Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
You should read the following discussion and analysis by our management of our financial condition and results of operations in conjunction with our consolidated financial statements and the accompanying notes.
The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Please also see the cautionary language at the beginning of this Annual Report on Form 10-K regarding forward-looking statements.
The following discussions also include use of the non-GAAP term “gross margin,” as well as other non-GAAP measures discussed in more detail under the heading “Non-GAAP Financial Measures.” Gross margin is determined by deducting the cost of sales from operating revenue. Cost of sales includes manufacturing direct and indirect labor, materials, services, fixed costs for rent, utilities and depreciation, and variable overhead. Gross margin should not be considered an alternative to operating income or net income, both of which are determined in accordance with GAAP. We believe that gross margin, although a non-GAAP financial measure, is useful and meaningful to investors as a basis for making investment decisions. It provides investors with information that demonstrates our cost structure and indicates the amount of funds available to cover our total costs and expenses. We use gross margin in measuring the performance of our business and have historically analyzed and reported gross margin information publicly. Other companies may calculate gross margin in a different manner.
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Potential Impact of COVID-19
In March 2020, the WHO declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 has spread throughout world, including the U.S., and continues to spread as additional variants emerge. As a result of the COVID-19 pandemic, our employees at our facilities in China, Latvia, and the U.S. were subject to stay-at-home orders during a portion of fiscal year 2021, which restrictions have since been lifted as of the date of this Annual Report on Form 10-K. In addition to stay-at-home orders, many jurisdictions also implemented social distancing and other restrictions and measures to slow the spread of COVID-19. These restrictions significantly impacted economic conditions in the U.S. in 2020 and continued into 2021, 2022 and 2023. Beginning in the spring of 2021, restrictions began to lift as vaccines became more available. Despite these stay-at-home orders and other measures and restrictions implemented in the areas in which we operate, as a critical supplier to both the medical and defense industries, we were deemed to be an essential business; thus, regardless of the stay-at-home orders, our workforce was permitted to work from our facilities and our business operations have generally continued to operate as normal.
To date, we have not experienced any significant direct financial impact of COVID-19 to our business. However, the COVID-19 pandemic continues to impact economic conditions, particularly in China, which has impacted the short-term and long-term demand from customers and, therefore, has negatively impacted our results of operations, cash flows, and financial position in that region. Additionally, some areas have had travel restrictions in place, including China until recently. Even though China’s travel restrictions are no longer in place, we are required to re-apply for travel visas and approvals which will continue to affect our ability to travel in China. As a result, some aspects of our operations that depend on travel, such as recruitment of senior positions, and travel of service providers to maintain our production equipment have been, and will continue to be, adversely impacted. Management is actively monitoring this situation and taking steps to mitigate the impact on our financial condition, liquidity, and results of operations globally. However, we are not able to precisely estimate the effects of the continuing COVID-19 pandemic on our future results of operations, financial, or liquidity in fiscal 2024 and beyond.
Effect of Certain Events Occurring at Our Chinese Subsidiaries
In April 2021, we terminated several employees of our China subsidiaries, LPOIZ and LPOI, including the General Manager, the Sales Manager, and the Engineering Manager, after determining that they had engaged in malfeasance and conduct adverse to our interests, including efforts to misappropriate certain of our proprietary technology, diverting sales to entities owned or controlled by these former employees and other suspected acts of fraud, theft and embezzlement. In connection with such terminations, our China subsidiaries have engaged in certain legal proceedings with the terminated employees.
We have incurred various expenses associated with our investigation into these matters prior and subsequent to the termination of the employees and the associated legal proceedings. These expenses, which included legal, consulting and other transitional management fees, totaled $718,000 during the year ended June 30, 2021. During the year ended June 30, 2022, approximately $400,000 of related expenses were incurred. During the year ended June 30, 2023, expenses incurred related to the legal proceedings were immaterial. Such expenses were recorded as “Selling, general and administrative” expenses in the accompanying Consolidated Statements of Comprehensive Income (Loss).
We also identified a further liability in the amount of $210,000, which could have been incurred in the future due to the actions of these employees. This amount was accrued as of June 30, 2021, pending further investigation, and was included in “Other Expense, net” in the Consolidated Statement of Comprehensive Income (Loss) for the year ended June 30, 2021. During the third quarter of fiscal year 2022, it was determined that our Chinese subsidiary would not be responsible for this amount. As such, this accrual was reversed and is included in the accompanying Consolidated Statements of Comprehensive Income (Loss) in the line item entitled “Other income (expense), net” for the year ended June 30, 2022.
Knowing that employee transitions in international subsidiaries can lead to lengthy and expensive legal proceedings that can be disruptive to operations, compounded by the fact that our officers could not travel to China to oversee the transitions because of the travel restrictions imposed by COVID-19, we chose to enter into severance agreements with certain of the employees at the time of termination. Pursuant to the severance agreements, LPOIZ and LPOI agreed to pay such employees severance of approximately $485,000 in the aggregate, to be paid over a six-month period. After the execution of the severance agreements, we discovered additional wrongdoing by the terminated employees. As a result, LPOIZ and LPOI have not yet paid the severance payments and have disputed the employees’ rights to such payments. Currently, there are ongoing civil actions in China in connection with LPOIZ’s and LPOI’s refusal to pay these severance amounts due to the employees’ non-compliance. However, based on the likelihood that the courts in China will determine that our subsidiaries will ultimately be obligated to pay these amounts, we have accrued for these payments as of June 30, 2021, and such expenses were recorded as “Selling, general and administrative” expenses in the accompanying Consolidated Statement of Comprehensive Income (Loss) in fiscal year 2021. As of June 30, 2022, approximately $430,000 was accrued. The Chinese Labor Court ruled in favor of the former employees, as expected, and these severance payments were paid out during the first half of fiscal year 2023. We continue to have litigation pending in the Chinese court system related to these matters, but there has been little activity during fiscal year 2023.
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We have transitioned the management of LPOI and LPOIZ to a new management team without any significant detrimental effects on their ability to operate. We have not experienced any material adverse impact to the business operations of LPOI or LPOIZ as a result of the transition.
We expect to incur additional legal fees and consulting expenses in future periods as we continue to pursue our legal options and remedies; however, such future fees are expected to be at lower levels than have been incurred to date.
Although we have taken steps to minimize the business impacts from the termination of the local management employees and transition to new management personnel, we experienced some short-term adverse impacts on LPOIZ’s and LPOI’s domestic sales in China and results of operations in the three-month period ended June 30, 2021, which continued through fiscal year 2022. We have not experienced, nor do we anticipate, any material adverse impact on LPOIZ’s or LPOI’s production and supply of products to LightPath for LightPath’s customers.
Results of Operations
Operating Results for Fiscal Year Ended June 30, 2023 compared to the Fiscal Year Ended June 30, 2022:
Revenue.
Revenue for fiscal year 2023 was approximately $32.9 million, a decrease of 7%, as compared to $35.6 million in fiscal year 2022. Revenue generated by infrared products was approximately $16.7 million in fiscal year 2023, a decrease of 11%, as compared to the prior fiscal year. The decrease in revenue is primarily driven by sales of BD6-based molded infrared products, particularly to customers in the China commercial and industrial markets. The decrease in sales to customers in the China commercial and industrial markets were partially offset by increased revenue from sales of BD6-based products to customers in the defense industry. Sales of diamond-turned infrared products were nearly flat for fiscal years 2023 and 2022, however there were shifts in the customer mix, with growth from some newer key customers.
Revenue generated by PMO products was approximately $13.4 million for fiscal year 2023, a decrease of 11%, as compared to the prior fiscal year. The decrease in revenue is due to a decrease in sales to customers in the telecommunications industry and a decrease in sales of commercial products, partially offset by increases in sales to defense and industrial customers. PMO product sales to customers in China continue to be soft across all of the industries we serve due to unfavorable economic conditions in that region.
Revenue generated by specialty products was approximately $2.8 million in fiscal year 2023, an increase of approximately 54% as compared to fiscal year 2022. The increase is primarily due to increase demand for collimator assemblies, and increased sales of a custom visible lens assembly to a medical customer, for which we have and end of life order with backlog going into fiscal 2025. The first quarter of fiscal 2023 also included a charge for in-process materials billed to a customer upon order cancellation, during the first quarter of fiscal 2023.
Cost of Sales and Gross Margin.
Gross margin for fiscal year 2023 was approximately $11.1 million, a decrease of 6%, as compared to approximately $11.8 million in fiscal year 2022. Total cost of sales was approximately $21.9 million for fiscal year 2023, compared to $23.7 million for fiscal year 2022, a decrease of 8%. Gross margin as a percentage of revenue was 34% for fiscal year 2023 as compared to 33% for fiscal year 2022. The mix of revenue by product group for fiscal 2023 was similar to that of the prior fiscal year, however the overall revenue was 7% lower. The lower revenue level for fiscal 2023, as compared to the prior fiscal year, resulted in less contribution toward fixed manufacturing costs. Improving gross margin to 34% at the lower revenue level reflects the benefit of a number of the operational and cost structure improvements that we implemented in fiscal years 2022 and 2023. The benefits of those improvements were partially offset by increased costs in the second half of fiscal 2023, as we temporarily outsourced certain production processes during the consolidation and construction of our Orlando manufacturing facility.
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Selling, General and Administrative.
For fiscal year 2023, Selling, General and Administrative (“SG&A”) costs were approximately $11.4 million, an increase of approximately $215,000, or 2%, as compared to the prior fiscal year. The increase in SG&A for fiscal year 2023 is primarily due to an increase in stock compensation, partially due to director retirements that occurred during the second quarter of fiscal year 2023, as well as increases in other personnel-related costs. We also incurred costs of approximately $140,000 associated with the acquisition of Visimid, which closed in July 2023. In addition, we incurred approximately $129,000 during fiscal year 2023 related to the exit of our secondary facility in Orlando, the lease for which terminated in February 2023. SG&A costs for fiscal year 2023 also include fees of $53,000 paid to BankUnited under our Amended Loan Agreement as a result of not prepaying the BankUnited Term Loan by certain specified dates. Please refer to Note 13, Loans Payable, in the Consolidated Financial Statements in this Annual Report on Form 10-K for additional information. These increases were partially offset by the following decreases: (i) decrease of $248,000 in value-added tax (“VAT”) and related taxes from prior years that were accrued by one of our Chinese subsidiaries in the second quarter of fiscal 2022; and (ii) decrease of approximately $400,000 of expenses associated with the previously disclosed events that occurred at our Chinese subsidiaries, including legal and consulting fees incurred during fiscal year 2022. Please refer to Note 14, Contingencies , in the Consolidated Financial Statements in this Annual Report on Form 10-K for additional information.
New Product Development.
New product development costs were approximately $2.1 million in fiscal year 2023, an increase of approximately 3% as compared to the prior fiscal year. This increase was primarily due to greater spending on internally-funded development projects in fiscal year 2023, such as the MANTIS reference design camera, whereas in fiscal year 2022, new product development consisted of more customer- and government-funded NRE projects.
Other Expense.
Interest expense was approximately $283,000 for fiscal year 2023, compared to approximately $229,000 in the prior fiscal year. The increase in interest expense is due to rising interest rates, partially offset by a 30% reduction in our total debt, including finance lease obligations, and excluding operating lease liabilities, as of June 30, 2023, as compared to the end of the prior fiscal year.
Other income, net, was approximately $25,000 for fiscal year 2023, compared to $177,000 for fiscal year 2022. Other income, net, for fiscal year 2022 includes a benefit of $210,000, which represents the reversal of a potential liability related to the actions of the terminated employees of our subsidiaries in China, as previously discussed. This potential liability was accrued as of June 30, 2021, pending further investigation, and it was determined in the third quarter of fiscal year 2022 that our Chinese subsidiary would not be responsible for this amount. Other income, net also includes net foreign currency transaction gains and losses. We execute all foreign sales from our U.S. facilities and inter-company transactions in U.S. dollars, partially mitigating the impact of foreign currency fluctuations. Assets and liabilities denominated in non-United States currencies, primarily the Chinese Yuan and Euro, are translated at rates of exchange prevailing on the balance sheet date, and revenues and expenses are translated at average rates of exchange for the year. During fiscal year 2023, we incurred net foreign currency transaction losses of approximately $37,000, compared to $3,000 for fiscal year 2022.
Income Taxes.
During fiscal year 2023, we recorded income tax expense of approximately $234,000, compared to approximately $863,000 in fiscal year 2022, primarily related to our operations in China. Income taxes for fiscal years 2023 and 2022 also included Chinese withholding tax expenses of $235,000 and $230,000, respectively, the majority of which are associated with intercompany dividends declared by LPOIZ, payable to us as the parent company. While this repatriation transaction resulted in some additional Chinese withholding taxes, LPOIZ currently qualifies for a reduced Chinese income tax rate; therefore, the total tax on those earnings was still below the normal income tax rate. The income tax provision for fiscal year 2022 also includes a true-up of deferred tax liabilities for LPOIZ. Please refer to Note 8, Income Taxes , in the Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for additional information related to each of our tax jurisdictions.
Net Income (Loss).
Net loss for fiscal year 2023 was approximately $4.0 million, or $0.13 basic and diluted loss per share, compared to approximately $3.5 million, or $0.13 basic and diluted loss per share, for fiscal year 2022. The increase in net loss for fiscal year 2023, as compared to fiscal year 2022, is attributable to the approximately $927,000 increase in operating loss resulting from lower revenue and gross margin and increased operating expenses. Other income also decreased approximately $152,000, primarily due to the aforementioned $210,000 accrual reversal in fiscal year 2022, after a potential liability associated with the actions of our terminated employees of our Chinese subsidiaries was favorably resolved. The increased operating loss and decrease in other income were partially offset by a favorable difference of approximately $629,000 in the provision for income taxes for fiscal year 2023 as compared to fiscal year 2022.
Weighted-average common stock shares outstanding were 31,637,445 for both basic and diluted in fiscal year 2023, compared to 27,019,534 for both basic and diluted in fiscal year 2022. The increase in the weighted-average basic common shares was due to the sale of an aggregate of 9,090,910 shares of Class A common stock pursuant to a public offering which closed January 17, 2023, as well as the issuance of shares of Class A common stock under the 2014 ESPP and underlying vested RSUs and RSAs. Potential dilutive common stock equivalents were excluded from the calculation of diluted shares for fiscal years 2023 and 2022, as their effects would have been anti-dilutive due to the net loss in those periods.
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Liquidity and Capital Resources
At June 30, 2023, we had working capital of approximately $14.9 million and total cash and cash equivalents and restricted cash of approximately $7.1 million. Greater than 25% of our total cash, cash equivalents and restricted cash was held by our foreign subsidiaries in China and Latvia. Cash, cash equivalents and restricted cash held by our foreign subsidiaries in China and Latvia were generated in-country as a result of foreign earnings. Historically, we considered unremitted earnings held by our foreign subsidiaries to be permanently reinvested. However, during fiscal year 2020, we began declaring intercompany dividends to remit a portion of the earnings of our foreign subsidiaries to us, as the U.S. parent company. It is still our intent to reinvest a significant portion of earnings generated by our foreign subsidiaries, however we also plan to repatriate a portion of their earnings.
In China, before any funds can be repatriated, the retained earnings of the legal entity must equal at least 50% of the registered capital. During fiscal years 2023 and 2022, we repatriated approximately $1.9 million and $2.8 million, respectively, from LPOIZ. As of June 30, 2023, LPOIZ had approximately $2.9 million in retained earnings available for repatriation, and LPOI did not have any earnings available for repatriation, based on earnings accumulated through December 31, 2022, the end of the most recent statutory tax year, that remained undistributed as of June 30, 2023. Based on our previous intent, we had not historically provided for future Chinese withholding taxes on the related earnings. However, during fiscal year 2020 we began to accrue for these taxes on the portion of earnings that we intend to repatriate.
Loans payable as of June 30, 2023 consisted of the term loan in the original principal amount of approximately $5.8 million (the “BankUnited Term Loan”) issued in favor of BankUnited, N.A. (“BankUnited”) and two third-party equipment loans. Details of the loans are as follows:
BankUnited Loans.
On February 26, 2019, we entered into a Loan Agreement (the “Loan Agreement”) with BankUnited for (i) a revolving line of credit up to a maximum amount of $2,000,000 (the “Revolving Line”), (ii) a term loan in the amount of up to $5,813,500 (“Term Loan”), and (iii) a non-revolving guidance line of credit up to a maximum amount of $10,000,000 (the “Guidance Line” and, together with the Revolving Line and Term Loan, the “BankUnited Loans”) as evidenced by certain promissory notes we executed in favor of BankUnited (the “BankUnited Notes”). Since then, we have entered into several amendments to the Loan Agreement and pursuant to those amendments and the associated waivers of compliance with certain financial covenants, we have maintained our compliance with all financial and non-financial covenants under the Loan Agreement. The Guidance Line was terminated on May 6, 2019. The Revolving Line expired on February 26, 2022 and was not renewed. For additional information on the amendments and the terms of the Loan Agreement, see Note 13, Loans Payable , to the Notes to the Consolidated Financial Statements to this Annual Report on Form 10-K.
Pursuant to that certain Fourth Amendment to Loan Agreement dated February 7, 2023, the Term Loan, the only remaining BankUnited Loan, matures and is due and payable in full on December 31, 2024. The Term Loan bears interest at BankUnited’s then prime rate of interest, as adjusted from time to time (8.25% as of June 30, 2023). Monthly payments of $75,000 are due and payable on the first day of each month, and commencing on January 1, 2024 and continuing on the first day of each month thereafter until the maturity date, monthly payments will increase to $100,000, with each such payment applied first to interest, costs and expenses and then to principal. Upon maturity, all principal and interest shall be immediately due and payable. Pursuant to that certain Fifth Amendment to the Loan Agreement dated May 9, 2023, the security interest in certain collateral securing the Term Loan as of such date terminated and was replaced by a security interest in a cash collateral account maintained at BankUnited, initially in the amount of approximately $2,457,000, with a portion of such cash collateral to be released on a quarterly basis equal to 110% of the principal reductions effected during that quarter. The cash collateral is reflected as Restricted Cash in the accompanying balance sheet as of June 30, 2023. An exit fee equal to 1% of the outstanding principal balance will be due on December 31, 2023 and (b) 4% of the outstanding principal balance on December 31, 2024 (to the extent the Term Loan is still outstanding on the respective dates and has not been refinanced with another lender). As of June 30, 2023, the outstanding principal balance on the Term Loan was approximately $2.2 million.
We have commenced discussions with other lenders with the intent of refinancing our credit facility prior to maturity. There can be no assurance that we will be successful in such refinancing or that we such refinancing will be available under reasonable commercial terms. If we are unable to refinance the credit facility with other commercial lenders prior to maturity, we may need to raise additional equity financing, source financing through non-commercial lenders or reduce operating expenses and capital expenditures in order to repay our credit facility and all charges related thereto upon its maturity on December 31, 2024. For additional information on liquidity, see Note 13, Loans Payable , to the Notes to the Consolidated Financial Statements to this Annual Report on Form 10-K.
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Equipment Loans.
In December 2020, ISP Latvia entered into an equipment loan with a third party (the “2020 Equipment Loan”), which is also a significant customer. The 2020 Equipment Loan is subordinate to the Term Loan and is collateralized by certain equipment. The initial advance under the 2020 Equipment Loan was 225,000 EUR (or USD $275,000), payable in equal installments over 60 months, the proceeds of which were used to make a prepayment to a vendor for equipment to be delivered at a future date. The 2020 Equipment Loan bears interest at a fixed rate of 3.3%. An additional 225,000 EUR (or USD $267,000) was drawn in September 2021, which proceeds were paid to the vendor for the equipment, payable in equal installments over 52 months. As of June 30, 2023, the outstanding balance on the 2020 Equipment Loan was 237,000 EUR (or USD $259,000).
In May 2023, ISP Latvia entered into an equipment loan with a third party (the “2023 Equipment Loan”). The 2023 Equipment Loan is collateralized by certain equipment. The initial advance under the 2023 Equipment Loan was 128,815 EUR (or USD $141,245), the proceeds of which were used to make a prepayment to a vendor for equipment to be delivered at a future date. The 2023 Equipment Loan will be payable over 48 months, with monthly installments beginning January 1, 2024. The 2023 Equipment Loan bears interest at the six-month EURIBOR rate, plus 2.84% (6.75% as of June 30, 2023).
For additional information regarding the BankUnited Loans and the equipment loans, see Note 13, Loans Payable , to the Notes to the Consolidated Financial Statements to this Annual Report on Form 10-K.
Equity Financing.
In February 2022, we filed a shelf registration statement to facilitate the issuance of our Class A common stock, warrants exercisable for shares of our Class A common stock, and/or units up to an aggregate offering price of $75.8 million from time to time. In connection with the filing of the shelf registration statement, we also included a prospectus supplement relating to an at-the-market equity program under which we may issue and sell shares of our Class A common stock up to an aggregate offering price of $25.2 million from time to time, decreasing the aggregate offering price available under our shelf registration statement to $50.6 million. The shelf registration statement was declared effective by the SEC on March 1, 2022. We have not issued any shares of our Class A common stock pursuant to the at-the-market equity program.
On January 12, 2023, the Company entered into a securities purchase agreement (“Purchase Agreement”), pursuant to which the Company agreed to issue and sell in a public offering under the shelf registration statement an aggregate of 9,090,910 shares of the Company’s Class A common stock, par value $0.01 per share for a purchase price of $1.10 per share and filed a prospectus supplement with the SEC related thereto. The sale of shares pursuant to the Purchase Agreement closed on January 17, 2023, and resulted in net proceeds of approximately $9.2 million after payment of placement agent fees, and certain other costs and expenses of the offering.
Based on the capital raise that was completed in January 2023, we do not expect to need additional equity capital for the foreseeable future and we believe we have adequate financial resources to sustain our current and anticipated operations in the coming year. We have established milestones that will be tracked to ensure that as funds are expended we are achieving results before additional funds are committed. However, there are a number of factors that could result in the need to raise additional funds in the longer term, including a decline in revenue or a lack of anticipated sales growth, increased material costs, increased labor costs, planned production efficiency improvements not being realized, increases in property, casualty, benefit and liability insurance premiums, and increases in other costs. In addition, greater than 25% of our cash, cash equivalents and restricted cash is held by our foreign subsidiaries and, although we regularly repatriate cash, it may not be readily available to repay our liabilities in the U.S. should our cash assets in the U.S. not be sufficient. We may also identify opportunities for acquisitions and other strategic transactions to expand and further enhance our business that may require that we raise additional capital should we elect to pursue any of such transactions. Finally, we may need to raise capital through the issuance of our equity securities if we are unable to refinance the Term Loan on acceptable terms prior to its maturity on December 31, 2024.
We intend to continue efforts to keep costs under control as we seek renewed sales growth. Our efforts are directed toward generating positive cash flow and profitability. If these efforts are not successful, we may need to raise additional capital. Should capital not be available to us at reasonable terms, other actions may become necessary in addition to cost control measures and continued efforts to increase sales. These actions may include the sale of certain product lines, the creation of joint ventures or strategic alliances under which we will pursue business opportunities, the creation of licensing arrangements with respect to our technology, or other alternatives.
Cash Flows – Operating.
Cash flow used in operations was approximately $2.8 million for fiscal year 2023, compared to cash provided by operations of approximately $1.5 million for fiscal year 2022. The decrease in cash flows from operations during fiscal year 2023 is primarily due to an increase in accounts receivable, due to higher revenues in the fourth quarter of fiscal year 2023 as compared to fiscal 2022, and an increase in inventory during the second half of fiscal year 2023. The cash outflow for accounts payable and accrued liabilities for fiscal years 2022 and 2023 was primarily due to the previously described events that occurred at our Chinese subsidiaries, for which certain expenses were accrued as of June 30, 2021 and paid during fiscal years 2022 and 2023. Fiscal year 2022 also reflects the payment of certain bonuses paid to our executive officers and other employees which were earned and accrued during fiscal year 2021 and paid during fiscal year 2022. During fiscal years 2022 and 2023 we also made the installment payments for payroll taxes deferred in fiscal year 2020 under the CARES Act.
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We anticipate continued improvement in our cash flows provided by operations in future years, as many of these non-recurring payables are behind us, and as we continue to focus on managing our receivables, payables and inventory, while continuing to grow our sales and improve gross margins, with moderate increases in general, administrative, sales and marketing and new product development costs.
Cash Flows – Investing.
During fiscal year 2023, we expended approximately $3.1 million for capital equipment, as compared to approximately $1.6 million during fiscal year 2022. During fiscal year 2023, our capital expenditures were primarily related to the expansion of our Orlando Facility. Our capital expenditures during fiscal year 2022 were primarily related to the continued expansion of our Riga Facility to increase our infrared coating capacity as well as increasing our lens diamond turning capacity to meet current and forecasted demand.
We anticipate a similar level of capital expenditures during fiscal year 2023; however, the total amount expended will depend on sales growth opportunities and other circumstances.
Cash Flows – Financings.
Net cash provided by financing activities was approximately $7.5 million in fiscal year 2023, compared to cash used in financing activities of approximately $636,000 in fiscal year 2022. Cash provided by financing activities for fiscal year 2023 reflects equity proceeds of $9.2 million from a public offering of Class A common stock, which closed in January 2023, offset by approximately $1.9 million in principal payments on our loans and finance leases, offset by proceeds of approximately $141,000 from the 2023 Equipment Loan and approximately $40,000 in proceeds from the sale of Class A common stock under the 2014 ESPP. Cash used in financing activities for fiscal year 2022 reflects approximately $894,000 in principal payments on our loans and finance leases and $61,000 in loan costs, offset by proceeds of approximately $267,000 from the 2020 Equipment Loan and approximately $52,000 in proceeds from the sale of Class A common stock under the 2014 ESPP.
How We Operate
We have continuing sales of two basic types: sales via ad-hoc purchase orders of mostly standard product configurations (our “turns” business) and the more challenging and potentially more rewarding business of customer product development. In this latter type of business, we work with customers to help them determine optical specifications and even create certain optical designs for them, including complex multi-component designs that we call “engineered solutions.” This is followed by “sampling” small numbers of the product for the customers’ test and evaluation. Thereafter, should a customer conclude that our specification or design is the best solution to their product need; we negotiate and “win” a contract (sometimes called a “design win”) – whether of a “blanket purchase order” type or a supply agreement. The strategy is to create an annuity revenue stream that makes the best use of our production capacity, as compared to the turns business, which is unpredictable and uneven. This annuity revenue stream can also generate low-cost, high-volume type orders. A key business objective is to convert as much of our business to the design win and annuity model as is possible. We face several challenges in doing so:
·
Maintaining an optical design and new product sampling capability, including a high-quality and responsive optical design engineering staff;
·
The fact that as our customers take products of this nature into higher volume, commercial production (for example, in the case of molded optics, this may be volumes over one million pieces per year) they begin to work seriously to reduce costs – which often leads them to turn to larger or overseas producers, even if sacrificing quality; and
·
Our small business mass means that we can only offer a moderate amount of total productive capacity before we reach financial constraints imposed by the need to make additional capital expenditures – in other words, because of our limited cash resources and cash flow, we may not be able to service every opportunity that presents itself in our markets without arranging for such additional capital expenditures.
Despite these challenges to winning more “annuity” business, we nevertheless believe we can be successful in procuring this business because of our unique capabilities in optical design engineering that we make available on the merchant market, a market that we believe is underserved in this area of service offering. Additionally, we believe that we offer value to some customers as a source of supply in the U.S. should they be unwilling to commit to purchase their supply of a critical component from foreign merchant production sources. For information regarding revenue recognition related to our various revenue streams, refer to Critical Accounting Policies and Estimates in this Annual Report on Form 10-K.
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Our Key Performance Indicators
Usually on a weekly basis, management reviews several performance indicators. Some of these indicators are qualitative and others are quantitative. These indicators change from time to time as the opportunities and challenges in the business change. They are mostly non-financial indicators, such as units of shippable output by product line, production yield rates by major product line, and the output and yield data from significant intermediary manufacturing processes that support the production of the finished shippable product. These indicators can be used to calculate such other related indicators as fully yielded unit production per-shift, which varies by the product and our state of automation in production of that product at any given time. Higher unit production per shift means lower unit cost, and, therefore, improved margins or improved ability to compete, where desirable, for price sensitive customer applications. The data from these reports is used to determine tactical operating actions and changes. We believe that our non-financial production indicators, such as those noted, are proprietary information.
Financial indicators that are usually reviewed at the same time include the major elements of the micro-level business cycle:
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sales backlog;
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revenue dollars and units by product group;
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inventory levels;
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accounts receivable levels and quality; and
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other key indicators.
These indicators are similarly used to determine tactical operating actions and changes and are discussed in more detail below. Management will evaluate these key indicators as we transition to our new strategic plan to determine whether any changes or updates to our key indicators are warranted.
Sales Backlog.
We believe sales growth has been and continues to be our best indicator of success. Our best view into the efficacy of our sales efforts is in our “order book.” Our order book equates to sales “backlog.” It has a quantitative and a qualitative aspect: quantitatively, our backlog’s prospective dollar value and qualitatively, what percent of the backlog is scheduled by the customer for date-certain delivery. Historically, we evaluated our backlog on a 12-month basis, which examined orders required by a customer for delivery within a one-year period. To better align with our strategic focus on longer-term customer orders and relationships, beginning in fiscal year 2021, management began evaluating our total backlog, which includes all firm orders requested by a customer that are reasonably believed to remain in the backlog and be converted into revenues. This includes customer purchase orders and may include amounts under supply contracts if they meet the aforementioned criteria. Generally, a higher total backlog is better for us.
Quarterly backlog levels for fiscal years 2023 and 2022 are as follows:
Quarter
Total Backlog
($ 000)
Change From Prior Year End
Change From Prior Quarter End
Q1 2022
$ 19,265
-10 %
-10 %
Q2 2022
$ 21,929
3 %
14 %
Q3 2022
$ 19,678
-8 %
-10 %
Q4 2022
$ 17,767
-17 %
-10 %
Q1 2023
$ 22,973
29 %
29 %
Q2 2023
$ 29,427
66 %
28 %
Q3 2023
$ 26,620
50 %
-10 %
Q4 2023
$ 21,652
22 %
-19 %
The increase in backlog during fiscal year 2023 was due to several large customer orders. One such order is a $4 million supply agreement with a long time European customer of precision motion control systems and OEM assemblies. The new supply agreement went into effect in the fourth quarter of our fiscal year 2023 and is expected to run for approximately 12 to18 months. During the second quarter of fiscal year 2023 we also received the renewal of a large annual contract for infrared products, for an amount 20% greater than the previous renewal. We began to ship against the new contract in the third quarter of fiscal year 2023, after shipments against the previous contract were completed. Also, during the second quarter of fiscal year 2023, we were qualified to provide advanced infrared optics for a critical international military program, and received an initial order valued at $2.5 million from the related customer. This order represents a significant increase in this customer's business with us. In addition, we received orders from existing customers in the U.S. and Europe related to several other significant long-term projects.
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The timing of multi-year contract renewals are not always consistent and, thus, backlog levels may increase substantially when annual and multi-year orders are received, and decrease as shipments are made against these orders. We anticipate that our existing annual and multi-year contracts will be renewed in future quarters.
Markets continue to experience growing demand for infrared products used in the industrial, defense and first responder sectors. Demand for infrared products continues to be fueled by interest in lenses made with our proprietary BD6 and our new BDNL4 materials. With the global supply of germanium currently concentrated in Russia and China, recent global events are generating renewed interest in germanium alternatives such as our proprietary BD6 material, and other materials we are currently developing under an exclusive license with the Naval Research Lab. As we have outlined in our Strategic direction, we do not expect to see significant growth in our visible PMO product group in the near future. Competition in that product line has grown substantially over the last few years, and some of our new molding capabilities and technologies such as free-form molded optics, might take longer than anticipated to reach full commercialization, depending on economic conditions and technology trends in the area of AR\VR. However, order bookings for both PMO and infrared products continue to be slow in China. We believe the terminations of certain of our management employees in our China subsidiaries, LPOIZ and LPOI, and transition to new management personnel in fiscal year 2021, adversely impacted the domestic sales in China of these subsidiaries during fiscal year 2022 and fiscal year 2023. Although our new sales and management personnel have now established relationships with customers, domestic sales in China have also been adversely impacted by the economic downturn in China, which negatively impacted fiscal year 2023 revenue and bookings in that region.
Revenue Dollars and Units by Product Group.
The following table sets forth revenue dollars and units by our three product groups for the three and twelve months ended June 30, 2023 and 2022:
(unaudited)
Three Months Ended June 30,
Quarter
Year Ended June 30,
Year-to-date
2023
2022
% Change
2023
2022
% Change
Revenue
PMO
$ 3,170,928
$ 3,411,877
-7 %
$ 13,425,643
$ 15,020,542
-11 %
Infrared Products
5,465,084
5,046,555
8 %
16,735,869
18,735,325
-11 %
Specialty Products
1,048,709
448,799
134 %
2,772,437
1,803,293
54 %
Total revenue
$ 9,684,721
$ 8,907,231
9 %
$ 32,933,949
$ 35,559,160
-7 %
Units
PMO
314,906
398,064
-21 %
1,462,800
1,999,200
-27 %
Infrared Products
42,877
100,715
-57 %
167,095
438,508
-62 %
Specialty Products
16,208
4,079
297 %
58,197
18,948
207 %
Total units
373,991
502,858
-26 %
1,688,092
2,456,656
-31 %
Three months ended June 30, 2023 compared to three months ended June 30, 2022.
Our revenue increased by 9% in the fourth quarter of fiscal year 2023, as compared to the same quarter of the prior fiscal year, driven by increases in infrared and specialty products.
Revenue from the PMO product group for the fourth quarter of fiscal year 2023 was $3.2 million, a decrease of 7%, as compared to the same quarter of the prior fiscal year. The decrease in revenue is due to a decrease in sales to customers in the telecommunications industry and a decrease in sales of commercial products, partially offset by increases in sales to defense and industrial customers. PMO product sales to customers in China continue to be soft across all of the industries we serve due to unfavorable economic conditions in that region.
Revenue generated by the infrared product group for the fourth quarter of fiscal year 2023 was $5.5 million, an increase of 8%, as compared to the same quarter of the prior fiscal year. The increase in revenue is primarily driven by sales of diamond-turned infrared products and is primarily attributable to customers in the defense and industrial markets. Sales of BD6-based molded infrared products decreased, particularly to customers in the China industrial and commercial markets. These decreases were partially offset by increased revenue from BD6-based products driven by customers in the defense industry. Molded infrared products are higher in volume and lower in average selling prices than diamond-turned infrared products.
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Our specialty products revenue increased by 134% for the fourth quarter of fiscal year 2023, as compared to the same period of the prior fiscal year. The increase is due to increased sales of a custom visible lens assembly to a medical customer, for which we have an end of life order in backlog going into fiscal 2025.
Year ended June 30, 2023 compared to year ended June 30, 2022.
Our revenue decreased by approximately 7%, for fiscal year 2023, as compared to fiscal year 2022, with decreases in both infrared and PMO product sales.
Revenue from the PMO product group for fiscal year 2023 was $13.4 million, a decrease of 11%, as compared to fiscal year 2022. The decrease in revenue is due to a decrease in sales to customers in the telecommunications industry and a decrease in sales of commercial products, partially offset by increases in sales to defense and industrial customers. PMO product sales to customers in China continue to be soft across all of the industries we serve due to unfavorable economic conditions in that region. Sales of PMO units decreased by 27%, as compared to the same period of the prior fiscal year, and average selling prices increased by 22%. The volume decrease was largely driven by a lower mix of telecommunications products, which typically have lower average selling prices.
Revenue generated by the infrared product group for fiscal year 2023 was $16.7 million, a decrease of approximately 11%, as compared to the prior fiscal year. The decrease in revenue is primarily driven by sales of BD6-based molded infrared products, particularly to customers in the China commercial and industrial markets. These decreases were partially offset by increased revenue from BD6-based products driven by customers in the defense industry. Sales of diamond-turned infrared products were nearly flat for fiscal years 2023 and 2022, however, there were shifts in revenue from key customers. The timing of shipments against a large annual contract, which has renewed each November for several years, was such that revenues from this contract were lower in fiscal year 2023 than in fiscal year 2022. The most recent contract renewal in November 2022 represented an increase of 20% over the previous contract. As such, the decrease from fiscal year 2023 as compared to fiscal year 2022 is not expected to re-occur. The decrease in revenues from this contract in fiscal year 2023 was offset by increases in revenues from two other key customers, in the defense and industrial markets.
In fiscal year 2023, our specialty products revenue increased by $969,000, or 54%, as compared to prior fiscal year. The increase is primarily due to increase demand for collimator assemblies, and increased sales of a custom visible lens assembly to a medical customer, for which we have and end of life order with backlog going into fiscal 2025. The first quarter of fiscal 2023 also included a charge for in-process materials billed to a customer upon order cancellation, during the first quarter of fiscal 2023.
Inventory Levels.
We manage inventory levels to minimize investment in working capital but still have the flexibility to meet customer demand to a reasonable degree. We review our inventory for obsolete items quarterly. While the mix of inventory is an important factor, including adequate safety stocks of long lead-time materials, an important aggregate measure of inventory in all phases of production is the quarter’s ending inventory expressed as a number of days’ worth of the quarter’s cost of sales, also known as “days cost of sales in inventory,” or “DCSI.” It is calculated by dividing the quarter’s ending inventory by the quarter’s cost of goods sold, multiplied by 365 and divided by 4. Generally, a lower DCSI measure equates to a lesser investment in inventory, and, therefore, more efficient use of capital. The table below shows our DCSI for the immediately preceding eight fiscal quarters:
Fiscal Quarter
Ended
DCSI (days)
Q4-2023
6/30/2023
102
Q3-2023
3/31/2023
154
Q2-2023
12/31/2022
120
Q1-2023
9/30/2022
125
Fiscal Year 2023 Average
125
Q4-2022
6/30/2022
104
Q3-2022
3/31/2022
132
Q2-2022
12/31/2021
104
Q1-2022
9/30/2021
134
Fiscal Year 2022 Average
118
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Our average DCSI for fiscal year 2023 was 126, compared to 118 for fiscal year 2022. The increase in average DCSI is driven by the increase in inventory levels, particularly in the second half of fiscal year 2023 where shipments were disrupted by the Orlando Facility construction and other factors. Our DCSI did improve during the most recent quarter, and we expect DCSI to maintain an average of between 110 to 120.
Accounts Receivable Levels and Quality.
Similarly, we manage our accounts receivable to minimize investment in working capital. We measure the quality of receivables by the proportions of the total that are at various increments past due from our normally extended terms, which are generally 30 days. The most important aggregate measure of accounts receivable is the quarter’s ending balance of net accounts receivable expressed as a number of days’ worth of the quarter’s net revenues, also known as “days sales outstanding,” or “DSO.” It is calculated by dividing the quarter’s ending net accounts receivable by the quarter’s net revenues, multiplied by 365 and divided by 4. Generally, a lower DSO measure equates to a lesser investment in accounts receivable and, therefore, more efficient use of capital. The table below shows our DSO for the preceding eight fiscal quarters:
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Fiscal Quarter
Ended
DSO (days)
Q4-2023
6/30/2023
63
Q3-2023
3/31/2023
59
Q2-2023
12/31/2022
52
Q1-2023
9/30/2022
57
Fiscal Year 2023 Average
58
Q4-2022
6/30/2022
54
Q3-2022
3/31/2022
55
Q2-2022
12/31/2021
49
Q1-2022
9/30/2021
59
Fiscal Year 2022 Average
54
Our average DSO for fiscal year 2023 was 58, compared to 54 for fiscal year 2022. The increase in average DSO for fiscal year 2023 is driven by some key accounts with longer payment cycles that have increased in revenue. We strive to maintain a DSO of less than 60.
Other Key Indicators.
Other key indicators include various operating metrics, some of which are qualitative and others are quantitative. These indicators change from time to time as the opportunities and challenges in the business change. They are mostly non-financial indicators, such as on time delivery trends, units of shippable output by major product line, production yield rates by major product line, and the output and yield data from significant intermediary manufacturing processes that support the production of the finished shippable product. These indicators can be used to calculate such other related indicators as fully-yielded unit production per-shift, which varies by the particular product and our state of automation in production of that product at any given time. Higher unit production per shift means lower unit cost, and, therefore, improved margins or improved ability to compete where desirable for price sensitive customer applications. The data from these reports is used to determine tactical operating actions and changes. Management also assesses business performance and makes business decisions regarding our operations using certain non-GAAP measures. These non-GAAP measures are described in more detail below under the heading “Non-GAAP Financial Measures”.
Non-GAAP Financial Measures
We report our historical results in accordance with GAAP; however, our management also assesses business performance and makes business decisions regarding our operations using certain non-GAAP financial measures. We believe these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition and results of operations computed in accordance with GAAP; however, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other companies use.
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EBITDA.
EBITDA is a non-GAAP financial measures used by management, lenders, and certain investors as a supplemental measure in the evaluation of some aspects of a corporation’s financial position and core operating performance. Investors sometimes use EBITDA as it allows for some level of comparability of profitability trends between those businesses differing as to capital structure and capital intensity by removing the impacts of depreciation and amortization. EBITDA also does not include changes in major working capital items, such as receivables, inventory, and payables, which can also indicate a significant need for, or source of, cash. Since decisions regarding capital investment and financing and changes in working capital components can have a significant impact on cash flow, EBITDA is not a good indicator of a business’s cash flows. We use EBITDA for evaluating the relative underlying performance of our core operations and for planning purposes. We calculate EBITDA by adjusting net income to exclude net interest expense, income tax expense or benefit, depreciation, and amortization, thus the term “Earnings Before Interest, Taxes, Depreciation and Amortization” and the acronym “EBITDA.”
The following table adjusts net income to EBITDA for the three and twelve months ended June 30, 2023 and 2022:
(unaudited)
Quarter Ended June 30,
Year Ended June 30,
2023
2022
2023
2022
Net loss
$ (808,840 )
$ (1,359,790 )
$ (4,046,871 )
$ (3,542,181 )
Depreciation and amortization
815,019
854,123
3,174,569
3,617,743
Income tax provision
11,618
534,579
234,034
862,907
Interest expense
54,561
78,411
283,266
229,475
EBITDA
$ 72,358
$ 107,323
$ (355,002 )
$ 1,167,944
% of revenue
1 %
1 %
-1 %
3 %
Our EBITDA for the quarter ended June 30, 2023 was approximately $72,000, compared to $107,000 for the same period of the prior fiscal year. The decrease in EBITDA in the fourth quarter of fiscal year 2023 was primarily attributable to the increase in operating expenses, including SG&A and new product development, which were partially offset by higher revenue and gross margin.
Our EBITDA for fiscal year 2023 was a loss of approximately $355,000, compared to income of $1.2 million for fiscal year 2022. The decrease in EBITDA for fiscal year 2023 is primarily attributable to lower revenue and gross margin, coupled with increased SG&A expenses and a decrease in Other income.
Off Balance Sheet Arrangements
We do not engage in any activities involving variable interest entities or off balance sheet arrangements.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of income and expense during the reporting periods presented. Our critical estimates include the allowance for trade receivables, which is made up of allowances for bad debts, allowances for obsolete inventory, valuation of compensation expense on stock-based awards and accounting for income taxes. Although we believe that these estimates are reasonable, actual results could differ from those estimates given a change in conditions or assumptions that have been consistently applied. We also have other policies that we consider key accounting policies, such as our policy for revenue recognition, however, the application of these policies does not require us to make significant estimates or judgments that are difficult or subjective.
Management has discussed the selection of critical accounting policies and estimates with our Board, and the Board has reviewed our disclosure relating to critical accounting policies and estimates in this Annual Report on Form 10-K. The critical accounting policies used by management and the methodology for its estimates and assumptions are as follows:
Allowance for accounts receivable is calculated by taking 100% of the total of invoices that are over 90 days past due from the due date and 10% of the total of invoices that are over 60 days past due from the due date for U.S.- and Latvia-based accounts and 100% on invoices that are over 120 days past due for China-based accounts without an agreed upon payment plan. Accounts receivable are customer obligations due under normal trade terms. We perform continuing credit evaluations of our customers’ financial condition. Recovery of bad debt amounts which were previously written off is recorded as a reduction of bad debt expense in the period the payment is collected. If our actual collection experience changes, revisions to our allowance may be required. After attempts to collect a receivable have failed, the receivable is written off against the allowance. To date, our actual results have been materially consistent with our estimates, and we expect such estimates to continue to be materially consistent in the future.
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Inventory obsolescence allowance is calculated by reserving 100% for items that have not been sold in two years or that have not been purchased in two years. These items, as identified, are allowed for at 100%, as well as allowing 50% for other items deemed to be slow moving within the last twelve months and allowing 25% for items deemed to have low material usage within the last six months. Items of which we have greater than a two-year supply are also reserved at 25% to 100%, depending on usage rates. The parts identified are adjusted for recent order and quote activity to determine the final inventory allowance. To date, our actual results have been materially consistent with our estimates, and we expect such estimates to continue to be materially consistent in the future.
Revenue is generally recognized upon transfer of control, including the risks and rewards of ownership, of products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. The performance obligations for the sale of optical components and assemblies are satisfied at a point in time. We generally bear all costs, risk of loss, or damage and retain title to the goods up to the point of transfer of control of products to customers. Shipping and handling costs are included in the cost of goods sold. Revenues from product development agreements are recognized as performance obligations are met in accordance with the terms of the agreements and upon transfer of control of products, reports or designs to the customer. Product development agreements are generally short term in nature, with revenue recognized upon satisfaction of the performance obligation, and transfer of control of the agreed-upon deliverable. Invoiced amounts for VAT related to sales are posted to the balance sheet and are not included in revenue.
Stock-based compensation is measured at grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period. We estimate the fair value of each stock option as of the date of grant using the Black-Scholes-Merton pricing model. Our directors, officers, and key employees were granted stock-based compensation through our Amended and Restated Omnibus Incentive Plan, as amended (the “Omnibus Plan”), through October 2018 and after that date, the 2018 Stock and Incentive Compensation Plan (the “SICP”). Most options granted under the Omnibus Plan and the SICP vest ratably over two to four years and generally have ten-year contract lives. The volatility rate is based on four-year historical trends in common stock closing prices and the expected term was determined based primarily on historical experience of previously outstanding options. The interest rate used is the U.S. Treasury interest rate for constant maturities. The likelihood of meeting targets for option grants that are performance based are evaluated each quarter. If it is determined that meeting the targets is probable, then the compensation expense will be amortized over the remaining vesting period.
Goodwill and intangible assets acquired in a business combination are recognized at fair value using generally accepted valuation methods appropriate for the type of intangible asset and reported separately from goodwill. Purchased intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. Purchased intangible assets are carried at cost, less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally two to fifteen years. We periodically reassess the useful lives of intangible assets when events or circumstances indicate that useful lives have significantly changed from the previous estimate. Definite-lived intangible assets consist primarily of customer relationships, know-how/trade secrets and trademarks. They are generally valued as the present value of estimated cash flows expected to be generated from the asset using a risk-adjusted discount rate. When determining the fair value of our intangible assets, estimates and assumptions about future expected revenue and remaining useful lives are used. Goodwill and intangible assets are tested for impairment on an annual basis and during the period between annual tests if events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable.
We assess the qualitative factors to determine whether it is more likely than not that the fair value of its reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the goodwill impairment analysis. If we determine that it is more likely than not that its fair value is less than its carrying amount, then the goodwill impairment test is performed. The fair value of the reporting unit is compared to its carrying amount, and if the carrying amount exceeds its fair value, then an impairment charge would be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value, up to the total amount of goodwill allocated to that reporting unit.
Accounting for income taxes requires estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, benefits, and deductions, and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of the recognition of revenue and expense for tax and financial statement purposes. We assessed the likelihood of the realization of deferred tax assets and concluded that a valuation allowance is needed to reserve the amount of the deferred tax assets that may not be realized due to the uncertainty of the timing and amount of taxable income in certain jurisdictions. In reaching our conclusion, we evaluated certain relevant criteria, including the amount of pre-tax income generated during the current and prior two years, as adjusted for non-recurring items, the existence of deferred tax liabilities that can be used to realize deferred tax assets, the taxable income in prior carryback years in the impacted jurisdictions that can be used to absorb net operating losses and taxable income in future years. Our judgments regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. These changes, if any, may require material adjustments to these deferred tax assets, resulting in a reduction in net income or an increase in net loss in the period when such determinations are made, which, in turn, may result in an increase or decrease to our tax provision in a subsequent period.
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In the ordinary course of global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement and royalty arrangements among related entities, which could impact our income or loss in each jurisdiction in which we operate. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will not be different than that which is reflected in our historical income tax provisions and accruals. In the event our assumptions are incorrect, the differences could have a material impact on our income tax provision and operating results in the period in which such determination is made. In addition to the factors described above, our current and expected effective tax rate is based on then-current tax law. Significant changes during the year in enacted tax law could affect these estimates.
Impact of recently issued accounting pronouncements that have recently been issued but have not yet been implemented by us are described in Note 2, Summary of Significant Accounting Policies , to the Notes to the Consolidated Financial Statements to this Annual Report on Form 10-K, which describes the potential impact that these pronouncements are expected to have on our financial condition, results of operations and cash flows.