Item 7. Management’s Discussion and Analysis
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation s
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in Item 8 of this Form 10-K. This section of this Form 10-K generally discusses 2023 and 2022 items and year-to-year comparisons between 2023 and 2022. Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 are not included in this Form 10-K and can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022.
Our fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. Our fiscal year 2023 ended on December 30, 2023, fiscal year 2022 ended on December 31, 2022, and fiscal year 2021 ended on January 1, 2022. All fiscal years presented in this Form 10-K included 52 weeks. Additionally, all quarters included 13 weeks. Unless otherwise stated, all information presented herein is based on our fiscal calendar, and references to particular years, quarters, months or periods refer to our fiscal years ended in January or December and the associated quarters, months and periods of those fiscal years.
Overview
Netlist provides high-performance memory solutions to enterprise customers in diverse industries. Our products in various capacities and form factors, including our line of custom and specialty memory products, bring leading performance to customers in a variety of industries globally. Netlist also licenses its intellectual property.
Economic Conditions, Challenges and Risks
Our performance, financial condition and prospects are affected by a number of factors and are exposed to a number of risks and uncertainties. We operate in a competitive and rapidly evolving industry in which new risks emerge from time to time, and it is not possible for us to predict all of the risks we may face, nor can we assess the impact of all factors on our business or the extent to which any factor or combination of factors could cause actual results to differ from our expectations. See the discussion of certain risks that we face under “Risk Factors” in Item 1A of this report.
In recent periods, there has been a significant increase in worldwide supply of semiconductor memory and storage that has led to declines in demand and average selling prices for our products, which could materially and adversely affect our business, results of operations, or financial condition. Our suppliers generally seek to increase wafer output, improve yields, and reduce die size, which could result in further increases in worldwide supply and downward pressure on prices.
Fiscal Year Highlights
2023 SVB Credit Agreement
On November 7, 2023, we entered into a loan and security agreement (the “2023 SVB Credit Agreement”) with SVB, which provides for a revolving line of credit up to $10.0 million. The borrowing base is limited to 85% of eligible accounts receivable, subject to certain adjustments. Borrowings accrue interest on advance at a per annum rate equal to the greater of 8.50% and the Wall Street Journal prime rate (“Prime Rate”). The maturity date is November 7, 2025.
2023 Offering
On August 14, 2023, we entered into a Securities Purchase Agreement (the “2023 Purchase Agreement”) with certain investors, pursuant to which we agreed to issue and sell to the investors in a registered offering (the “2023 Offering”) an aggregate of 11,111,112 shares of our common stock and warrants to purchase up to an aggregate of 11,111,112 shares of our common stock at a per share purchase price of $2.70 per share. The 2023 Offering closed on August 17, 2023. The net proceeds to us from the 2023 Offering were approximately $28.6 million, after deducting placement agent fees and offering costs paid by us. The warrants are exercisable at any time on or after the issuance date,
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have a term of five years from the issuance date, and have an exercise price of $3.20 per share and contain customary 4.99%/9.99% blocker provisions.
On August 14, 2023 and in connection with the 2023 Offering, we entered into a Placement Agency Agreement (the “Placement Agreement”) with Roth Capital Partners, LLC (“Roth”), pursuant to which Roth agreed to act as the Company’s placement agent in connection with the 2023 Offering.
In addition, pursuant to the 2023 Purchase Agreement, the Company and its director and executive officers entered into lock-up agreements, pursuant to which they agreed not to offer for sale, contract to sell, or sell any shares of the Company’s common stock or any securities convertible into, or exercisable or exchangeable for, shares of the Company’s common stock, for a period of 90 days from the closing of the 2023 Offering, subject to certain customary exceptions.
Jury Verdict and Judgment Against Samsung
On August 11, 2023, a judgment was entered in the United States District Court for the Eastern District of Texas, which upheld the jury trial verdict on April 21, 2023 that awarded Netlist approximately $303 million in damages against Samsung for their willful infringement of five Netlist patents: U.S. Patent Nos. 10,949,339, 11,016,918, 11,232,054, 8,787,060, and 9,318,160. The products found to infringe these patents were Samsung DDR4 LRDIMMs, DDR5 UDIMMs, DDR5 SODIMMs, and DDR5 RDIMMs, and HBM2, HBM2E, and HBM3 components. Post-judgment motions are pending before the Court. Following entry of an Order regarding that post-judgment briefing, an appeal may be filed before the U.S. Court of Appeals for the Federal Circuit. Should any party file an appeal, that could cause a lengthy delay in our ability to collect a damages award from Samsung, lead to a reduction of the damages award, or lead to a remand or reversal of the jury’s verdict. Additionally, as of the reporting date, all of the patents confirmed as being infringed on the jury verdict are either subject to Inter Partes Review (“IPR”) final written decisions, or an active IPR trial. The outcome of each of the IPR proceedings related to each of these patents may affect the underlying collectability of the jury award in this matter.
September 2021 Lincoln Park Purchase Agreement
On September 28, 2021, we entered into a purchase agreement (the “September 2021 Purchase Agreement”) with Lincoln Park, pursuant to which we have the right to sell to Lincoln Park up to an aggregate of $75 million in shares of our common stock over the 36-month term of the September 2021 Purchase Agreement subject to the conditions and limitations set forth in the September 2021 Purchase Agreement.
During 2023, Lincoln Park purchased an aggregate of 7,865,000 shares of our common stock for a net purchase price of $23.4 million under the September 2021 Purchase Agreement. In connection with the purchases, we issued to Lincoln Park an aggregate of 44,939 shares of our common stock as additional commitment shares in noncash transactions.
Subsequently, from December 31, 2023 through February 19, 2024, Lincoln Park purchased an aggregate of 1,235,000 shares of our common stock for a net purchase price of $2.1 million under the September 2021 Purchase Agreement. In connection with the purchases, we issued to Lincoln Park an aggregate of 4,068 shares of our common stock as additional commitment shares in noncash transactions.
Ineffective Internal Control over Financial Reporting
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. In performing their audit of our internal control over financial reporting as required by Section 404, our independent registered public accounting firm concluded that
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our internal control over financial reporting was ineffective as of December 30, 2023 due to one material weakness. The identified material weakness, at December 30, 2023, relates to the lack of an independent board and audit committee.
While the control weaknesses identified did not result in any identified misstatements, a reasonable possibility exists that a material misstatement to the annual or interim consolidated financial statements and disclosures will not be prevented or detected on a timely basis.
In an effort to address the identified material weakness related to the lack of an independent board and audit committee and to enhance our internal controls, our finance and accounting personnel are continuing to follow all of the same procedures that they undertook in preparation for independent audit committee meetings on a quarterly and annual basis. Our Chief Executive Officer and sole director will oversee these processes and review materials prepared by the finance and accounting staff as well as our independent registered public accounting firm on a quarterly and annual basis. If our measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting occur in the future, we may not be able to timely or accurately report our results of operations or maintain effective disclosure controls and procedures. If we are unable to report financial information timely or accurately, or to maintain effective disclosure controls and procedures, we could be required to restate our financial statements and be subject to, among other things, regulatory or enforcement actions, securities litigation, limitations on our ability to access capital markets, debt rating agency downgrades or rating withdrawals, or loss in confidence of our investors, any one of which could adversely affect the valuation of our common stock and our business prospects. We can give no assurance that the measures we have taken and plan to take in the future will remediate the material weakness identified or that any additional material weaknesses will not arise in the future due to a failure to implement and maintain adequate internal control over financial reporting.
Results of Operations
Net Sales and Gross Margin
Net sales and gross margin for 2023 and 2022 were as follows (dollars in thousands):
2023
2022
Change
Net sales
$
69,205
$
161,637
(57%)
Cost of sales
66,812
149,745
(55%)
Gross profit
$
2,393
$
11,892
(80%)
Gross margin percentage
3%
7%
Net Sales
Net sales include resales of certain components, modules, and other products, which include DIMMs and SSDs. Net sales also include sales of Netlist’s own products.
Net sales decreased by approximately $92.4 million during 2023 compared to 2022, primarily as a result of a $56.6 million decrease in the sale of RDIMM and discrete component products, a $14.6 million decrease in the sale of Netlist’s flash and SSD products, and a $21.2 million decrease in sales of low-profile memory subsystem products.
Gross Profit and Gross Margin
Gross profit and gross margin percentage decreased in 2023 compared to 2022 due primarily to lower sales across all product groups and the change in our product mix.
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Operating Expenses
Operating expenses for 2023 and 2022 were as follows (dollars in thousands):
2023
2022
Change
Research and development
$
9,164
$
10,624
(14%)
Percentage of net sales
13%
7%
Intellectual property legal fees
$
42,572
$
20,421
108%
Percentage of net sales
62%
13%
Selling, general and administrative
$
12,414
$
14,347
(13%)
Percentage of net sales
18%
9%
Research and Development
Research and development expenses decreased in 2023 compared to 2022 due primarily to a decrease in outside services and new product research.
Intellectual Property Legal Fees
Intellectual property legal fees consist of legal fees incurred for enforcement, protection and patent filings and prosecution. Although we expect intellectual property legal fees to generally increase over time as we continue to protect, defend and enforce and seek to expand our patent portfolio, these increases may not be linear but may occur in lump sums depending on the due dates of patent filings and their associated fees and the arrangements we may make with our legal advisors in connection with enforcement proceedings, which may include fee arrangements or contingent fee arrangements in which we would pay these legal advisors on a scaled percentage of any negotiated fees, settlements or judgments awarded to us based on if, how and when the fees, settlements or judgments are obtained. See Note 7 — Commitments and Contingencies of the Notes to Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion.
Intellectual property legal fees increased during 2023 compared to 2022 due primarily to higher legal expenses incurred to defend and enforce our patent portfolio.
Selling, General and Administrative
Selling, general and administrative expenses decreased in 2023 compared to 2022 due primarily to a decrease in employee headcount and overhead and outside services.
Other Income, Net
Other income, net for 2023 and 2022 was as follows (dollars in thousands):
2023
2022
Change
Interest income, net
$
1,300
$
57
Other income, net
60
74
Total other income, net
$
1,360
$
131
938%
Interest income, net increased during 2023 compared to 2022, primarily as a result of higher interest rate earned on higher cash balances. Other income, net during 2023 was consistent compared to 2022.
Provision for Income Taxes
For 2023 and 2022, our effective tax rate was 0% due primarily to our net loss and valuation allowances.
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Liquidity and Capital Resources
We believe our existing balance of cash and cash equivalents (including restricted cash balances), which totaled $52.8 million as of December 30, 2023, along with cash receipts from revenues, borrowing availability under the 2023 SVB Credit Agreement, proceeds raised from 2023 Offering, the equity financing available under the September 2021 Lincoln Park Purchase Agreement, funds raised through other future debt and equity offerings and taking into account cash expected to be used in our operations, will be sufficient to meet our anticipated cash needs for at least the next 12 months.
In addition, on April 5, 2021, we entered into a Product Purchase and Supply Agreement (the “Supply Agreement”) with SK hynix and the Strategic Agreement. Both agreements have a term of 5 years. Under the Strategic Agreement, (a) we have granted to SK hynix worldwide, non-exclusive, non-assignable licenses to certain of our patents covering memory technologies and (b) SK hynix has granted to us worldwide, non-exclusive, non-assignable licenses to its patent portfolio. In addition, the Strategic Agreement provided for the settlement of all intellectual property proceedings between us and SK hynix and a settlement fee of $40 million paid to us by SK hynix. In addition, the parties have agreed to collaborate on certain technology development activities.
For a description of contractual obligations, see Note 4 — Debt and Note 5 — Leases of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Cash Flow Summary
Our cash flows from operating, investing and financing activities, as reflected in the consolidated statements of cash flows, are summarized as follows (in thousands):
2023
2022
Net cash provided by (used in):
Operating activities
$
(41,601)
$
(14,995)
Investing activities
—
(467)
Financing activities
50,835
594
Net change in cash, cash equivalents and restricted cash
$
9,234
$
(14,868)
Net cash used in operating activities for 2023 was primarily a result of net loss of $60.4 million, non-cash adjustments to net loss of $5.3 million, partially offset by net cash inflows from changes in operating assets and liabilities of $13.5 million driven predominantly by an increase in accounts payable and a decrease in accounts receivable and prepaid expenses and other assets, partially offset by a decrease in accrued expenses and other liabilities and an increase in inventories. Net cash provided by financing activities for 2023 primarily consisted of $23.4 million in net proceeds from issuance of common stock under the September 2021 Lincoln Park Purchase Agreement, $28.6 million in net proceeds from the 2023 Offering, and $0.5 million in proceeds from exercise of stock options, $3.8 million in net borrowings under the 2023 SVB Credit Agreement partially offset by $4.9 million in net repayments under the credit agreement between the Company and SVB, dated October 31, 2009, as amended, which was terminated on April 28, 2023 (the “2009 SVB Credit Agreement”), and $0.4 million in payments of note payable to finance insurance policies.
Net cash used in operating activities for 2022 was primarily a result of net loss of $33.4 million, non-cash adjustments to net loss of $4.2 million, partially offset by net cash inflows from changes in operating assets and liabilities of $14.2 million driven predominantly by an increase in accounts payable and accrued expenses and other liabilities and a decrease in accounts receivable and inventories. Net cash provided by financing activities for 2022 primarily consisted of $4.4 million in net proceeds from issuance of common stock under the September 2021 Lincoln Park Purchase Agreement and $0.3 million in proceeds from exercise of stock options, partially offset by $2.1 million in net payments under the 2009 SVB Credit Agreement, $0.6 million in payments of note payable to finance insurance policies, and $1.4 million in payments for taxes related to net share settlement of equity awards.
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Capital Resources
2023 SVB Credit Agreement
On November 7, 2023, we entered into a loan and security agreement (the “2023 SVB Credit Agreement”) with SVB, which provides for a revolving line of credit up to $10.0 million. The borrowing base is limited to 85% of eligible accounts receivable, subject to certain adjustments. Borrowings accrue interest on advance at a per annum rate equal to the greater of 8.50% and the Wall Street Journal prime rate (“Prime Rate”). The maturity date is November 7, 2025.
As of December 30, 2023, the outstanding borrowings under the 2023 SVB Credit Agreement were $3.8 million with no availability under the revolving line of credit. During the year ended December 30, 2023, we made net repayments of $1.1 million under the 2023 SVB Credit Agreement.
2023 Offering
On August 14, 2023, we entered into the 2023 Purchase Agreement with certain investors, pursuant to which we agreed to issue and sell to the investors an aggregate of 11,111,112 shares of our common stock and warrants purchase up to an aggregate of 11,111,112 shares of our common stock at a per share purchase price of $2.70 per share. The 2023 Offering closed on August 17, 2023. The net proceeds to us from the 2023 Offering were $28.6 million, after deducting placement agent fees and offering costs paid by us.
September 2021 Lincoln Park Purchase Agreement
On September 28, 2021, we entered into the September 2021 Purchase Agreement with Lincoln Park, pursuant to which we have the right to sell to Lincoln Park up to an aggregate of $75.0 million in shares of our common stock over the 36-month term of the September 2021 Purchase Agreement subject to the conditions and limitations set forth in the September 2021 Purchase Agreement. As of December 30, 2023, $36.3 million remains available under the September 2021 Purchase Agreement with Lincoln Park.
Critical Accounting Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States and our discussion and analysis of our financial condition and operating results require our management to make judgments, assumptions and estimates that affect the amounts reported. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. While our significant accounting policies are described in more detail in Note 1 — Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, we believe the accounting policies discussed below used in the preparation of our consolidated financial statements require the most significant estimates, judgments, assumptions and decisions.
Sales Return Reserves
Our revenue generating activities include variable consideration which is recorded as a reduction of the transaction price based upon expected amounts at the time revenue for the corresponding product sale is recognized. Common forms of variable consideration include limited rights of return for up to 30 days, except for sales of excess component inventories, which contain no right-of-return privileges and volume rebates for meeting established sales targets. Estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of the anticipated performance and all information (historical, current and forecasted) that is reasonably available.
Returns for products sold are estimated using the expected value method and are recorded as a reduction in reported revenues at the time of sale based upon historical product return experience and is adjusted for known trends to arrive at the amount of consideration to which we expect to receive. Estimated amounts are included in the transaction
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price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved.
Inventories
Inventories are valued at the lower of cost or the net realizable value. Cost is determined on an average cost basis which approximates actual cost on a first-in, first-out basis and includes raw materials, labor and manufacturing overhead. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. We evaluate inventory balances for excess quantities and obsolescence on a regular basis by analyzing estimated demand, inventory on hand, sales levels and other information and reduce inventory balances to net realizable value for excess and obsolete inventory based on this analysis. At the point of the write-down recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.
Warranties
We offer standard product warranties generally ranging from one to three years to our memory subsystem products customers, depending on the negotiated terms of any purchase agreements, and has no other post-shipment obligations or separately priced extended warranty or product maintenance contracts. These warranties require us to repair or replace defective product returned to us during the warranty period at no cost to the customer. Warranties are not offered on sales of component products. We record an estimate for warranty related costs at the time of sale based on our historical and estimated future product return rates and expected repair or replacement costs. Estimated future warranty costs are recorded in the period in which the sale is recorded and are included in cost of sales in the consolidated statements of operations.
Stock-Based Compensation
Stock-based awards are comprised principally of stock options and restricted stock units (“RSUs”). Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense over the requisite service period, which is the vesting period, on a straight-line basis, net of estimated forfeitures. We use the Black-Scholes option pricing model to determine the grant date fair value of stock options. The model requires us to estimate the expected volatility and expected term of the stock options, which are highly complex and subjective variables. The expected volatility is based on the historical volatility of our common stock. The expected term is computed using the simplified method as our best estimate given our lack of actual exercise history. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividend assumption is based on our history and management’s expectation regarding dividend payouts. The grant-date fair value of RSUs equals the closing price of our common stock on the grant date.
Uncertain Tax Positions
We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities based on the technical merits of our position. The tax benefit recognized in the financial statements for a particular tax position is based on the largest benefit that is more likely than not to be realized. The amount of unrecognized tax benefits is adjusted as appropriate for changes in facts and circumstances, such as significant amendments to existing tax laws, new regulations or interpretations by the taxing authorities, new information obtained during a tax examination, or resolution of an examination.
The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws and regulations may change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could require us to record additional tax liabilities or to reduce previously recorded tax liabilities, as applicable.
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Recent Accounting Standards
See Note 1 — Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion.
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