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 of Financial Condition and Results of Operations (“MD&A”) contains information intended to help provide an understanding of our financial condition and other related matters, including our liquidity, capital resources and results of operations. The MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the notes thereto included elsewhere in this report.
The following MD&A generally focuses on the operating results and year-over-year comparisons between fiscal years 2023 and 2022. Discussion of fiscal year 2021 results and year-over-year comparisons between fiscal years 2022 and 2021 that are not included in this Annual Report on Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended October 31, 2022, filed with the SEC on January 6, 2023.
EXECUTIVE OVERVIEW
Hurco Companies, Inc. is an international, industrial technology company operating in a single segment. We design, manufacture, and sell computerized (i.e., CNC) machine tools, consisting primarily of vertical machining centers (mills) and turning centers (lathes), to companies in the metal cutting industry through a worldwide sales, service, and distribution network. Although the majority of our computer control systems and software products are proprietary, they predominantly use industry standard personal computer components. Our computer control systems and software products are primarily sold as integral components of our computerized machine tool products. We also provide machine tool components, automation integration equipment and solutions for job shops, software options, control upgrades, accessories and replacement parts for our products, as well as customer service, training, and applications support.
The following overview is intended to provide a brief explanation of the principal factors that have contributed to our recent financial performance. This overview is intended to be read in conjunction with the more detailed information included in our financial statements, and notes thereto, that appear elsewhere in this report.
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The market for machine tools is international in scope. We have both significant foreign sales and significant foreign manufacturing operations. During fiscal year 2023, approximately 53% of our revenues were attributable to customers in Europe, where we typically sell more of our higher-performance VMX series machines. Additionally, approximately 8% of our revenues were attributable to customers in the Asia Pacific region, where we encounter greater pricing pressures.
We have three brands of CNC machine tools in our product portfolio. Hurco is the technology innovation brand for customers who want to increase productivity and profitability by selecting a brand with the latest software and motion technology. Milltronics is the value-based brand for shops that want easy-to-use machines at competitive prices. The Takumi brand is for customers that need very high speed, high efficiency performance, such as that required in the production, die and mold, aerospace, and medical industries. Takumi machines are equipped with industry standard controls instead of the proprietary controls found on Hurco and Milltronics machines. These three brands of CNC machine tools are responsible for the vast majority of our revenue. However, we have added other non-Hurco branded products to our product portfolio that have contributed product diversity and market penetration opportunity. These non-Hurco branded products are sold by our wholly-owned distributors and are comprised primarily of other general-purpose vertical milling centers and lathes, laser cutting machines, waterjet cutting machines, CNC grinders, compact horizontal machines, metal cutting saws, and CNC swill lathes. ProCobots is our wholly-owned subsidiary that provides automation solutions. In addition, through our wholly-owned subsidiary in Italy, LCM, we produce high value machine tool components and accessories.
We principally sell our products through approximately 180 independent agents and distributors throughout the Americas, Europe, and Asia. Although some distributors carry competitive products, we are the primary line for the majority of our distributors globally. We also have our own direct sales and service organizations in China, the Czech Republic, France, Germany, India, Italy, the Netherlands, Poland, Singapore, Taiwan, the United Kingdom, and certain parts of the United States , which are among the world's principal machine tool consuming markets. The vast majority of our machine tools are manufactured and assembled to our specifications primarily by our wholly-owned subsidiary in Taiwan, HML. Machine castings to support HML’s production are manufactured at our wholly-owned subsidiary in Ningbo, China, NHML. Components to support our SRT line of five-axis machining centers, such as the direct-drive spindle, swivel head, and rotary table, are manufactured by our wholly-owned subsidiary in Italy, LCM.
Our sales to foreign customers are denominated, and payments by those customers are made, in the prevailing currencies in the countries in which those customers are located (primarily the Euro, Pound Sterling, and Chinese Yuan). Our product costs are incurred and paid primarily in the New Taiwan Dollar and the U.S. dollar. Changes in currency exchange rates may have a material effect on our operating results and consolidated financial statements as reported under U.S. Generally Accepted Accounting Principles. For example, when the U.S. dollar weakens in value relative to a foreign currency, sales made, and expenses incurred, in that currency when translated to U.S. dollars for reporting in our financial statements, are higher than would be the case when the U.S. dollar is stronger. In the comparison of our period-to-period results, we discuss the effect of currency translation on those results, which reflect translation to U.S. dollars at exchange rates prevailing during the period covered by those financial statements.
Our high levels of foreign manufacturing and sales also expose us to cash flow risks due to fluctuating currency exchange rates. We seek to mitigate those risks through the use of derivative instruments – principally foreign currency forward exchange contracts.
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Results of Operations
The following table presents, for the fiscal years indicated, selected items from the Consolidated Statements of Operations expressed as a percentage of our worldwide sales and service fees and the year-to-year percentage changes in the dollar amounts of those items.
Percentage of Revenues
Year-to-Year % Change
2023
2022
2021
Increase/Decrease
’23 vs. ’22
’22 vs. ’21
Sales and service fees
100
%
100
%
100
%
(9)
%
7
%
Gross profit
25
%
26
%
24
%
(13)
%
15
%
Selling, general and administrative expenses
22
%
21
%
20
%
(4)
%
12
%
Operating income
3
%
5
%
4
%
(48)
%
24
%
Net income
2
%
3
%
3
%
(47)
%
22
%
Fiscal Year 2023 Compared to Fiscal Year 2022
Sales and Service Fees. Sales and service fees for fiscal year 2023 were $227.8 million, a decrease of $23.0 million, or 9%, compared to fiscal year 2022, and included an unfavorable currency impact of $2.4 million, or 1%, when translating foreign sales to U.S. dollars for financial reporting purposes.
Net Sales and Service Fees by Geographic Region
The following table sets forth net sales and service fees by geographic region for the fiscal years ended October 31, 2023 and 2022 (dollars in thousands):
Fiscal Year Ended October 31,
Increase/Decrease
2023
2022
Amount
%
Americas
$
88,329
39
%
$
95,964
38
%
$
(7,635)
(8)
%
Europe
120,525
53
%
126,050
50
%
(5,525)
(4)
%
Asia Pacific
18,953
8
%
28,800
12
%
(9,847)
(34)
%
Total
$
227,807
100
%
$
250,814
100
%
$
(23,007)
(9)
%
Sales in the Americas for fiscal year 2023 decreased by 8%, compared to fiscal 2022, primarily due to decreased shipments of Hurco and Milltronics machines, particularly the higher-performance VMX machines.
European sales for fiscal year 2023 decreased by 4%, compared to fiscal year 2022, and included an unfavorable currency impact of 1%, when translating foreign sales to U.S. dollars for financial reporting purposes. The year-over-year decrease in European sales was primarily attributable to a decreased volume of shipments of Hurco machines in Germany, France, and Italy, partially offset by increased sales of electro-mechanical components and accessories manufactured by LCM and increased shipments of Hurco machines in the United Kingdom and Milltronics machines throughout Europe where our customers are located.
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Asian Pacific sales for fiscal year 2023 decreased by 34%, compared to fiscal 2022, and included an unfavorable currency impact of 4%, when translating foreign sales to U.S. dollars for financial reporting purposes. The year-over-year decrease in Asian Pacific sales for the fiscal year primarily resulted from a reduced volume of shipments of Takumi machines in China and Hurco machines in Southeast Asia, China, and India, partially offset by an increased volume of shipments of Takumi machines in India.
Net Sales and Service Fees by Product Category
The following table sets forth net sales and service fees by product group and services for the fiscal years ended October 31, 2023 and 2022 (dollars in thousands):
Fiscal Year Ended October 31,
Increase/Decrease
2023
2022
Amount
%
Computerized Machine Tools
$
188,335
83
%
$
211,804
85
%
$
(23,469)
(11)
%
Computer Control Systems and Software †
2,805
1
%
2,634
1
%
171
6
%
Service Parts
28,439
12
%
28,219
11
%
220
1
%
Service Fees
8,228
4
%
8,157
3
%
71
1
%
Total
$
227,807
100
%
$
250,814
100
%
$
(23,007)
(9)
%
† Amounts shown do not include computer control systems and software sold as an integrated component of computerized machine systems.
Sales of computerized machine tools for fiscal year 2023 decreased by 11%, compared to fiscal year 2022, primarily due to a decreased volume of shipments of Hurco machines in all regions where our customers are located, except the United Kingdom; Milltronics machines in North America; and Takumi machines in China. Sales of computer control systems and software for fiscal 2023 increased by 6%, compared to fiscal 2022, due to increased sales of software for Hurco machines in North America. Sales of service parts for fiscal year 2023 increased by 1%, compared to fiscal year 2022, due mainly to increased volume of sales of Hurco and ProCobots parts in Europe and North America, mostly offset by a reduction in volume of sales of parts in North America. Service fees increased by 1% for fiscal year 2023, compared to fiscal year 2022, primarily due to increased service of Hurco machines in the United Kingdom, France and Italy, mostly offset by a reduction in service of Hurco machines in North America and Germany. During fiscal year 2023, sales for all product categories included an unfavorable currency impact of 1%, when translating foreign sales to U.S. dollars for financial reporting purposes.
Orders and Backlog . Orders for fiscal year 2023 were $209.7 million, a decrease of $31.3 million, or 13%, compared to fiscal 2022, and included an unfavorable currency impact of $2.0 million, or less than 1%, when translating foreign orders to U.S. dollars.
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The following table sets forth new orders booked by geographic region for the fiscal years ended October 31, 2023 and 2022 (dollars in thousands):
Fiscal Year Ended October 31,
Increase/Decrease
2023
2022
Amount
%
Americas
$
80,412
38
%
$
92,268
38
%
$
(11,856)
(13)
%
Europe
114,961
55
%
122,556
51
%
(7,595)
(6)
%
Asia Pacific
14,303
7
%
26,107
11
%
(11,804)
(45)
%
Total
$
209,676
100
%
$
240,931
100
%
$
(31,255)
(13)
%
Orders in the Americas for fiscal year 2023 decreased by 13%, compared to fiscal year 2022, mainly due to decreased customer orders for Hurco and Milltronics, particularly higher-performance VMX machines, partially offset by increased demand for Takumi machines.
European orders for fiscal 2023 decreased by 6%, compared to fiscal 2022, and included an unfavorable currency impact of 1%, when translating foreign orders to U.S. dollars. The year-over-year decrease in European demand was primarily attributable to decreased demand for Hurco machines in Germany and France, partially offset by increased customer demand for Hurco machines in the United Kingdom and Italy, and electro-mechanical components and accessories manufactured by LCM.
Asian Pacific orders for fiscal year 2023 decreased by 45%, compared to fiscal 2022, and included an unfavorable currency impact of 3%, when translating foreign orders to U.S. dollars. The decrease in Asian Pacific orders year-over-year was driven primarily by decreased customer demand for Hurco and Takumi machines in China and Hurco machines in Southeast Asia and India, partially offset by increased demand for Takumi machines in India.
Backlog at October 31, 2023 decreased to $28.3 million from $44.8 million at October 31, 2022, primarily due to decreased customer demand during fiscal year 2023 for Hurco, Milltronics, and Takumi machines in the U.S., Germany, France, China and Southeast Asia. We do not believe backlog is a useful measure of past performance or indicative of future performance. Backlog orders as of October 31, 2023 are expected to be fulfilled in fiscal year 2024.
Gross Profit. Gross profit for fiscal year 2023 was $56.2 million, or 25% of sales, compared to $64.5 million, or 26% of sales, for fiscal 2022. The year-over-year decreases in gross profit and gross profit as a percentage of sales were primarily due to the lower volume of sales of our higher-performance VMX machines and the negative impact of fixed costs on lower sales and production volumes.
Operating Expenses. Selling, general, and administrative expenses for fiscal year 2023 were $49.6 million, or 22% of sales, compared to $51.7 million, or 21% of sales, in fiscal 2022, and included a favorable currency impact of $0.4 million, when translating foreign expenses to U.S. dollars for financial reporting purposes. The year-over-year decrease in selling, general and administrative expenses in absolute dollar terms was primarily attributable to lower costs related to tradeshow expenses, sales commissions, and employee support costs for our global operations.
Operating Income. Operating income for fiscal year 2023 was $6.6 million, or 3% of sales, compared to $12.7 million, or 5% of sales, for fiscal year 2022. The year-over-year decrease in operating income was primarily due to decreased volume of machine shipments.
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Other Expense, Net. Other expense, net for fiscal year 2023 decreased by $1.3 million from fiscal year 2022, due mainly to a decrease in foreign currency exchange losses and increased gains on sale of property and equipment.
Provision for Income Taxes . We recorded income tax expense of $2.4 million for fiscal year 2023, compared to $3.7 million for fiscal year 2022. Our effective tax rate for fiscal year 2023 was 35%, compared to 31% for fiscal year 2022. The year-over-year increase in the effective tax rate in the full year was primarily due to changes in geographic mix of income and loss that includes jurisdictions with differing tax rates, discrete items related to stock compensation and the impact of valuation allowances for our China operations combined with lower levels of consolidated income before taxes.
Net Income. Net income for fiscal year 2023 was $4.4 million, or $0.66 per diluted share, compared to $8.2 million, or $1.23 per diluted share, for fiscal year 2022. The year-over-year decrease in net income was primarily due to decreased volume of machine shipments.
Liquidity and Capital Resources
At October 31, 2023, we had cash and cash equivalents of $41.8 million, compared to $63.9 million at October 31, 2022. The decrease in cash and cash equivalents was primarily a result of net cash used for payments of outstanding accounts payable, stock repurchases and dividend payments . Approximately 26% of our $41.8 million of cash and cash equivalents is held in the U.S. The balance is attributable to our foreign operations and is held in the local currencies of our various foreign entities, subject to fluctuations in currency exchange rates. We do not believe that the indefinite reinvestment of these funds offshore impairs our ability to meet our domestic working capital needs.
Working capital at October 31, 2023 was $193.3 million, compared to $194.7 million at October 31, 2022. The decrease in working capital was primarily driven by a decrease in cash and cash equivalents, mostly offset by decreases in accounts payable and customer deposits and increases in inventory and accounts receivable.
Inventories, net were $158.0 million at October 31, 2023, compared to $156.2 million at October 31, 2022, and included an unfavorable currency impact of $4.9 million, or 3%, when translating foreign inventories to U.S. dollars for financial reporting purposes. Inventory turns at October 31, 2023 were 1.1 compared to 1.2 at October 31, 2022.
Capital expenditures were $2.6 million in fiscal year 2023, compared to $2.2 million in fiscal year 2022. Capital expenditures for fiscal year 2023 were primarily for software development costs, purchases of factory equipment for production facilities, and purchases of general software and equipment for sales and service divisions. We funded these expenditures with cash flows from operations.
On January 6, 2023, we announced a share repurchase program in an aggregate amount of up to $25.0 million. Repurchases under the program may be made in the open market or through privately negotiated transactions from time to time through November 10, 2024, subject to applicable laws, regulations, and contractual provisions. The program may be amended, suspended, or discontinued at any time and does not commit us to repurchase any shares of our common stock. During fiscal year 2023, approximately 67,513 shares were repurchased at an aggregate value of approximately $1.8 million under that program, resulting in $23.2 million remaining available under the program as of October 31, 2023.
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Our prior $7.0 million share repurchase program also remained in effect until its scheduled expiration on March 10, 2023. During fiscal year 2023, approximately 98,776 shares were repurchased at an aggregate value of approximately $2.8 million under that program. Aggregate repurchases under all programs during fiscal year 2023 were approximately $4.6 million.
In addition, during fiscal year 2023, we paid cash dividends to our shareholders equal to $4.1 million. Future dividends are subject to approval of our Board of Directors and will depend upon many factors, including our results of operations, financial condition, capital requirements, regulatory and contractual restrictions, our business strategy and other factors deemed relevant by our Board of Directors from time to time.
On December 31, 2018, we and our subsidiary Hurco B.V. entered into a credit agreement with Bank of America, N.A., as the lender, which was subsequently amended on each of March 13, 2020, December 23, 2020, December 17, 2021, January 4, 2023, and December 19, 2023 (as amended, the “2018 Credit Agreement”). The 2018 Credit Agreement provides for an unsecured revolving credit and letter of credit facility in a maximum aggregate amount of $40.0 million. The 2018 Credit Agreement provides that the maximum amount of outstanding letters of credit at any one time may not exceed $10.0 million, the maximum amount of outstanding loans made to our subsidiary Hurco B.V. at any one time may not exceed $20.0 million, and the maximum amount of all outstanding loans denominated in alternative currencies at any one time may not exceed $20.0 million. Under the 2018 Credit Agreement, we and Hurco B.V. are borrowers, and certain of our other subsidiaries are guarantors. The scheduled maturity date of the 2018 Credit Agreement is December 31, 2025.
Borrowings under the 2018 Credit Agreement bear interest at floating rates based on, at our option, either (i) a rate based upon the secured overnight financing rate (“SOFR”), the Sterling Overnight Index Average Reference Rate, the Euro Interbank Offering Rate, or another alternative currency-based rate approved by the lender, depending on the term of the loan and the currency in which such loan is denominated, plus 1.00% per annum, or (ii) a base rate (which is the highest of (a) the federal funds rate plus 0.50%, (b) the prime rate or (c) the one month SOFR-based rate plus 1.00%), plus 0.00% per annum. Outstanding letters of credit will carry an annual rate of 1.00%.
The 2018 Credit Agreement contains customary affirmative and negative covenants and events of default, including covenants (1) restricting us from making certain investments, loans, advances and acquisitions (but permitting us to make investments in subsidiaries of up to $10.0 million); (2) restricting us from making certain payments, including (a) cash dividends, except that we may pay cash dividends as long as immediately before and after giving effect to such payment, the sum of the unused amount of the commitments under the 2018 Credit Agreement plus our cash on hand is not less than $10.0 million, and as long as we are not in default before and after giving effect to such dividend payments and (b) payments made to repurchase shares of our common stock, except that we may repurchase shares of our common stock as long as we are not in default before and after giving effect to such repurchases and the aggregate amount of payments made by us for all such repurchases during any fiscal year does not exceed $25.0 million; (3) requiring that we maintain a minimum working capital of $125.0 million; and (4) requiring that we maintain a minimum tangible net worth of $176.5 million. We may use the proceeds from advances under the 2018 Credit Agreement for general corporate purposes.
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In March 2019, our wholly-owned subsidiaries in Taiwan, HML, and China, NHML, closed on uncommitted revolving credit facilities with maximum aggregate amounts of 150 million New Taiwan dollars and 32.5 million Chinese Yuan, respectively. As uncommitted facilities, both the Taiwan and China credit facilities are subject to review and termination by the respective underlying lending institution from time to time. In February and December 2023, NHML and HML, respectively, renewed the above-referenced credit facilities on substantially similar terms and identical maximum aggregate limits.
As of October 31, 2023, our existing credit facilities consisted of a €1.5 million revolving credit facility in Germany, the 150 million New Taiwan dollars Taiwan credit facility, the 32.5 million Chinese Yuan China credit facility and the $40.0 million revolving credit facility under the 2018 Credit Agreement. We had no debt or borrowings under any of our credit facilities at October 31, 2023.
At October 31, 2023, we had an aggregate of approximately $50.6 million available for borrowing under our credit facilities and were in compliance with all covenants relating thereto.
We have an international cash pooling strategy that generally provides access to available cash deposits and credit facilities when needed in the U.S., Europe or Asia Pacific. We believe our access to cash pooling and our borrowing capacity under our credit facilities provide adequate liquidity to fund our global operations over the next twelve months and beyond, and allow us to remain committed to our strategic plan of product innovation, acquisitions, targeted penetration of developing markets, payment of dividends and our stock repurchase program.
We continue to receive and review information on businesses and assets for potential acquisition, including intellectual property assets that are available for purchase. We remain committed to a balanced capital allocation strategy that prioritizes a strong balance sheet and liquidity position while recognizing the importance of accretive growth and returning value to shareholders through dividends and stock repurchases, where appropriate. As such, we continue to actively evaluate acquisition opportunities that support our long-term strategic plan.
Contractual Obligations and Commitments
The following is a table of contractual obligations and commitments as of October 31, 2023 (in thousands):
Payments Due by Period
Less than
More than
Total
1 Year
1-3 Years
3-5 Years
5 Years
Operating leases
$
12,220
$
4,027
$
4,263
$
2,807
$
1,123
Accrued and deferred taxes and credits
5,779
349
1,027
—
4,403
Total
$
17,999
$
4,376
$
5,290
$
2,807
$
5,526
In addition to the contractual obligations and commitments disclosed above, we also have a variety of other obligations for the procurement of materials and services, none of which subject us to any material non-cancelable commitments. While some of these obligations arise under long-term supply agreements, we are not committed under these agreements to accept or pay for requirements that are not needed to meet our production needs. We have no material minimum purchase commitments or “take-or-pay” type agreements or arrangements. Unrecognized tax benefits in the amount of approximately $0.1 million, excluding any interest and penalties, have been excluded from the table above because we are unable to determine a reasonably reliable estimate of the timing of future payment.
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We expect capital spending in fiscal year 2024 to be approximately $3.8 million, which includes investments for software development, leasehold improvement, factory equipment, and production facilities, as well as general software and equipment for selling facilities. We expect to fund these commitments with cash on hand and cash generated from operations.
Off Balance Sheet Arrangements
From time to time, our subsidiaries guarantee third party payment obligations in connection with the sale of machines to customers that use financing. We follow Financial Accounting Standards Board (“FASB”) guidance for accounting for guarantees (codified in Accounting Standards Codification (“ASC”) 460). As of October 31, 2023, we had nine outstanding third party payment guarantees totaling approximately $1.0 million. The terms of these guarantees are consistent with the underlying customer financing terms. Upon shipment of a machine, the customer assumes the risk of ownership. The customer does not obtain title, however, until the customer has paid for the machine. A retention of title clause allows us to recover the machine if the customer defaults on the financing. We accrue liabilities under these guarantees at fair value, which amounts are insignificant.
Critical Accounting Estimates
Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. Generally Accepted Accounting Principles. The preparation of financial statements in conformity with those accounting principles requires us to make judgments and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Our accounting policies are frequently evaluated as our judgment and estimates are based upon historical experience and on various other assumptions that we believe to be reasonable under the circumstances.
Our judgments and estimates have a significant effect on the financial statements because they result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Actual results could differ from those estimates and such differences could be material to our financial condition and results of operations. Critical accounting estimates are those that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on our financial condition and results of operations.
While our significant accounting policies are more fully described in Note 1 to our consolidated financial statements included elsewhere in this report, we believe the following discussion addresses our most critical accounting estimates, which involve significant subjectivity and judgment, and changes to such estimates or assumptions could have a material impact on our financial condition or operating results. Therefore, we consider an understanding of the variability and judgment required in making these estimates and assumptions to be critical in fully understanding and evaluating our reported financial results.
Goodwill and Intangible Assets. Goodwill and indefinite-lived intangibles arising from a business combination are reviewed for impairment annually as of the last day of our third fiscal quarter, or more frequently, if circumstances arise indicating potential impairment. We have no goodwill as of October 31, 2023. Other indefinite-lived intangible assets primarily consist of trademarks and trade names and are not material to our consolidated financial statements. Finite-lived intangible assets are amortized over their estimated useful lives and are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recovered through future net cash flows generated by the assets. We are not aware of any events or changes in circumstances that indicate the carrying value of its finite-lived assets may not be recoverable.
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Impairment of Long-Lived Assets – We are required periodically to review the recoverability of certain assets, including property, plant, and equipment, intangible assets, and goodwill, based on projections of anticipated future cash flows, including future profitability assessments of various product lines. We estimate cash flows using internal budgets based on recent sales data. We are not aware of any events or changes in circumstances that indicate the carrying value of our long-lived assets may not be recoverable.
Inventories and Related Reserves – We determine at each balance sheet date how much, if any, of our inventory may ultimately prove to be either unsalable or unsalable at its carrying cost. Reserves are established to effectively adjust the carrying value of such inventory to lower of cost (first-in, first-out method) or net realizable value. To determine the appropriate level of valuation reserves, we evaluate current stock levels in relation to historical and expected patterns of demand for all of our products. We evaluate the need for changes to valuation reserves based on market conditions, competitive offerings, and other factors on a regular basis. We have not experienced substantive write-offs due to obsolescence.
Income Taxes – We account for income taxes and the related accounts under the asset and liability method. Deferred tax assets and liabilities are measured using enacted income tax rates in each jurisdiction in effect for the year in which the temporary differences are expected to be recovered or settled. These deferred tax assets are reduced by a valuation allowance, which is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. We operate in multiple jurisdictions through wholly-owned subsidiaries, and our global structure is complex. The estimates of our uncertain tax positions involve judgments and assessment of the potential tax implications. We recognize uncertain tax positions when it is more likely than not that the tax position will be sustained upon examination by relevant taxing authorities, based on the technical merits of the position. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Accordingly, the ultimate outcome with respect to taxes we may owe may differ from the amounts recognized. Our judgment regarding the realization of deferred tax assets may change due to future profitability and market conditions, change in U.S. or foreign tax laws, and other factors. These changes, if any, may require material adjustments to these deferred tax assets and an accompanying reduction or increase in net income.
Capitalized Software Development Costs – Costs incurred to develop computer software products and significant enhancements to software features of existing products are capitalized as required by FASB guidance relating to accounting for the costs of computer software to be sold, leased, or otherwise marketed, and such capitalized costs are amortized over the estimated product life of the related software. The determination as to when in the product development cycle technological feasibility has been established, and the expected product life, require judgments and estimates by management and can be affected by technological developments, innovations by competitors, and changes in market conditions affecting demand. We periodically review the carrying values of these assets and make judgments as to ultimate realization considering the above-mentioned risk factors.
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Derivative Financial Instruments – Critical aspects of our accounting policy for derivative financial instruments that we designate as hedging instruments include conditions that require that critical terms of a hedging instrument are essentially the same as a hedged forecasted transaction. Another important element of our policy demands that formal documentation be maintained as required by FASB guidance relating to accounting for derivative instruments and hedging activities. Failure to comply with these conditions would result in a requirement to recognize changes in market value of hedge instruments in earnings. We routinely monitor significant estimates, assumptions, and judgments associated with derivative instruments and compliance with formal documentation requirements.
Stock Compensation – We account for share-based compensation according to FASB guidance relating to share-based payments, which requires the measurement and recognition of compensation expense for all share-based awards made to employees and directors based on estimated fair values on the grant date. This guidance requires that we estimate the fair value of share-based awards on the date of grant and recognize as expense the value of the portion of the award that is ultimately expected to vest over the requisite service period.