024, June 30, 2023, and July 1, 2022 are referred to as “fiscal 2024”, “fiscal 2023” and “fiscal 2022”, respectively. Aviat’s fiscal year ends on the Friday nearest to June 30. For a comparison of the results of operations for fiscal 2023 and 2022, refer to Aviat’s Annual Report on Form 10-K for the fiscal year ended June 30, 2023, filed with the SEC on August 30, 2023.
Overview
Aviat is a global supplier of microwave networking and access networking solutions, backed by an extensive suite of professional services and support. Aviat sells radios, routers, software and services integral to the functioning of data transport networks. Aviat has more than 3,000 customers and significant relationships with global service providers and private network operators. Aviat’s North America manufacturing base consists of a combination of contract manufacturing and assembly and testing operated in Austin, Texas by Aviat. Additionally, Aviat utilizes a contract manufacturer based in Asia for much of its international equipment demand. Aviat’s technology is underpinned by more than 300 patents. Aviat competes on the basis of total cost of ownership, microwave radio expertise and solutions for mission critical communications.
Acquisitions
NEC’s Wireless Transport Business
On May 9, 2023, the Company entered into a Master Sale of Business Agreement (as amended on November 30, 2023, the “Purchase Agreement”) with NEC Corporation (“NEC”), to acquire NEC’s wireless transport business (the “NEC Transaction”). The Company completed the NEC Transaction on November 30, 2023.
Prior to the acquisition date, NEC was a leader in wireless backhaul networks with an extensive installed base of their Pasolink series products. The completion of the NEC Transaction increases the scale of Aviat, enhances the Company’s product portfolio with a greater capability to innovate, and creates a more diversified business. Refer to Note 12. Acquisitions of the Notes to the consolidated financial statements in this Annual Report on Form 10-K (the “Notes”) for further information.
The fair value of the consideration transferred at the closing of the NEC Transaction was comprised of (i) cash of $32.2 million, and (ii) the issuance of 736,750 shares or $22.3 million of Company common stock. Aggregate consideration transferred at closing was approximately $54.5 million, which is subject to certain post-closing adjustments. The Company estimates additional cash consideration of approximately $19.9 million will be transferred to NEC in the first half of fiscal 2025, primarily related to settlement of the post-closing working capital adjustment. The Company funded the cash portion of the NEC Transaction with Term Loan borrowings under its Credit Facility (as defined below). Refer to Note 7. Credit Facility and Debt of the Notes for further information.
Redline Communications Group Inc.
In the first quarter of fiscal 2023, the Company acquired all of the issued and outstanding shares of Redline Communications Group Inc. (“Redline”), for a purchase price of $20.4 million. Redline is a leading provider of mission-critical data infrastructure. See Note 12. Acquisitions of the Notes for further information.
Operations Review
The market for mobile backhaul continued to be the Company’s primary addressable market segment globally in fiscal 2024. In North America, the Company supported 5G and long-term evolution (“LTE”) deployments of its mobile operator customers, public safety network deployments for state and local governments, and private network implementations for utilities and other customers. In international markets, the Company’s business continued to rely on a combination of customers increasing their capacity to handle subscriber growth and the ongoing build-out of some large LTE and 5G deployments. Aviat’s position continues to be to support its customers for 5G and LTE readiness and ensure that its technology roadmap is well aligned with evolving market requirements. Aviat’s strength in turnkey and after-sale support
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services is a differentiating factor that wins business for the Company and enables it to expand its business with existing customers. Additionally, Aviat operates an e-commerce on-line platform, Aviat Store, that provides low-cost services, a simple experience, and fast delivery to mobile operators and private network customers. However, as disclosed in the “Risk Factors” section in Item 1A of this Annual Report on Form 10-K, a number of factors could prevent the Company from achieving its objectives, including ongoing pricing pressures attributable to competition and macroeconomic conditions in the geographic markets that it serves.
Revisions to Prior Period Consolidated Financial Statements
Subsequent to the issuance of the consolidated financial statements and related disclosures for the fiscal year ended June 30, 2023, the Company identified certain errors in its previously issued consolidated financial statements. The Company evaluated the materiality of the errors and determined that the impacts were not material, individually or in the aggregate, to the Company’s previously issued consolidated financial statements for any of the prior reporting periods in which they occurred. The Company has revised the prior period financial statements for fiscal 2024 and fiscal 2023 to correct the errors. The revisions ensure comparability across all periods presented herein. Refer to Note 16. Revisions to Prior Period Consolidated Financial Statements of the Notes for further information.
Fiscal 2024 Compared to Fiscal 2023
Revenue
The Company manages its sales activities primarily on a geographic basis in North America and three international geographic regions: (1) Africa and the Middle East, (2) Europe and (3) Latin America and Asia Pacific. Revenue by region for fiscal 2024 and 2023 and the related changes were as follows:
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
North America $ 206,073 $ 200,678 $ 5,395 2.7 %
Africa and the Middle East 48,884 59,674 (10,790) (18.1) %
Europe 24,608 18,772 5,836 31.1 %
Latin America and Asia Pacific 128,518 65,309 63,209 96.8 %
Total Revenue $ 408,083 $ 344,433 $ 63,650 18.5 %
The Company achieved revenue growth of 18.5% in fiscal 2024 primarily driven by contributions from the NEC Transaction and increased private network and mobile 5G operator demand. Contributions from the NEC Transaction totaled $54.9 million for the period from December 2023 to June 2024. Key revenue growth areas include 44% growth in software sales, 359% growth in Access LTE/5G, 36% growth in Managed Services and an increase in sales through the Aviat Store of 21%.
Revenue in North America increased by $5.4 million in fiscal 2024 primarily due to private network and mobile 5G operator demand. Services revenue in North America remained flat year-over-year as significant projects ended in fiscal 2024.
Revenue in Africa and the Middle East decreased by $(10.8) million in fiscal 2024 primarily due to cyclical softness in the capital expenditure plans of large mobile operators in the region and currency impacts from locally provided services. The Middle East as a sub-region increased by $3.3 million primarily due to contributions from the NEC Transaction of $2.5 million.
Revenue in Europe increased by $5.8 million in fiscal 2024 primarily due to increased sales to mobile operators in the region. The NEC Transaction contributed $5.6 million in sales in Europe.
Revenue in Latin America and Asia Pacific increased by $63.2 million in fiscal 2024 primarily due to contributions from the NEC Transaction totaling $44.6 million and higher volumes of projects with mobile operators, including organic volume growth of $17.6 million in Asia Pacific compared to the prior year.
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Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Product sales
$ 274,205 $ 238,579 $ 35,626 14.9 %
Services
133,878 105,854 28,024 26.5 %
Total Revenue
$ 408,083 $ 344,433 $ 63,650 18.5 %
Revenue from product sales and services increased by 14.9% and 26.5%, respectively in fiscal 2024 primarily due to the same overall factors of revenue growth discussed previously.
Gross Margin
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Revenue $ 408,083 $ 344,433 $ 63,650 18.5 %
Cost of revenue 263,351 222,051 41,300 18.6 %
Gross margin $ 144,732 $ 122,382 $ 22,350 18.3 %
% of revenue 35.5 % 35.5 %
Product margin % 37.4 % 36.9 %
Service margin % 31.6 % 32.5 %
Gross margin for fiscal 2024 increased by $22.4 million compared with fiscal 2023 primarily due to the revenue growth described previously. Gross margin as a percentage of revenue was flat compared to the prior year as a result of the expected near term dilution effect of the NEC Transaction, offsetting margin expansion in the core Aviat business compared to the prior year driven by favorable customer mix and higher software sales compared to fiscal 2023.
Research and Development Expenses
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Research and development expenses
$ 36,426 $ 24,908 $ 11,518 46.2 %
% of revenue 8.9 % 7.2 %
Research and development expenses increased by $11.5 million in fiscal 2024 primarily due to increased product development activities and additional costs resulting from the NEC Transaction. The NEC Transaction contributed $7.2 million of the increase compared to the prior year.
Selling and Administrative Expenses
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Selling and administrative expenses
$ 85,038 $ 69,842 $ 15,196 21.8 %
% of revenue 20.8 % 20.3 %
Selling and administrative expenses increased by $15.2 million in fiscal 2024 primarily due to merger and acquisition expenses and additional costs resulting from the NEC Transaction.
Restructuring Charges
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Restructuring charges $ 3,867 $ 3,012 $ 855 28.4 %
% of revenue 0.9 % 0.9 %
During fiscal 2024 restructuring charges were $3.9 million, an increase of $0.9 million compared to fiscal 2023, primarily related to restructuring activities associated with the NEC Transaction and reductions in workforce in certain of the Company’s operations. The prior year includes non-recurring restructuring charges primarily associated with the Redline acquisition completed in the first quarter of fiscal 2023.
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The Company’s success in restructuring initiatives has enabled it to restructure specific groups to optimize skill sets and align its organizational structure to execute on strategic deliverables, in addition to aligning cost structure with the core business.
Interest Expense, Net
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Interest expense, net $ 2,337 $ 532 $ 1,805 339.3 %
Interest expense, net increased by $1.8 million in fiscal 2024 primarily due to interest expense incurred on the Term Loan borrowings used to fund the NEC Transaction in the second quarter of fiscal 2024.
Other Expense, Net
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Other expense, net $ 158 $ 2,774 $ (2,616) (94.3) %
Other expense, net decreased by $(2.6) million in fiscal 2024 primarily due to non-recurring losses of $1.7 million recognized on the sale of marketable securities included in the prior year.
Income Taxes
Fiscal Year
(In thousands, except percentages) 2024 2023 $ Change % Change
Income before income taxes
$ 16,906 $ 21,314 $ (4,408) (20.7) %
Provision for income taxes 6,146 11,145 (4,999) (44.9) %
As % of income before income taxes
36.4 % 52.3 %
The Company estimates its annual effective tax rate at the end of each reporting period, and records the tax effect of certain discrete items in the interim period in which they occur, including changes in judgment about uncertain tax positions and deferred tax valuation allowances.
Tax expense was $6.1 million in fiscal 2024 and $11.1 million in fiscal 2023. Tax expense in fiscal 2024 was primarily attributable to tax expense for the U.S. entity and profitable foreign subsidiaries, partially offset by a Canada valuation allowance release. Tax expense in fiscal 2023 was primarily attributable to tax expense related to U.S. and profitable foreign subsidiaries, including deferred tax expense associated with the acquisition of Redline (as defined above) in July 2022 and the subsequent restructuring and integration impact.
Fiscal 2023 Compared to Fiscal 2022
For a comparison of the results of operations for fiscal 2023 and 2022, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Aviat’s Annual Report on Form 10-K for the fiscal year ended June 30, 2023, filed with the SEC on August 30, 2023.
Liquidity, Capital Resources and Financial Strategies
Sources of Cash
As of June 28, 2024, the Company’s total cash and cash equivalents were $64.6 million. Approximately $34.0 million, or 53% was held in the United States. The remaining balance of $30.6 million, or 47% was held outside the United States. Of the amount of cash and cash equivalents held by the Company’s foreign subsidiaries on June 28, 2024, $30.2 million was held in jurisdictions where its undistributed earnings are indefinitely reinvested, and if repatriated, would be subject to foreign withholding taxes.
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Operating Activities
Operating cash flows is presented as net income adjusted for certain non-cash items and changes in operating assets and liabilities. Net cash provided by (used in) operating activities was $30.5 million for fiscal 2024, compared with $(1.6) million in the prior year. The $32.2 million increase is primarily attributable to increased net income prior to non-cash adjustments and improvements in the net changes in operating assets and liabilities compared to the prior year. Net changes in operating assets and liabilities resulted in $(2.5) million of cash used in operating activities for fiscal 2024, compared to $(38.8) million in fiscal 2023. The $36.3 million decrease compared to the prior year is primarily attributable to decreases in inventory on higher sales volume, increases in accounts payable and accrued expenses due to the timing of payments, and non-recurring increases in contract manufacturing and other prepaid assets included in the prior year comparison period. These improvements were partially offset by net increases in accounts receivable and unbilled costs as a result of the timing of sales, billing activities and cash collections in the current year.
Investing Activities
Net cash used in investing activities was $35.2 million for fiscal 2024, compared to $11.9 million in the prior year. The $23.3 million increase is primarily due to payments of the cash consideration associated with the NEC Transaction of $32.2 million, partially offset by non-recurring activity included in the prior year related to proceeds received on the sale of marketable securities of $9.2 million.
Financing Activities
Financing cash flows consist primarily of borrowings and repayments under the Company’s Credit Facility and proceeds from the exercise of employee stock options. Net cash provided by (used in) financing activities was $48.7 million for fiscal 2024, compared with $(0.7) million in the prior year. The $49.4 million increase is primarily due to the $50.0 million of Term Loan borrowings primarily used to settle the cash portion of the consideration associated with the NEC Transaction.
As of June 28, 2024, the Company’s sources of liquidity consisted of $64.6 million in cash and cash equivalents, $35.1 million of available credit under its Credit Facility, and future collections of receivables from customers. The Company regularly requires letters of credit from certain customers, and, from time to time, these letters of credit are discounted without recourse shortly after shipment occurs in order to meet immediate liquidity requirements and to reduce its credit and sovereign risk. Historically, the Company’s primary sources of liquidity have been cash flows from operations and credit facilities.
The Company believes that its existing cash and cash equivalents, the available borrowings under its Credit Facility, the availability under its effective shelf registration statement and future cash collections from customers will be sufficient to provide for its anticipated requirements and plans for cash for at least the next 12 months. In addition, the Company believes these sources of liquidity will be sufficient to provide for its anticipated requirements and plans for cash beyond the next 12 months.
Available Credit Facility, Borrowings and Repayment of Debt
The Company entered into a Secured Credit Facility Agreement (the “Credit Facility”), dated May 9, 2023, amended as of November 22, 2023, with Wells Fargo Bank, National Association, as administrative agent, swingline lender and issuing lender and Wells Fargo Securities LLC, Citigroup Global Markets Inc., and Regions Capital Markets as lenders. The Credit Facility provides for a $40.0 million revolving credit facility (the “Revolver”) and a $50.0 million Delayed Draw Term Loan Facility (the “Term Loan”) with a maturity date of May 8, 2028. The $40.0 million Revolver can be borrowed with a $10.0 million sub-limit for letters of credit, and a $10.0 million swingline loan sub-limit. Refer to Note 7. Credit Facility and Debt of the Notes for further information.
In November 2023, the Company borrowed $50.0 million against the Term Loan to primarily settle the cash portion of the consideration associated with the NEC Transaction. Refer to Note 12. Acquisitions of the Notes for further information.
As of June 28, 2024, the available credit under the Revolver was $35.1 million, reflecting the available limit of $40.0 million less outstanding letters of credit of $4.9 million. The Company borrowed and repaid $33.2 million against the Revolver in fiscal 2024. As of June 28, 2024, the Company had $48.8 million outstanding under its Term Loan and no borrowings under its Revolver.
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Outstanding borrowings under the Credit Facility bear interest at either: (a) Adjusted Term Secured Overnight Financing Rate (“SOFR”) plus the applicable margin; or (b) the Base Rate plus the applicable margin. The pricing levels for interest rate margins are determined based on the Consolidated Total Leverage Ratio as determined and adjusted quarterly. As of June 28, 2024, the applicable margin on Adjusted Term SOFR and Base Rate borrowings was 2.5% and 1.5%, respectively. The effective rate of interest on the outstanding Term Loan borrowings as of June 28, 2024 was 7.9%.
The Credit Facility requires the Company and its subsidiaries to maintain a fixed charge coverage ratio to be greater than 1.25 to 1.00 as of the last day of any fiscal quarter of the Company. The Credit Facility also requires that the Company maintain a maximum leverage ratio of 3.00 times EBITDA, with a step-down to 2.75 times EBITDA after four full quarters, and 2.50 times EBITDA after eight full quarters. The Credit Facility contains customary affirmative and negative covenants, including, among others, covenants limiting the ability of the Company and its subsidiaries to dispose of assets, permit a change in control, merge or consolidate, make acquisitions, incur indebtedness, grant liens, make investments, make certain restricted payments, and enter into transactions with affiliates, in each case subject to customary exceptions. As of June 28, 2024, the Company was in compliance with all financial covenants contained in the Credit Facility.
Restructuring Payments
The Company had liabilities for restructuring activities totaling $1.7 million as of June 28, 2024, which was classified as current and are expected to be paid in cash within the next 12 months. The Company expects to fund the future payments with available cash and cash provided by operations. Refer to Note 8. Restructuring Activities of the Notes for further information.
Financial Risk Management
In the normal course of doing business, the Company is exposed to the risks associated with foreign currency exchange rates and changes in interest rates. The Company employs established policies and procedures governing the use of financial instruments to manage its exposure to such risks.
Exchange Rate Risk
The Company conducts business globally in numerous currencies and is therefore exposed to foreign currency risks. From time to time, the Company uses derivative instruments to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. The Company does not hold or issue derivatives for trading purposes or make speculative investments in foreign currencies.
The Company enters into foreign exchange forward contracts to mitigate the change in fair value of specific non-functional currency assets and liabilities on the balance sheet. All balance sheet hedges are marked to market through earnings every period. Changes in the fair value of these derivatives are largely offset by re-measurement of the underlying assets and liabilities. The Company did not have any foreign exchange forward contracts outstanding as of June 28, 2024 or June 30, 2023.
Net foreign exchange (gains) losses recorded in the consolidated statements of operations during fiscal 2024, 2023 and 2022 were $(0.3) million, $1.0 million and $1.1 million, respectively.
Certain of the Company’s international business are transacted in non-U.S. dollar (“USD”) currencies. From time to time, the Company utilizes foreign currency hedging instruments to minimize the currency risk of non-USD transactions. The impact of translating the assets and liabilities of foreign operations to USD is included as a component of stockholders’ equity. As of June 28, 2024 and June 30, 2023, the cumulative translation adjustment decreased stockholders’ equity by $19.3 million and $16.0 million, respectively.
Interest Rate Risk
The Company’s exposure to market risk for changes in interest rates relates primarily to its cash equivalents and borrowings under its Credit Facility.
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Exposure on Cash Equivalents
The Company had $64.6 million in total cash and cash equivalents as of June 28, 2024. Cash equivalents totaled $10.3 million as of June 28, 2024 and were comprised of money market funds and bank certificates of deposit. Cash equivalents have been recorded at fair value. Fair value is measured using inputs that fall into a three-level hierarchy that prioritizes the inputs used to measure fair value based on observability of such inputs. Refer to Note 6. Fair Value Measurements of Assets and Liabilities of the Notes for further information.
The Company’s cash equivalents earn interest at fixed rates; therefore, changes in interest rates will not generate a gain or loss on these investments unless they are sold prior to maturity. The weighted-average days to maturity for cash equivalents held as of June 28, 2024 was approximately 30 days, and these investments had an average yield of approximately 5.0% per annum. A 10% change in interest rates on the Company’s cash equivalents is not expected to have a material impact on its financial position, results of operations, or cash flows.
Exposure on Borrowings
As of June 28, 2024, the Company had $48.8 million outstanding under its Term Loan and no borrowings under its Revolver. Refer to Note 7 Credit Facility and Debt of the Notes for further information.
The Company’s borrowings under the current Credit Facility bear interest at either: (a) Adjusted Term SOFR plus the applicable margin; or (b) the Base Rate plus the applicable margin. The pricing levels for interest rate margins are determined based on the Consolidated Total Leverage Ratio as determined and adjusted quarterly. As of June 28, 2024, the applicable margin on Adjusted Term SOFR and Base Rate borrowings was 2.5% and 1.5%, respectively. The effective rate of interest on the Company’s outstanding Term Loan borrowings as of June 28, 2024 was 7.9%.
A 10% change in interest rates is estimated to have a $0.4 million impact on annual interest expense on the Company’s outstanding long-term debt as of June 28, 2024.
Critical Accounting Estimates
The Company’s consolidated financial statements are prepared in accordance with U.S. GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us.
These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.
The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:
• revenue recognition for estimated costs to complete over-time services;
• inventory valuation and provision for excess and obsolete inventory losses;
• income taxes valuation; and
• business combinations.
In some cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result. Our senior management has reviewed these critical accounting policies and related disclosures with the Audit Committee of the Board.
The following is not intended to be a comprehensive list of all of our accounting policies or estimates. Our significant accounting policies are more fully described in Note 1. The Company and Summary of Significant Accounting Policies of the Notes. In preparing our financial statements and accounting for the underlying transactions and balances, we apply those accounting policies. We consider the estimates discussed below as critical to an understanding of our financial statements because their application places the most significant demands on our judgment, with financial reporting results relying on estimates about the effect of matters that are inherently uncertain.
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Besides estimates that meet the “critical” accounting estimate criteria, we make many other accounting estimates in preparing our financial statements and related disclosures. All estimates, whether or not deemed critical, affect reported amounts of assets, liabilities, revenue and expenses as well as disclosures of contingent assets and liabilities. Estimates are based on experience and other information available prior to the issuance of the financial statements. Materially different results can occur as circumstances change and additional information becomes known, including for estimates that we do not deem “critical.”
Revenue Recognition
We recognize revenue by applying the following five-step approach: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract; and (5) recognition of revenue when, or as, we satisfy a performance obligation.
Revenue from services includes certain network planning and design, engineering, installation and commissioning, extended warranty, customer support, consulting, training, and education. Maintenance and support services are generally offered to our customers and recognized over a specified period of time and from sales and subsequent renewals of maintenance and support contracts. The network planning and design, engineering and installation related services noted are recognized based on an over-time recognition model using the cost-input method. Certain judgment is required when estimating total contract costs and progress to completion on the over-time arrangements, as well as whether a loss is expected to be incurred on the contract. The cost estimation process for these contracts is based on the knowledge and experience of the Company’s project managers, engineers, and financial professionals. Changes in job performance and job conditions are factors that influence estimates of the total costs to complete those contracts and the Company’s revenue recognition. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward completion, revisions to the estimates are made in a timely manner. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are reflected in income in the period in which the circumstances that gave rise to the revision become known to us. We perform ongoing profitability analysis of our service contracts accounted for under this method to determine whether the latest estimates of revenues, costs, and profits require updating. In rare circumstances if these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately.
Inventory Valuation and Provisions for Excess and Obsolete Losses
Our inventories have been valued at the lower of cost or net realizable value. Net realizable value is defined as the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. We balance the need to maintain prudent inventory levels to ensure competitive delivery performance with the risk of excess or obsolete inventory due to changing technology and customer requirements, and new product introductions. The manufacturing of our products is handled primarily by contract manufacturers. Our contract manufacturers procure components and manufacture our products based on our forecast of product demand. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand, the stage of the product life cycle, anticipated end of product life and production requirements. Several factors may influence the sale and use of our inventories, including decisions to exit a product line, technological change, new product development and competing product offerings. These factors could result in a change in the amount of obsolete inventory quantities on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case the provision required for excess and obsolete inventory may be overstated or understated. In the future, if we determine that our inventory is overvalued, we would be required to recognize such costs in cost of product sales and services in our consolidated statements of operations at the time of such determination. In the case of goods which have been written down below cost at the close of a fiscal quarter, such reduced amount is considered the new lower cost basis for subsequent accounting purposes, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. We did not make any material changes in the valuation methodology during the past three fiscal years.
Our customer service inventories are stated at the lower of cost or net realizable value. We carry service parts because we generally provide product warranty for 12 to 36 months and earn revenue by providing enhanced and extended warranty and repair service during and beyond this warranty period. Customer service inventories consist of both component parts, which are primarily used to repair defective units, and finished units, which are provided for customer use permanently or on a temporary basis while the defective unit is being repaired. We record adjustments to reduce the carrying value of customer service inventories to their net realizable value. Factors influencing these adjustments include product life cycles, end of
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service life plans and volume of enhanced or extended warranty service contracts. Estimates of net realizable value involve significant estimates and judgments about the future, and revisions would be required if these factors differ from our estimates.
Income Taxes Valuation
We record the estimated future tax effects of temporary differences between the tax basis of assets and liabilities of amounts reported in our consolidated balance sheets, as well as operating loss and tax credit carryforwards. Certain judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the opening and closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences may result in an increase or decrease to our tax provision in a subsequent period in which such determination is made.
We record deferred taxes by applying enacted statutory tax rates to the respective jurisdictions and follow specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded on the consolidated balance sheets and provide necessary valuation allowances as required. Future realization of deferred tax assets ultimately depends on meeting certain criteria in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 740, Income Taxes (“ASC 740”). One of the major criteria is the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carry-back or carry-forward periods available under the tax law. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. Our judgments regarding future profitability may change due to many factors, including future market conditions and our ability to successfully execute our business plans and/or tax planning strategies. Should there be a change in our ability to recover our deferred tax assets, our tax provision would increase or decrease in the period in which the assessment is changed.
The accounting estimates related to the liability for uncertain tax position require us to make judgments regarding the sustainability of each uncertain tax position based on its technical merits. It is inherently difficult and subjective to estimate our reserves for the uncertain tax positions. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will be the same as these estimates. These estimates are updated quarterly based on factors such as changes in facts or circumstances, changes in tax law, new audit activity, and effectively settled issues.
Business Combinations
The Company accounts for acquisitions as required by FASB ASC Topic 805, Business Combinations (“ASC 805”). Under the acquisition method of accounting, the assets and liabilities of acquired businesses are recorded at their estimated fair values at the date of acquisition. The excess of the purchase price over the estimated fair values of the assets acquired and liabilities assumed is recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment and involves the use of significant estimates and assumptions to properly allocate purchase price consideration between the fair value of the assets acquired and liabilities assumed. The Company leverages independent third-party valuations in determining the estimated fair values of acquired tangible assets, identifiable intangible assets, and assumed liabilities. If assumptions or estimates used in determining fair values change based on information that becomes available during the one-year period from the acquisition date, we record measurement period adjustments to the assets acquired and liabilities assumed with a corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.
Impact of Recently Issued Accounting Pronouncements
Refer to Note 1. The Company and Summary of Significant Accounting Policies of the Notes for a full description of recently issued accounting pronouncements, including the respective expected dates of adoption and effects on the consolidated financial position and results of operations.
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