ICHOR HOLDINGS, LTD. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and related notes included elsewhere in this report. The following discussion contains forward‑looking statements based upon our current plans, expectations, and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward‑looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in “Risk Factors.” Overview We are a leader in the design, engineering and manufacturing of critical fluid delivery subsystems for semiconductor capital equipment. Our primary offerings include gas and chemical delivery subsystems, collectively known as fluid delivery subsystems, which are key elements of the process tools used in the manufacturing of semiconductor devices. Our gas delivery subsystems deliver, monitor and control precise quantities of the specialized gases used in semiconductor manufacturing processes such as etch and deposition. Our chemical delivery subsystems precisely blend and dispense the reactive liquid chemistries used in semiconductor manufacturing processes such as electroplating and cleaning. We also manufacture certain components such as weldments and precision machined components for use in fluid delivery systems for direct sales to our customers. This vertically integrated portion of our business is primarily focused on metal and plastic parts that are used in gas and chemical systems, respectively. Fluid delivery subsystems ensure accurate measurement and uniform delivery of specialty gases and chemicals at critical steps in the semiconductor manufacturing process. Any malfunction or material degradation in fluid delivery reduces yields and increases the likelihood of manufacturing defects in these processes. Historically, semiconductor OEMs internally designed and manufactured the fluid delivery subsystems used in their process tools. Currently, most OEMs outsource the design, engineering, and manufacturing of their gas delivery subsystems to a few specialized suppliers, including us. Additionally, many OEMs are also increasingly outsourcing the design, engineering, and manufacturing of their chemical delivery subsystems due to the increased fluid expertise required to manufacture these subsystems. Outsourcing these subsystems has allowed OEMs to leverage the suppliers’ highly specialized engineering, design, and production skills while focusing their internal resources on their own value-added processes. We believe that this outsourcing trend has enabled OEMs to reduce their fixed costs and development time, as well as provided significant growth opportunities for specialized subsystems suppliers like us. We have a global footprint with production facilities in Malaysia, Singapore, South Korea, California, Florida, Minnesota, Oregon, and Texas. Our two largest customers by revenue were Lam Research and Applied Materials for all periods presented. The following summarizes key financial information for the periods indicated: Three Months Ended Six Months Ended June 26, 2020 June 28, 2019 June 26, 2020 June 28, 2019 (dollars in thousands) Net sales $ 221,564 $ 139,195 $ 441,592 $ 277,026 Gross profit $ 29,262 $ 19,533 $ 58,036 $ 39,756 Gross margin 13.2 % 14.0 % 13.1 % 14.4 % Operating expenses $ 19,958 $ 16,521 $ 43,232 $ 33,807 Operating income $ 9,304 $ 3,012 $ 14,804 $ 5,949 U.S. GAAP net income $ 6,811 $ 336 $ 10,210 $ 1,854 Non-GAAP adjusted net income (1) $ 12,569 $ 5,118 $ 24,627 $ 10,669 (1) Please see “Non‑GAAP Results” within Item 2 for a reconciliation of Non‑GAAP net income to U.S. GAAP net income. COVID-19 Pandemic and Market Conditions Update The COVID‑19 pandemic and related economic repercussions have created, and are expected to continue to create, significant volatility, uncertainty, and turmoil in our industry. While we are currently not subject to any site-wide government shutdowns, “social distancing” guidelines are resulting, and will continue to result in, reduced factory capacity. In addition, an increase in direct costs within our factories associated with employee personal protective equipment (“PPE”), facility cleaning and layout changes, together with increases in logistics costs and employee labor costs, as well as other operating inefficiencies have resulted in, and may continue to result in, lower revenues and operating margins. The extent and duration of these impacts cannot be specifically quantified given the dynamic nature and breadth of the pandemic’s impact on our operations and that of our customers and suppliers. 13 In response to the COVID ‑ 19 pandemic , we have instituted weekly Business Continuity Plan (“B CP ”) meetings with executive management , including our CEO, to address new challenges to our current ope rating environment and review the effectiveness of our current BCP appr oach to managing our business. As necessary, our CEO communicates with our board of directors regarding our BCP to ensure all stakeholders remain informed of COVID ‑19 challenges affecting our business and the measures taken to address them. We have implemented , at minimum , the following steps at our facilities in order to ensure the safety and welfare of our employees, customers, suppliers, and visitors to our operations: (1) PPE has been provided to all employees and temperature screening is performed on all personnel entering our facilities , (2) p roduction work environments have been set up and altered to meet social dist ancing guidelines, (3) m ost of our non - direct line manufacturing employee s are working remotely, (4) b usiness travel has largely stopped, with exceptions req uiring CEO staff member approval, (5) i ncreased cleaning and sanitizing of our facilities , and (6) p roduction shift schedule changes to reduce the number of employees per shift with in each production facilit y . Results of Operations The following table sets forth our unaudited results of operations for the periods presented. The period‑to‑period comparison of results is not necessarily indicative of results for future periods. Three Months Ended Six Months Ended June 26, 2020 June 28, 2019 June 26, 2020 June 28, 2019 (in thousands) Consolidated Statements of Operations Data: Net sales $ 221,564 $ 139,195 $ 441,592 $ 277,026 Cost of sales 192,302 119,662 383,556 237,270 Gross profit 29,262 19,533 58,036 39,756 Operating expenses: Research and development 3,509 2,634 6,831 5,025 Selling, general, and administrative 13,113 10,685 29,731 22,443 Amortization of intangible assets 3,336 3,202 6,670 6,339 Total operating expenses 19,958 16,521 43,232 33,807 Operating income 9,304 3,012 14,804 5,949 Interest expense 2,302 2,762 4,676 5,530 Other expense (income), net 2 7 (29 ) 31 Income before income taxes 7,000 243 10,157 388 Income tax expense (benefit) 189 (93 ) (53 ) (1,466 ) Net income $ 6,811 $ 336 $ 10,210 $ 1,854 The following table sets forth our unaudited results of operations as a percentage of our total sales for the periods presented. Three Months Ended Six Months Ended June 26, 2020 June 28, 2019 June 26, 2020 June 28, 2019 Consolidated Statements of Operations Data: Net sales 100.0 100.0 100.0 100.0 Cost of sales 86.8 86.0 86.9 85.6 Gross profit 13.2 14.0 13.1 14.4 Operating expenses: Research and development 1.6 1.9 1.5 1.8 Selling, general, and administrative 5.9 7.7 6.7 8.1 Amortization of intangible assets 1.5 2.3 1.5 2.3 Total operating expenses 9.0 11.9 9.8 12.2 Operating income 4.2 2.2 3.4 2.1 Interest expense 1.0 2.0 1.1 2.0 Other expense (income), net 0.0 0.0 0.0 0.0 Income before income taxes 3.2 0.2 2.3 0.1 Income tax expense (benefit) 0.1 (0.1 ) 0.0 (0.5 ) Net income 3.1 0.2 2.3 0.7 14 Comparison of the Three and Six Months Ended June 26 , 20 20 and June 28 , 201 9 Net Sales Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Net sales $ 221,564 $ 139,195 $ 82,369 59.2 % $ 441,592 $ 277,026 $ 164,566 59.4 % The increase in net sales from the three and six months ended June 28, 2019 to the three and six months ended June 26, 2020 was primarily due to increased demand from our customers as a result of growth in the global wafer fabrication equipment market as it comes out of the recent cyclical downturn, as well as share-gains at our largest customers. On a geographic basis, sales in the U.S. increased by $40.8 million and $85.0 million from the three and six months ended June 28, 2019, respectively, to $117.7 million and $238.5 million for the three and six months ended June 26, 2020, respectively. Foreign sales increased by $41.6 million and $79.6 million from the three and six months ended June 28, 2019, respectively, to $103.9 million and $203.1 million for the three and six months ended June 26, 2020, respectively. Cost of Sales and Gross Profit Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Cost of sales $ 192,302 $ 119,662 $ 72,640 60.7 % $ 383,556 $ 237,270 $ 146,286 61.7 % Gross profit $ 29,262 $ 19,533 $ 9,729 49.8 % $ 58,036 $ 39,756 $ 18,280 46.0 % Gross margin 13.2 % 14.0 % - 80 bps 13.1 % 14.4 % - 130 bps The increase in cost of sales and gross profit from the three and six months ended June 28, 2019 to the three and six months ended June 26, 2020 was primarily due to increased sales volume. The decrease in our gross margin from the second quarter of 2019 to the second quarter of 2020 was primarily due to increased costs to operate our production facilities in response to the COVID‑19 pandemic (see “COVID‑19 Pandemic and Market Conditions Update” above for expanded commentary) and unfavorable product mix, partially offset by higher operating leverage as a result of increased factory utilization. As a result of governmental shelter-in-place orders instituted in March 2020, our facilities in California and Malaysia were shut down for durations ranging from approximately 1‑3 weeks near the end of the first quarter, which also impacted output early in the second quarter. Additionally, during the second quarter of 2020, we made the decision to close our Union City, California facility, resulting in inventory write-off and severance costs of $1.5 million. The impact of this event resulted in a 70 basis point reduction in our gross margin during the second quarter of 2020. The decrease in our gross margin from the six months ended June 28, 2019 to the six months ended June 26, 2020 was primarily due to increased costs to operate our production facilities and lower factory utilization in response to the COVID‑19 pandemic (see “COVID‑19 Pandemic and Market Conditions Update” above for expanded commentary) and unfavorable product mix, partially offset by higher operating leverage as a result of increased factory utilization. As a result of governmental shelter-in-place orders instituted in March 2020, our facilities in California and Malaysia were shut down for durations ranging from approximately 1‑3 weeks near the end of the first quarter. Additionally, during the first quarter of 2020, we reached a mutual settlement with the counterparty of a contract dispute and, accordingly, recorded a $1.4 million contract settlement loss to cost of sales, and during the second quarter of 2020, we made the decision to shut down our Union City, California facility, resulting in inventory write-off and severance costs of $1.5 million. The impact of these events resulted in a 70 basis point reduction in our gross margin during the six months ended June 26, 2020. 15 Research and Development Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Research and development $ 3,509 $ 2,634 $ 875 33.2 % $ 6,831 $ 5,025 $ 1,806 35.9 % The increase in research and development expenses from the second quarter of 2019 to the second quarter of 2020 was primarily due to $0.7 million in increased employee-related expense resulting from increased engineering headcount, of which approximately $0.4 million was due to a small engineering team assumed in connection with our purchase of developed technology assets in the second quarter of 2019. The increase in research and development expenses from the six months ended June 28, 2019 to the six months ended June 26, 2020 was primarily due to $1.4 million in increased employee-related expense resulting from increased engineering headcount, of which approximately $0.8 million was due to a small engineering team assumed in connection with our purchase of developed technology assets in the second quarter of 2019. Selling, General, and Administrative Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Selling, general, and administrative $ 13,113 $ 10,685 $ 2,428 22.7 % $ 29,731 $ 22,443 $ 7,288 32.5 % The increase in selling, general, and administrative expense from the second quarter of 2019 to the second quarter of 2020 was primarily due (i) $1.6 million in increased employee-related expense, of which $0.6 million was from increased share-based compensation expense, (ii) $0.5 million in increased legal and professional fees, and (iii) $0.3 million in increased occupancy costs. The increase in selling, general, and administrative expense from the six months ended June 28, 2019 to the six months ended June 26, 2020 was primarily due (i) $1.8 million in executive transition costs associated with the transition of our former CEO to Executive Chairman, (ii) $4.2 million in increased employee-related expense, of which $2.0 million was from increased share-based compensation expense, (iii) $0.9 million in increased legal and professional fees, and (iv) $0.5 million in increased occupancy costs; partially offset by the release of a $0.7 million indemnification asset in the first quarter of 2019, which was recorded in connection with our acquisition of Cal‑Weld in 2017, that did not repeat in the first quarter of 2020. Amortization of Intangible Assets Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Amortization of intangibles assets $ 3,336 $ 3,202 $ 134 4.2 % $ 6,670 $ 6,339 $ 331 5.2 % The increase in amortization expense from the three and six months ended June 28, 2019 to the three and six months ended June 26, 2020 was primarily due to incremental amortization expense from purchased developed technology assets during the second quarter of 2019. 16 Interest Expense Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Interest expense $ 2,302 $ 2,762 $ (460 ) -16.7 % $ 4,676 $ 5,530 $ (854 ) -15.4 % The decrease in interest expense from the second quarter of 2019 to the second quarter of 2020 was primarily due to a decrease in our weighted average interest rate, from 4.89% to 3.93%, partially offset by a $4.1 million increase in our average amount borrowed during the quarter. The decrease in interest expense from the six months ended June 28, 2019 to the six months ended June 26, 2020 was primarily due to a decrease in our weighted average interest rate, from 4.83% to 4.17%, and a $9.7 million decrease in our average amount borrowed during the six months ended June 26, 2020. Other Expense (Income), Net Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Other expense (income), net $ 2 $ 7 $ (5 ) n/m $ (29 ) $ 31 $ (60 ) n/m The change in other income, net was primarily due to exchange rate fluctuations on transactions denominated in the local currencies of our foreign operations, principally the Singapore dollar, Malaysian ringgit, British pound, euro, and South Korean won. Income Tax Expense (Benefit) Three Months Ended Change Six Months Ended Change June 26, 2020 June 28, 2019 Amount % June 26, 2020 June 28, 2019 Amount % (dollars in thousands) Income tax expense (benefit) $ 189 $ (93 ) $ 282 -303.2 % $ (53 ) $ (1,466 ) $ 1,413 -96.4 % The decrease in income tax benefit from the second quarter of 2019 to the second quarter of 2020 was primarily due to increased taxable income in the U.S. in 2020. The decrease in income tax benefit from the six months ended June 28, 2019 to the six months ended June 26, 2020 was primarily due to a decrease in releases of certain tax reserves related to statute of limitation expirations or settlements in the first quarter of 2020 compared to the first quarter of 2019, as well as increased taxable income in the U.S. in 2020. 17 Non ‑GAAP Results Management uses non-GAAP metrics to evaluate our operating and financial results. We believe the presentation of non-GAAP results is useful to investors for analyzing business trends and comparing performance to prior periods, along with enhancing investors’ ability to view our results from management’s perspective. Non-GAAP net income is defined as: net income excluding (1) amortization of intangible assets, share-based compensation expense, and non-recurring expenses, including contract settlement losses; and (2) the tax impacts associated with our non-GAAP adjustments, as well as non-recurring discrete tax items. Non-GAAP diluted EPS is defined as non-GAAP net income divided by weighted average diluted ordinary shares outstanding during the period. The following table presents our unaudited non‑GAAP net income and a reconciliation from net income, the most comparable GAAP measure, for the periods indicated: Three Months Ended Six Months Ended June 26, 2020 June 28, 2019 June 26, 2020 June 28, 2019 (dollars in thousands, except per share amounts) Non-GAAP Data: U.S. GAAP net income $ 6,811 $ 336 $ 10,210 $ 1,854 Non-GAAP adjustments: Amortization of intangible assets 3,336 3,202 6,670 6,339 Share-based compensation 2,141 1,475 5,006 2,805 Other non-recurring expense, net (1) 195 496 2,885 1,847 Contract settlement loss (2) — — 1,386 — Facility shutdown costs (3) 1,536 — 1,536 — Tax adjustments related to non-GAAP adjustments (4) (1,450 ) (391 ) (3,066 ) (2,176 ) Non-GAAP net income $ 12,569 $ 5,118 $ 24,627 $ 10,669 U.S. GAAP diluted EPS $ 0.30 $ 0.01 $ 0.44 $ 0.08 Non-GAAP diluted EPS $ 0.54 $ 0.23 $ 1.07 $ 0.47 Shares used to compute diluted EPS 23,066,976 22,663,053 23,099,946 22,596,412 ( 1 ) Included in this amount for the second quarter of 2020 and the six months ended June 26, 2020 are (i) a $1.8 million bonus payment to our former CEO in connection with his transition to executive chairman, (ii) acquisition-related expenses, comprised primarily of expense associated with a two-year retention agreement between the Company and key management personnel of IAN (the “IAN retention agreement”), which we acquired in April 2018, and (iii) non-capitalizable costs incurred in connection with our implementation of a new ERP system and a Sarbanes-Oxley (“SOX”) compliance program. Included in this amount for the second quarter of 2019 are (i) acquisition-related expenses, comprised primarily of expense associated with a two-year retention agreement between the Company and key management personnel of IAN, which we acquired in April 2018 and (ii) costs associated with restructuring and transitioning key leadership roles. Included in this amount for the six months ended June 28, 2019 are (i) acquisition-related expenses, comprised primarily of a charge to expense from the extinguishment of an indemnification asset related to our acquisition of Cal‑Weld in 2017 and expense associated with a two-year retention agreement between the Company and key management personnel of IAN, (ii) costs incurred in connection with reorganizing our key personnel and leadership, and (iii) costs incurred with implementing a new ERP system. (2) During the first quarter of 2020, we reached a mutual settlement with the counterparty of a contract dispute and, accordingly, recorded a $1.4 million contract settlement loss to cost of sales. (3) During the second quarter of 2020, we announced the closure of our manufacturing facility in Union City, California, which we expect to complete by the end of our 2020 fiscal year. Included in this amount are inventory write-off costs of $1.3 million and severance costs of $0.2 million associated with the affected employees. ( 4 ) Adjusts U.S. GAAP income tax benefit for impact of our non-GAAP adjustments, as defined, including the impacts of excluding share-based compensation, amortization of intangible assets, and other non-recurring expenses. This adjustment also excludes the impact of non-recurring discrete tax items, including the release of tax reserves related to purchase accounting and the release or placement of a valuation allowance. Non-GAAP results have limitations as an analytical tool, and you should not consider them in isolation or as a substitute for our results reported under GAAP. Other companies may calculate non-GAAP results differently or may use other measures to evaluate their performance, both of which could reduce the usefulness of our non-GAAP results as a tool for comparison. 18 Because of these limitations, you should consider non-GAAP results alongside other financial performance measures and results presented in accordance with GAAP. In addition, in evaluating non-GAAP results , you should be aware that in the future we will incur expenses such as those that are the subject of adjustments in deriving non-GAAP results and you should not infer from our presentation of non-GAAP results that our future results will not be affected by these expenses or any unusual or non-recurring items. Liquidity and Capital Resources We ended the second quarter of 2020 with cash of $57.0 million, a decrease of $3.6 million from December 27, 2019. The decrease was primarily due to cash used in operating activities of $25.2 million and capital expenditures of $5.7 million, partially offset by net proceeds from our credit facilities of $25.6 million and net proceeds from the issuance of shares under our share-based compensation plans of $1.6 million. The various impacts of the COVID‑19 pandemic on the U.S. economy, our operations, and our industry have been significant. Nonetheless, at this time, w e believe that our cash, the amounts available under our revolving credit facility, and our cash flows from operations will be sufficient to meet our anticipated cash needs for at least the next 12 months. Cash Flow Analysis Six Months Ended June 26, 2020 June 28, 2019 (in thousands) Cash provided by (used in) operating activities $ (25,183 ) $ 20,660 Cash used in investing activities (5,665 ) (14,264 ) Cash provided by (used in) financing activities 27,205 (8,774 ) Net decrease in cash $ (3,643 ) $ (2,378 ) Operating Activities Our cash used in operating activities of $25.2 million for the six months ended June 26, 2020 consists of net income of $10.2 million and net non-cash charges of $17.5 million, offset by an increase in our net operating assets and liabilities of $52.9 million. Net non-cash charges primarily consist of depreciation and amortization of $11.7 million and share-based compensation of $5.0 million. The increase in our net operating assets and liabilities was primarily due to an increase in inventories of $22.2 million, an increase in accounts receivable of $20.0 million, and a decrease of accounts payable of $13.7 million. The increase in inventories is primarily due to an increase in purchases to support increased volume, and the increase in accounts receivable is primarily due to increased sales volume during the quarter compared to the fourth quarter of 2019, as well as the timing of second quarter sales being heavily back-end weighted. Investing Activities Our cash used in investing activities of $5.7 million for the six months ended June 26, 2020 consists of capital expenditures. Financing Activities Our cash provided by financing of $27.2 million for the six months ended June 26, 2020 consists of net proceeds from our credit facilities of $25.6 million, partially offset by net proceeds from the issuance of ordinary shares under our share-based compensation plans of $1.6 million. Critical Accounting Policies Our consolidated financial statements have been prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. The critical accounting policies requiring estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are identified and described in our annual consolidated financial statements and the notes included in our Annual Report on Form 10‑K for the year ended December 27, 2019 (our “Annual Report”). 19