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 unaudited 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 and are headquartered in California, 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 Nine Months Ended September 25, 2020 September 27, 2019 September 25, 2020 September 27, 2019 (dollars in thousands) Net sales $ 227,678 $ 154,456 $ 669,270 $ 431,482 Gross profit $ 32,506 $ 20,693 $ 90,542 $ 60,449 Gross margin 14.3 % 13.4 % 13.5 % 14.0 % Operating expenses $ 19,974 $ 17,371 $ 63,206 $ 51,178 Operating income $ 12,532 $ 3,322 $ 27,336 $ 9,271 U.S. GAAP net income $ 10,548 $ 923 $ 20,758 $ 2,777 Non-GAAP net income (1) $ 14,581 $ 6,748 $ 39,208 $ 17,417 U.S. GAAP diluted EPS $ 0.45 $ 0.04 $ 0.89 $ 0.12 Non-GAAP diluted EPS (1) $ 0.62 $ 0.30 $ 1.69 $ 0.77 (1) Please see “Non‑GAAP Results” within Item 2 for a reconciliation of U.S. GAAP net income to Non‑GAAP net income. 13 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. 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. While our facilities 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. In response to the COVID‑19 pandemic, we have instituted weekly Business Continuity Plan (“BCP”) meetings with executive management, including our CEO, to address new challenges to our current operating environment and review the effectiveness of our current BCP approach 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) production work environments have been set up and altered to meet social distancing guidelines, (3) most of our non-direct line manufacturing employees are working remotely, (4) business travel has largely stopped, with exceptions requiring CEO staff member approval, (5) increased cleaning and sanitizing of our facilities, (6) production shift schedule changes to reduce the number of employees per shift within each production facility, and (7) office work spaces have been enhanced to reduce transmission as certain office employees return to work. 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 Nine Months Ended September 25, 2020 September 27, 2019 September 25, 2020 September 27, 2019 (in thousands) Consolidated Statements of Operations Data: Net sales $ 227,678 $ 154,456 $ 669,270 $ 431,482 Cost of sales 195,172 133,763 578,728 371,033 Gross profit 32,506 20,693 90,542 60,449 Operating expenses: Research and development 3,269 2,987 10,100 8,012 Selling, general, and administrative 13,367 11,048 43,098 33,491 Amortization of intangible assets 3,338 3,336 10,008 9,675 Total operating expenses 19,974 17,371 63,206 51,178 Operating income 12,532 3,322 27,336 9,271 Interest expense 2,052 2,663 6,728 8,193 Other expense (income), net 242 (43 ) 213 (12 ) Income before income taxes 10,238 702 20,395 1,090 Income tax benefit (310 ) (221 ) (363 ) (1,687 ) Net income $ 10,548 $ 923 $ 20,758 $ 2,777 14 The following table sets forth our unaudited results of operations as a percentage of our total sales for the periods presented. Three Months Ended Nine Months Ended September 25, 2020 September 27, 2019 September 25, 2020 September 27, 2019 Consolidated Statements of Operations Data: Net sales 100.0 100.0 100.0 100.0 Cost of sales 85.7 86.6 86.5 86.0 Gross profit 14.3 13.4 13.5 14.0 Operating expenses: Research and development 1.4 1.9 1.5 1.9 Selling, general, and administrative 5.9 7.2 6.4 7.8 Amortization of intangible assets 1.5 2.2 1.5 2.2 Total operating expenses 8.8 11.2 9.4 11.9 Operating income 5.5 2.2 4.1 2.1 Interest expense 0.9 1.7 1.0 1.9 Other expense (income), net 0.1 0.0 0.0 0.0 Income before income taxes 4.5 0.5 3.0 0.3 Income tax benefit (0.1 ) (0.1 ) (0.1 ) (0.4 ) Net income 4.6 0.6 3.1 0.6 Comparison of the Three and Nine Months Ended September 25, 2020 and September 27, 2019 Net Sales Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Net sales $ 227,678 $ 154,456 $ 73,222 47.4 % $ 669,270 $ 431,482 $ 237,788 55.1 % The increase in net sales from the three and nine months ended September 27, 2019 to the three and nine months ended September 25, 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 $47.5 million and $132.5 million from the three and nine months ended September 27, 2019, respectively, to $125.5 million and $364.1 million for the three and nine months ended September 25, 2020, respectively. Foreign sales increased by $25.7 million and $105.2 million from the three and nine months ended September 27, 2019, respectively, to $102.1 million and $305.2 million for the three and nine months ended September 25, 2020, respectively. Cost of Sales and Gross Profit Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Cost of sales $ 195,172 $ 133,763 $ 61,409 45.9 % $ 578,728 $ 371,033 $ 207,695 56.0 % Gross profit $ 32,506 $ 20,693 $ 11,813 57.1 % $ 90,542 $ 60,449 $ 30,093 49.8 % Gross margin 14.3 % 13.4 % + 90 bps 13.5 % 14.0 % - 50 bps The increase in cost of sales and gross profit from the three and nine months ended September 27, 2019 to the three and nine months ended September 25, 2020 was primarily due to increased sales volume. 15 The increase in our gross margin from the third quarter of 2019 to the third quarter of 2020 was primarily due to higher operating leverage as a result of increased factory utilization and favorable product mix on a quarter-over-quarter basis , partially offset by 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) . Additionally , during the second quarter of 2020, we made the decision to close our Union City, California facility, resulting in severance costs of $ 0 . 2 million and accelerated depreciation charges associated with property and equipment expected to be abandoned of $0.2 million during the third quarter . The impact of these costs associated with the Union City closure resulted in a n approximate 20 basis point reduction in our gross margin during the third quarter of 2020. The decrease in our gross margin from the nine months ended September 27, 2019 to the nine months ended September 25, 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 product mix compared to the nine months ended September 27, 2019, partially offset by higher operating leverage as a result of increased factory utilization in 2020. 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 costs of $1.3 million, severance costs of $0.4 million, and accelerated depreciation charges associated with property and equipment expected to be abandoned of $0.2 million during the nine months ended September 25, 2020. The impact of these costs associated with the contract settlement and Union City closure resulted in an approximate 50 basis point reduction in our gross margin during the nine months ended September 25, 2020. Research and Development Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Research and development $ 3,269 $ 2,987 $ 282 9.4 % $ 10,100 $ 8,012 $ 2,088 26.1 % The increase in research and development expenses from the third quarter of 2019 to the third quarter of 2020 was primarily due to $0.4 million in increased new product development costs, partially offset by a $0.1 million reduction in travel-related expenses. The increase in research and development expenses from the nine months ended September 27, 2019 to the nine months ended September 25, 2020 was primarily due to $1.8 million in increased employee-related expense resulting from increased engineering headcount to support new product development, of which approximately $1.0 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 Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Selling, general, and administrative $ 13,367 $ 11,048 $ 2,319 21.0 % $ 43,098 $ 33,491 $ 9,607 28.7 % The increase in selling, general, and administrative expense from the third quarter of 2019 to the third quarter of 2020 was primarily due (i) $1.3 million in increased employee-related expense, of which $0.5 million was from increased share-based compensation expense, (ii) $0.8 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 nine months ended September 27, 2019 to the nine months ended September 25, 2020 was primarily due (i) $1.8 million in executive transition costs associated with the transition of our former CEO to Executive Chairman, (ii) $5.6 million in increased employee-related expense, of which $2.5 million was from increased share-based compensation expense, (iii) $1.7 million in increased legal and professional fees, and (iv) $0.9 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. 16 Amortization of Intangible Assets Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Amortization of intangibles assets $ 3,338 $ 3,336 $ 2 0.1 % $ 10,008 $ 9,675 $ 333 3.4 % The increase in amortization expense from the nine months ended September 27, 2019 to the nine months ended September 25, 2020 was primarily due to incremental amortization expense from purchased developed technology assets during the second quarter of 2019. Interest Expense Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Interest expense $ 2,052 $ 2,663 $ (611 ) -22.9 % $ 6,728 $ 8,193 $ (1,465 ) -17.9 % The decrease in interest expense from the third quarter of 2019 to the third quarter of 2020 was primarily due to a decrease in our weighted average interest rate, from 4.83% to 3.37%, partially offset by a $14.4 million increase in our average amount borrowed during the quarter. The decrease in interest expense from the nine months ended September 27, 2019 to the nine months ended September 25, 2020 was primarily due to a decrease in our weighted average interest rate, from 4.83% to 3.89%, and a $1.6 million decrease in our average amount borrowed during the nine months ended September 25, 2020. Other Expense (Income), Net Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Other expense (income), net $ 242 $ (43 ) $ 285 n/m $ 213 $ (12 ) $ 225 n/m The increase in other expense, net from three and nine months ended September 27, 2019 to the three and nine months ended September 25, 2020 was primarily due to transactions denominated in the local currencies of our foreign operations, as the U.S. dollar fell against the local currencies during most of the third quarter. These local currencies consist primarily of the Singapore dollar, Malaysian ringgit, British pound, euro, and South Korean won. Income Tax Benefit Three Months Ended Change Nine Months Ended Change September 25, 2020 September 27, 2019 Amount % September 25, 2020 September 27, 2019 Amount % (dollars in thousands) Income tax benefit $ (310 ) $ (221 ) $ (89 ) 40.3 % $ (363 ) $ (1,687 ) $ 1,324 -78.5 % The increase in income tax benefit from the third quarter of 2019 to the third quarter of 2020 was primarily due to increased excess tax benefits associated with stock option exercise activity during the quarter, partially offset by increased taxable income in the U.S. in 2020. The decrease in income tax benefit from the nine months ended September 27, 2019 to the nine months ended September 25, 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, partially offset by increased excess tax benefits associated with stock option exercise activity during the third quarter of 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 Nine Months Ended September 25, 2020 September 27, 2019 September 25, 2020 September 27, 2019 (dollars in thousands, except per share amounts) Non-GAAP Data: U.S. GAAP net income $ 10,548 $ 923 $ 20,758 $ 2,777 Non-GAAP adjustments: Amortization of intangible assets 3,338 3,336 10,008 9,675 Share-based compensation 2,417 1,792 7,423 4,597 Other non-recurring expense, net (1) 239 476 3,124 2,323 Contract settlement loss (2) — — 1,386 — Facility shutdown costs (3) 481 — 2,017 — Tax adjustments related to non-GAAP adjustments (4) (2,442 ) 221 (5,508 ) (1,955 ) Non-GAAP net income $ 14,581 $ 6,748 $ 39,208 $ 17,417 U.S. GAAP diluted EPS $ 0.45 $ 0.04 $ 0.89 $ 0.12 Non-GAAP diluted EPS $ 0.62 $ 0.30 $ 1.69 $ 0.77 Shares used to compute diluted EPS 23,347,460 22,718,882 23,199,618 22,629,855 ( 1 ) Included in this amount for the third quarter of 2020 are primarily 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 third quarter of 2019 are primarily (i) acquisition-related expenses associated with the IAN retention agreement and (ii) costs associated with restructuring and transitioning key leadership roles. Included in this amount for the nine months ended September 25, 2020 are primarily (i) acquisition-related expenses associated with the IAN retention agreement, and (ii) 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 nine months ended September 27, 2019 are primarily (i) acquisition-related expenses associated with a charge to expense from the extinguishment of an indemnification asset related to our acquisition of Cal‑Weld in 2017 and the IAN retention agreement, (ii) costs associated with restructuring and transitioning key leadership roles, and (iii) non-capitalizable 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 the first quarter of 2021. Included in this amount are (i) inventory write-off costs of zero and $1.3 million amount for the three and nine months ended September 25, 2020; (ii) severance costs associated with affected employees of $0.2 million and $0.4 million for the three and nine months ended September 25, 2020, respectively; and (iii) accelerated depreciation charges in excess of pre-shutdown decision run-rate associated with property and equipment expected to be abandoned at the time of facility closure of $0.3 million for the three and nine months ended September 25, 2020. ( 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. 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 third quarter of 2020 with cash of $78.9 million, an increase of $18.3 million from December 27, 2019. The increase was primarily due to net proceeds from our credit facilities of $23.4 million and net proceeds from the issuance of shares under our share-based compensation plans of $5.0 million, partially offset by capital expenditures of $8.3 million and cash used in operating activities of $1.9 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 Nine Months Ended September 25, 2020 September 27, 2019 (in thousands) Cash provided by (used in) operating activities $ (1,878 ) $ 25,003 Cash used in investing activities (8,291 ) (16,495 ) Cash provided by (used in) financing activities 28,476 (22,167 ) Net increase (decrease) in cash $ 18,307 $ (13,659 ) Operating Activities Our cash used in operating activities of $1.9 million for the nine months ended September 25, 2020 consisted of net income of $20.8 million and net non-cash charges of $26.2 million, offset by an increase in our net operating assets and liabilities of $48.9 million. Net non-cash charges primarily consisted of depreciation and amortization of $18.0 million and share-based compensation of $7.4 million. The increase in our net operating assets and liabilities was primarily due to a decrease of accounts payable of $23.7 million, an increase in accounts receivable of $19.3 million, and an increase in inventories of $10.5 million, partially offset by an increase in accrued and other liabilities of $5.1 million. The decrease in accounts payable was primarily due to the timing of purchases, material receipts, and payments near the end of the third quarter of 2020 and the fourth quarter of 2019; the fourth quarter of 2019 included higher purchasing activity near the end of the quarter compared to the third quarter of 2020. The increase in accounts receivable was primarily due to increased sales volume during the quarter compared to the fourth quarter of 2019, as well as the timing of third quarter sales being heavily back-end weighted. Investing Activities Our cash used in investing activities of $8.3 million for the nine months ended September 25, 2020 consists of capital expenditures. Financing Activities Our cash provided by financing activities of $28.5 million for the nine months ended September 25, 2020 consists of net proceeds from our credit facilities of $23.4 million, partially offset by net proceeds from the issuance of ordinary shares under our share-based compensation plans of $5.0 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. 19 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 2 7 , 201 9 (our “Annual Report”).