Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the notes to those statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed below and elsewhere in this report. See also “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report.
We use a 52- to 53-week fiscal year ending on the last Friday in August. Unless the context indicates otherwise, whenever we refer in this report to a particular year, with respect to ourselves, we mean the fiscal year ending in that particular calendar year. Financial information for two of our subsidiaries SMART Brazil and SMART do Brazil is included in our consolidated financial statements on a one-month lag because their fiscal years begin August 1 and end July 31.
For an overview of our business, see “Part I – Item 1. Business Overview.”
Components of Operating Results
Net Sales
We generate product revenues predominantly from sales of our solutions, which include memory components and modules and specialty compute and storage products, to OEMs, as well as end users that compete in the computing, networking, communications, storage, aerospace, defense, mobile and industrial markets. Sales of our products are made primarily pursuant to purchase orders and are not based on long-term supply agreements. We generate service revenue by providing procurement, logistics, inventory management, temporary warehousing, kitting and packaging services. Our net sales are substantially dependent upon demand in the end markets for our customers’ products and fluctuations in end-user demand can have a rapid and material effect on our net sales. Furthermore, sales to relatively few customers have accounted for, and we expect for the foreseeable future will continue to account for, a significant percentage of our net sales.
Cost of Sales
The most significant components of cost of sales are materials, fixed manufacturing costs, labor, depreciation, freight and customs charges. Increases in capital expenditures may increase our future cost of sales due to higher levels of depreciation expense. Cost of sales also includes any inventory write-downs. We have in the past, and may in the future, write down inventory for a variety of reasons, including obsolescence, excess quantities and declines in market value below our cost. A significant percentage of our cost of sales consists of the cost of DRAM and Flash components and wafers. While we have historically received competitive pricing and have had consistent sources of supply for these supplies, we do not have agreements that provide us with fixed pricing or guarantees of supply. Increases in DRAM pricing typically improve our margins, at least in the short term and particularly in our operations in Brazil, as we consume previously purchased inventory. However, declines in DRAM pricing often require us to reduce our prices even as we consume higher priced DRAM inventory, thereby reducing our margins.
Gross Profit
Gross profit and gross margin has been and will continue to be affected by a variety of factors, including the average sales prices of our products, manufacturing and overhead costs, the mix of products sold and our ability to leverage our existing infrastructure as we continue to grow. We expect our gross margins to fluctuate over time depending on the factors described above.
Operating Expenses
Our operating expenses consist of research and development expense, selling, general and administrative expense and management advisory fees. Personnel costs are the most significant component of operating expenses.
65
Research and development expense. Research and development expense consists primarily of personnel costs, consulting costs, allocated overhead and other costs to support our development activities. To date, we have expensed all research and development costs as incurred. We expect research and development expense to increase in absolute dollars as we continue to invest in our research and product development efforts to enhance our product capabilities and access new customer markets, although such expense may fluctuate as a percentage of total net sales. In order to qualify for certain tax incentives under PADIS and PPB/IT Program in Brazil, we are required to expend a minimum amount on research and development in Brazil.
Selling, general and administrative expense.
Sales and marketing expense consists primarily of personnel costs, sales commission costs and allocated overhead. We expense sales commission costs as incurred. Sales and marketing expense also includes costs for recruiting and training channel partners, market development programs, promotional and other marketing activities, travel, office equipment and outside consulting costs. We expect sales and marketing expense to increase in absolute dollars as we expand our sales and marketing headcount in all markets and expand our international operations, although such expense may fluctuate as a percentage of net sales.
General and administrative expense consists primarily of personnel costs, facilities and non-manufacturing equipment costs, allowances for bad debt and other support costs, including utilities, insurance and professional fees. We have experienced and will continue to experience increased general and administrative expenses as a result of being a publicly-traded company, including significant increased legal and accounting costs related to compliance with rules and regulations implemented by the SEC and NASDAQ, as well as additional insurance, investor relations and other costs associated with being a public company.
Interest Expense, Net
Interest expense, net consists primarily of interest expense on our debt obligations.
Other Expense, Net
Other expense, net includes gains and losses from foreign currency transactions and other non-operating items.
Provision for Income Taxes
We record income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, we generally consider all expected future events other than enactments or changes in the tax law or rates. We provide valuation allowances when necessary to reduce deferred tax assets to the amount expected to be realized.
We recognize a tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. We then measure the tax benefits recognized in the financial statements from such positions based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. In the event that we recognize any unrecognized tax benefits, the effective tax rate will be affected. If recognized, approximately $1.7 million of unrecognized tax benefit would impact the effective tax rate at August 28, 2020. Although we believe our estimates are reasonable, we cannot assure that the final tax outcome of these matters will be the same as these estimates. We update these estimates quarterly based on factors such as changes in facts or circumstances, changes in tax law, new audit activity and effectively settled issues.
We follow specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded on the balance sheet and provide necessary valuation allowances as required. Future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback or carryforward periods available under the tax law. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. Our judgments regarding future profitability may change due to many factors, including future market conditions
66
and our ability to successfully execute our business plans and/or tax planning strategies. Should there be a change in our ability to recover our deferred tax assets, our tax provision would increase or decrease in the period in which the assessment is changed.
Results of Operations
The following is a summary of our results of operations for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods.
Fiscal Year Ended
August 28,
2020
% of
sales*
August 30,
2019
% of
sales*
August 31,
2018
% of
sales*
Consolidated Statement of Operations Data:
Net sales
$
1,122,377
100
%
$
1,211,999
100
%
$
1,288,821
100
%
Cost of sales (1)(2)
905,981
81
%
974,472
80
%
997,235
77
%
Gross profit
216,396
19
%
237,527
20
%
291,586
23
%
Operating expenses:
Research and development (1) (2)
52,056
5
%
47,920
4
%
39,824
3
%
Selling, general and administrative (1) (2)
119,523
11
%
103,226
9
%
84,541
7
%
Restructuring charge
3,487
0
%
—
—
—
—
Change in estimated fair value of
acquisition-related contingent consideration
—
—
(2,700
)
0
%
(3,000
)
0
%
Total operating expenses
175,066
16
%
148,446
12
%
121,365
9
%
Income from operations
41,330
4
%
89,081
7
%
170,221
13
%
Other income (expense):
Interest expense, net
(15,000
)
(1
%)
(20,716
)
(2
%)
(19,144
)
(1
%)
Other expense, net
(16,970
)
(2
%)
(2,161
)
0
%
(13,299
)
(1
%)
Total other expense
(31,970
)
(3
%)
(22,877
)
(2
%)
(32,443
)
(3
%)
Income before income taxes
9,360
1
%
66,204
5
%
137,778
11
%
Provision for income taxes
10,503
1
%
14,872
1
%
18,315
1
%
Net income (loss)
$
(1,143
)
0
%
$
51,332
4
%
$
119,463
9
%
Earnings per share:
Basic
$
(0.05
)
$
2.24
$
5.42
Diluted
$
(0.05
)
$
2.19
$
5.17
Shares used in computing earnings per share:
Basic
23,994
22,959
22,051
Diluted
23,994
23,468
23,119
* Summations may not compute precisely due to rounding.
(1) Includes share-based compensation expense as follows:
Cost of sales
$
3,022
$
2,485
$
1,335
Research and development
3,069
2,654
1,460
Selling, general and administrative
12,625
13,060
7,763
(2) Includes amortization of intangible assets expense as follows:
Cost of sales
$
2,587
$
566
$
7
Research and development
—
—
987
Selling, general and administrative
11,067
5,048
5,136
67
Comparison of the Years Ended August 28, 2020 and August 30, 2019
Fiscal Year Ended
Change
August 28,
2020
August 30,
2019
Amount
%
(in thousands, except percentages)
Net sales
$
1,122,377
$
1,211,999
$
(89,622
)
(7.4
%)
Cost of sales (1)
905,981
974,472
(68,491
)
(7.0
%)
Gross profit
$
216,396
$
237,527
$
(21,131
)
(8.9
%)
Gross margin
19.3
%
19.6
%
(1)
Includes share-based compensation expense of $3.0 million and $2.5 million, and intangible amortization of $2.6 million and $0.6 million in fiscal 2020 and 2019, respectively.
Net Sales, Cost of Sales and Gross Margin
Net sales decreased by $89.6 million, or 7.4%, during fiscal 2020 compared to the prior fiscal year. Net sales were negatively impacted by a decrease in Brazil product sales of $147.1 million, or a decline of 27.4% compared to the prior year. The decrease in Brazil was primarily due to 50.1% and 36.5% lower average selling prices for DRAM and mobile memory, respectively. Net sales were positively impacted by higher overall revenue from SCSS of $48.6 million, or an increase of 22.4% over the prior fiscal year, primarily driven by our two acquisitions in July 2019 which did not contribute to sales for the full year in fiscal 2019, partially offset by lower Penguin revenue due to lower federal spending as a result of COVID-19. In addition, our sales of Specialty products increased by $8.9 million, or 1.9% over the prior fiscal year, primarily due to higher Flash revenue resulting from 59.2% higher average selling prices mainly due to increased OEM sales , partially offset by lower DRAM revenue resulting from 18.4% lower average selling prices mainly due to a change in product mix.
Cost of sales decreased by $68.5 million, or 7.0%, during fiscal 2020 compared to the prior fiscal year, primarily due to lower cost of materials of $78.2 million or 9.2% due to lower level of sales, partially offset by higher production costs related to the increased revenue and additional costs from the SCSS acquisitions. Included in the cost of sales changes was a favorable foreign exchange impact of $4.5 million due to locally sourced cost of sales in Brazil.
Gross margin remained relatively flat at 19.3% during fiscal 2020, compared to 19.6% for fiscal 2019.
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Operating Expenses
Fiscal Year Ended
Change
August 28,
2020
August 30,
2019
Amount
%
(in thousands, except percentages)
Operating expenses:
Research and development (1) (2)
$
52,056
$
47,920
$
4,136
8.6
%
Selling, general and administrative (1) (2)
119,523
103,226
16,297
15.8
%
Restructuring
3,487
—
3,487
100.0
%
Change in estimated fair value of acquisition-
related contingent consideration
—
(2,700
)
2,700
(100.0
%)
Total operating expenses
$
175,066
$
148,446
$
26,620
17.9
%
(1) Includes share-based compensation expense as follows:
Research and development
$
3,069
$
2,654
$
415
15.6
%
Selling, general and administrative
12,625
13,060
(435
)
(3.3
%)
Total
$
15,694
$
15,714
$
(20
)
(0.1
%)
(2) Includes amortization of intangible assets expense as follows:
Selling, general and administrative
11,067
5,048
6,019
119.2
%
Total
$
11,067
$
5,048
$
6,019
119.2
%
Research and Development Expense
Research and development, or (“R&D”), expense increased by $4.1 million, or 8.6% in fiscal 2020 compared to the prior fiscal year primarily due to $12.4 million higher costs from the addition of our SCSS acquisitions, partially offset by $6.4 million of Brazil financial credits resulting from amendments to the IT law implemented in April 2020. Included in the R&D expense increase was a favorable foreign exchange impact of $2.2 million.
Selling, General and Administrative Expense
Selling, general and administrative, or (“SG&A”), expense increased by $16.3 million, or 15.8%, during fiscal 2020 compared to the prior fiscal year. The increase was primarily due to $16.8 million of higher costs from the addition of our SCSS acquisitions (including intangible amortization expense), as well as integration expenses associated with the acquisitions. Included in the SG&A expense increase was a favorable foreign exchange impact of $1.5 million.
Restructuring Charge
In fourth quarter of fiscal 2020, we made the decision to cease manufacturing and selling of products under the battery product line, the operations of which are reported under the operating segment for Brazil products. The decision to cease this activity is due to unattractive benefits for our customers in score based PPB which impacts our ability to remain competitive as customers can get these products cheaper from other international sources without having a negative impact on their PPB score. This action was put into effect as of the end of the fourth quarter of fiscal 2020, and all operations related to this product line ceased as of that date. All employees associated with the product line were reassigned to other parts of the business.
During fiscal 2020, we recorded restructuring charges amounting to $3.5 million, composed of $2.7 million of asset impairment, $0.4 million of deferred ICMS taxes related to impaired assets, and $0.4 million accrued for contract termination costs. As of August 28, 2020, the amounts accrued for contract termination costs have yet to be paid. We do not expect additional costs to be incurred before completion of the restructuring efforts. We anticipate completion of these restructuring efforts, including payment on all outstanding amounts to be complete by January 2021.
69
Other Income (Expense)
Fiscal Year Ended
Change
August 28,
2020
August 30,
2019
Amount
%
(in thousands, except percentages)
Other income (expense):
Interest expense, net
$
(15,000
)
$
(20,716
)
$
5,716
(27.6
%)
Other expense, net
(16,970
)
(2,161
)
(14,809
)
685.3
%
Total other expense
$
(31,970
)
$
(22,877
)
$
(9,093
)
39.7
%
Interest expense, net decreased $5.7 million, or 27.6%, during fiscal 2020 compared to the prior fiscal year primarily due to lower interest expense resulting from the issuance of our Notes and the extinguishment of our term loans in the second quarter of fiscal 2020. For additional information, see Note 7, Long-Term Debt , in our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K. Other expense, net increased by $14.8 million primarily due to $7.7 million mark-to-market losses on the Capped Calls and $6.8 million extinguishment loss on long-term debt and revolver.
Provision for Income Taxes
Fiscal Year Ended
Change
August 28,
2020
August 30,
2019
Amount
%
(in thousands, except percentages)
Provision for income taxes
$
10,503
$
14,872
$
(4,369
)
(29.4
%)
Provision for income taxes decreased by $4.4 million, or 29.4% compared to the prior fiscal year primarily due to lower income in non-U.S. jurisdictions subject to tax.
Our Malaysian subsidiary was previously approved for income tax holidays for the operations of its Pioneer business and Global Supply Chain (GSC) business. We have received approvals for a continuation of these tax incentives for up to ten years, subject to certain operating conditions. The impact of these tax incentives will be recorded in the period in which they become effective. In general, these future tax holidays will have tax rates greater than our prior approved tax holidays, and therefore we expect that our effective income tax rate in the future may be higher depending on a combination of our overall and jurisdictional profitability. For additional information, see Note 6, Income Taxes , in our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K.
Comparison of the Years Ended August 30, 2019 and August 31, 2018
Fiscal Year Ended
Change
August 30,
2019
August 31,
2018
Amount
%
(in thousands, except percentages)
Net sales
$
1,211,999
$
1,288,821
$
(76,822
)
(6.0
%)
Cost of sales (1)
974,472
997,235
(22,763
)
(2.3
%)
Gross profit
$
237,527
$
291,586
$
(54,059
)
(18.5
%)
Gross margin
19.6
%
22.6
%
(1)
Includes share-based compensation expense of $2.5 million and $0.6 million, and intangible amortization of $1.3 million and $0 million in fiscal 2019 and 2018, respectively.
Net Sales, Cost of Sales and Gross Margin
Net sales decreased by $76.8 million, or 6.0%, during fiscal 2019 compared to the prior fiscal year. Net sales were negatively impacted by lower mobile memory and DRAM sales in Brazil in fiscal 2019 of $266.0 million, or a decline of 33.3% from the prior fiscal year. These decreases were primarily due to lower customer demand for
70
mobile memory and DRAM products of 25% and 26%, respectively, as well as 22% lower average selling prices for mobile memory. The decreases in Brazil were partially offset by additional sales from Penguin Computing for the full year in fiscal 2019 compared to just a partial year in fiscal 2018. Penguin, which was acquired in June 2018, contributed additional revenue of $150.4 million in fiscal 2019 as compared to the prior fiscal year as Penguin’s results were only consolidated into the Company’s results for one quarter in fiscal 2018. The sales decrease was also offset in part by 7% higher Specialty DRAM sales in fiscal 2019 as compared to the prior fiscal year, which was driven by 8% higher average selling prices due to changes in product mix, as well as sales of new products and increased customer penetration.
Cost of sales decreased by $22.8 million, or 2.3%, during fiscal 2019 compared to the prior fiscal year, primarily due to a decrease of 4.6% in the cost of materials for the lower level of sales, offset by higher production costs related to the increased revenue and additional costs for the new SCSS business. Included in the cost of sales decreases was a favorable foreign exchange impact of $6.8 million due to locally sourced cost of sales in Brazil.
Gross margin decreased to 19.6% during fiscal 2019, compared to 22.6% for fiscal 2018, primarily due to higher cost of sales for SCSS, as well as fixed manufacturing costs for Brazil.
Operating Expenses
Fiscal Year Ended
Change
August 30,
2019
August 31,
2018
Amount
%
(in thousands, except percentages)
Operating expenses:
Research and development (1) (2)
$
47,920
$
39,824
$
8,096
20.3
%
Selling, general and administrative (1) (2)
103,226
84,541
18,685
22.1
%
Change in estimated fair value of acquisition-
related contingent consideration
(2,700
)
(3,000
)
300
(10.0
%)
Total operating expenses
$
148,446
$
121,365
$
27,081
22.3
%
(1) Includes share-based compensation expense as follows:
Research and development
$
2,654
$
1,460
$
1,194
81.8
%
Selling, general and administrative
13,060
7,763
5,297
68.2
%
Total
$
15,714
$
9,223
$
6,491
70.4
%
(2) Includes amortization of intangible assets expense as follows:
Research and development
$
—
$
987
$
(987
)
(100.0
%)
Selling, general and administrative
5,048
5,136
(88
)
(1.7
%)
Total
$
5,048
$
6,123
$
(1,075
)
(17.6
%)
Research and Development Expense
Research and development, or R&D, expense increased by $8.1 million, or 20.3% in fiscal 2019 compared to the prior fiscal year mainly due to $7.8 million higher costs from our new SCSS businesses, as well as higher depreciation and share-based compensation, partially offset by lower intangible amortization expense as some intangible assets became fully amortized. Included in the R&D expense increase was a favorable foreign exchange impact of $2.3 million.
Selling, General and Administrative Expense
Selling, general and administrative, or SG&A, expense increased by $18.7 million, or 22.1%, during fiscal 2019 compared to the prior fiscal year. The increase was primarily due to $22.8 million higher costs from our new SCSS business, as well as higher share based compensation, partially offset by lower professional services and
71
personnel-related expenses. Included in the SG&A expense increase was a favorable foreign exchange impact of $1.4 million.
Other Income (Expense)
Fiscal Year Ended
Change
August 30,
2019
August 31,
2018
Amount
%
(in thousands, except percentages)
Other income (expense):
Interest expense, net
$
(20,716
)
$
(19,144
)
$
(1,572
)
8.2
%
Other expense, net
(2,161
)
(13,299
)
11,138
(83.8
%)
Total other expense
$
(22,877
)
$
(32,443
)
$
9,566
(29.5
%)
Interest expense, net increased $1.6 million, or 8.2%, during fiscal 2019 compared to the prior fiscal year primarily due to higher interest expense from an incremental loan in connection with the Penguin acquisition. Other expense, net decreased by $11.1 million, or 83.8% over the prior fiscal year primarily due to $10.1 million foreign currency gains/losses.
Provision for Income Taxes
Fiscal Year Ended
Change
August 30,
2019
August 31,
2018
Amount
%
(in thousands, except percentages)
Provision for income taxes
$
14,872
$
18,315
$
(3,443
)
(18.8
%)
Provision for income taxes decreased by $3.4 million, or 18.8% during fiscal 2019 compared to the prior fiscal year primarily due to lower income in non-U.S. jurisdictions subject to tax.
Our Malaysian subsidiary was approved for income tax holidays for the operations of its Pioneer business and Global Supply Chain (GSC) business. We have received approvals for a continuation of these tax incentives for up to ten years, subject to certain operating conditions. The impact of these tax incentives will be recorded in the period in which they become effective. In general, these future tax holidays will have tax rates greater than our prior approved tax holidays, thus our effective income tax rate in the future may be higher depending on a combination of our overall and jurisdictional profitability.
Liquidity and Capital Resources
Fiscal Year Ended
August 28,
2020
August 30,
2019
August 31,
2018
(in thousands)
Cash provided by operating activities
$
87,205
$
169,657
$
67,907
Cash used in investing activities
(32,041
)
(109,440
)
(67,749
)
Cash provided by financing activities
12,594
100
7,944
Effect of exchange rate changes on cash and
cash equivalents
(15,086
)
588
(331
)
Net increase in cash and cash equivalents
$
52,672
$
60,905
$
7,771
At August 28, 2020, we had cash and cash equivalents of $150.8 million, of which approximately $95.3 million was held outside of the United States.
In February 2020, we issued $250.0 million in aggregate principal amount of 2.25% convertible senior notes due 2026 for which we received proceeds of $243.1 million, net of issuance costs. We used $204.9 million for
72
extinguishment of long-term debt and $21.8 million for purchasing privately-negotiated capped calls. For additional information, s ee Note 7 , Long-Term Debt , in our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K .
In July 2019, we acquired SMART EC and SMART Wireless for purchase prices of approximately $77 million and $15 million, respectively. We financed these acquisitions using cash from operations, as well as approximately $11 million in SGH ordinary shares attributable to the SMART Wireless acquisition.
In June 2018, we acquired Penguin for a purchase price of approximately $45 million and assumed approximately $32.3 million of Penguin’s outstanding indebtedness. We financed this acquisition with net proceeds from the $60 million Incremental Amendment. For additional information, see Note 2, Business Acquisitions , and Note 7, Long-Term Debt , in our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K.
We expect that our existing cash and cash equivalents, line of credit and cash generated by operating activities will be sufficient to fund our operations for at least the next twelve months. Our principal uses of cash and capital resources are acquisitions, debt service requirements as described below, capital expenditures, R&D expenditures and working capital requirements. We expect that future capital expenditures will focus on expanding capacity of our operations , expanding our R&D activities, manufacturing equipment upgrades, acquisitions and IT infrastructure and software upgrades. Cash and cash equivalents consist of funds held in demand deposit accounts and money market funds. We do not enter into investments for trading or speculative purposes.
Operating Activities
During fiscal 2020, cash provided by operating activities was $87.2 million. The primary factors affecting our cash flows during this period were a $1.1 million net loss, $7.5 million in change in our net operating assets and liabilities and $80.8 million of non-cash related expenses. The $7.5 million change in net operating assets and liabilities consisted of a decrease of $5.8 million in prepaid expenses and other assets and increases of $70.1 million in accounts payable and $0.5 million in accrued expenses and other liabilities, offset by increases of $12.3 million in accounts receivable and $51.8 million in inventory and a decrease of $4.8 million in operating leases. The increase in accounts receivable was primarily due to timing of sales, while the increases in inventory and accounts payable were primarily due to the transition of manufacturing from contract manufacturers to the company due to our recent acquisitions, as well as higher purchases for certain programs.
During fiscal 2019, cash provided by operating activities was $169.7 million. The primary factors affecting our cash flows during this period were a $51.3 million net income, $71.6 million in change in our net operating assets and liabilities and $46.8 million of non-cash related expenses. The $71.6 million change in net operating assets and liabilities consisted of decreases of $35.2 million in accounts receivable and $102.1 million in inventory and an increase of $0.4 million in accrued expenses and other liabilities, offset by increases of $1.6 million in prepaid expenses and other assets and a decrease of $64.6 million in accounts payable. The decrease in accounts receivable was primarily due to lower gross sales. The decreases in inventory and accounts payable were primarily due to the reduction of inventory along all business areas as product lead times and average selling prices reduced.
Investing Activities
Net cash used in investing activities during fiscal 2020 was $32.0 million consisting primarily of purchases of property and equipment. Net cash used in investing activities during fiscal 2019 was $109.4 million consisting primarily of $76.1 million for the new SCSS acquisitions, net of cash acquired, and $33.4 million used for purchases of property and equipment.
Financing Activities
Net cash provided by financing activities during fiscal 2020 was $12.6 million, consisting primarily of $243.1 million proceeds from issuance of convertible notes and $5.5 million proceeds from issuance of ordinary shares from share option exercises and employee share purchase plans, partially offset by $204.9 million payment for extinguishment of long-term debt, $21.8 million purchase of Capped Calls, $8.5 million long-term debt payments for both the Amended Credit Agreement and the BNDES Credit Agreement and $0.8 million for withholding tax on restricted stock units. Net cash provided by financing activities during fiscal 2019 was $0.1 million, consisting primarily of $7.4 million of proceeds from issuance of ordinary shares from share option exercises and purchases
73
under our employee share purchase plan, offset by $6.8 million of long-term debt payments for the BNDES Credit Agreements and $0.5 million for withholding tax on the vesting of restricted share units.
Contractual Obligations
Our contractual obligations as of August 28, 2020 are set forth below:
Payments due by Period
1 year
2-3 years
4-5 years
After
5 years
Total
(in millions)
Notes
$
—
$
—
$
—
$
250.0
$
250.0
Interest expense in connection with the Notes
5.6
11.3
11.3
2.8
31.0
Operating leases
7.2
8.7
6.5
14.2
36.6
Non-cancellable product purchase commitments
49.9
—
—
—
49.9
Total contractual obligations
$
62.7
$
20.0
$
17.8
$
267.0
$
367.5
As of August 28, 2020, we had gross unrecognized tax benefits of $16.5 million which includes penalties and interest. Approximately $0.4 million has been recorded as a noncurrent liability. At this time, we are unable to make a reasonably reliable estimate of the timing of payments in individual years in connection with these tax liabilities and therefore such amounts are not included in the above contractual obligation table.
Convertible Senior Notes due 2026
In February 2020, the Company issued $250.0 million in aggregate principal amount of 2.25% convertible senior notes due 2026 (the Notes), in a private placement, including $30.0 million in aggregate principal amount of the Notes that the Company issued resulting from initial purchasers fully exercising their option to purchase additional notes.
The Notes are general unsecured obligations and bear interest at an annual rate of 2.25% per year, payable semi-annually on February 15 and August 15 of each year, beginning on August 15, 2020. The Notes are governed by an indenture (the Indenture) between the Company and U.S. Bank National Association, as trustee. The Notes will mature on February 15, 2026, unless earlier converted, redeemed or repurchased. No sinking fund is provided for the Notes.
The initial conversion rate of the Notes is 24.6252 ordinary shares per $1,000 principal amount of Notes, which represents an initial conversion price of approximately $40.61 per ordinary share. The conversion rate is subject to adjustment upon the occurrence of certain specified events as set forth in the Indenture.
The holders of the Notes may convert their Notes at their option in the following circumstances:
•
during any fiscal quarter commencing after the fiscal quarter ending on August 28, 2020 (and only during such fiscal quarter), if the last reported sale price per ordinary share exceeds 130% of the conversion price for each of at least 20 trading days, whether or not consecutive, during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding fiscal quarter;
•
during the five consecutive business days immediately after any 10 consecutive trading day period (such 10 consecutive trading day period, the measurement period) in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price per ordinary share on such trading day and the conversion rate on such trading day;
•
upon the occurrence of certain corporate events or distributions on the Company’s ordinary shares, as provided in the Indenture;
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•
if the Company calls such Notes for redemption; and
•
on or after August 15, 2025 until the close of business on the second scheduled trading day immediately before the maturity date.
Upon conversion, the Company will pay or deliver, as applicable, cash, ordinary shares or a combination of cash and ordinary shares at the Company's election. The Company’s intent is to settle conversions through combination settlement with a specified dollar amount of $1,000 per $1,000 principal amount of Notes, which involves repayment of the principal portion of such Notes in cash and any excess of the conversion value over the principal amount in ordinary shares, with cash in lieu of any fractional ordinary shares.
Upon the occurrence of a “make-whole fundamental change” (as defined in the Indenture), the Company will in certain circumstances increase the conversion rate for a specified period of time. In addition, upon the occurrence of a “fundamental change” (as defined in the Indenture), holders of the Notes may require the Company to repurchase their Notes at a cash repurchase price equal to the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any.
If any taxes imposed or levied by or on behalf of the Cayman Islands (or certain other jurisdictions described in the Indenture) are required to be withheld or deducted from any payments or deliveries made under or with respect to the Notes, then, subject to certain exceptions, the Company will pay or deliver to the holder of each Note such additional amounts as may be necessary to ensure that the net amount received by the beneficial owner of such Note after such withholding or deduction (and after withholding or deducting any taxes on the additional amounts) will equal the amounts that would have been received by such beneficial owner had no such withholding or deduction been required.
The Company has a right to redeem the Notes, in whole or in part, at its option at any time, and from time to time, from February 21, 2023 through the 40th scheduled trading day immediately before the maturity date, at a cash redemption price equal to the principal amount of the Notes to be redeemed, plus accrued and unpaid interest. However, the repurchase right is only applicable if the last reported per share sale price of ordinary share exceeds 130% of the conversion price on each of at least twenty trading days during the thirty consecutive trading days ending on, and including, the trading day immediately before the redemption notice date for such redemption.
In accounting for the issuance of the Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability component of approximately $197.5 million was calculated by using a discount rate of 6.53%, which was the Company’s borrowing rate on the date of the issuance of the Notes for a similar debt instrument without the conversion feature. The carrying amount of the equity component of approximately $52.5 million, representing the conversion option, was determined by deducting the fair value of the liability component from the par value of the Notes. The equity component of the Notes is included in additional paid-in capital in the consolidated balance sheet and is not remeasured as long as it continues to meet the conditions for equity classification, which the Company will reassess every reporting period. The difference between the principal amount of the Notes and the liability component (the debt discount) is amortized to interest expense using the effective interest method over the term of the Notes.
Debt issuance costs for the issuance of the Notes were approximately $8.0 million, consisting of initial purchasers' discount and other issuance costs. In accounting for the transaction costs, the Company allocated the total amount incurred to the liability and equity components using the same proportions as the proceeds from the Notes. Transaction costs attributable to the liability component were approximately $6.3 million, were recorded as debt issuance cost (presented as contra debt in the consolidated balance sheet) and are being amortized to interest expense over the term of the Notes using the effective interest method. The transaction costs attributable to the equity component were approximately $1.7 million and were netted with the equity component in shareholders’ equity.
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The carrying value of the Notes is as follows (in thousands):
August 28,
2020
Principal
$
250,000
Unamortized debt discount
48,586
Unamortized issuance costs
5,841
Net carrying amount
$
195,573
As of August 28, 2020, the remaining life of the Notes was approximately 66 months. The unamortized debt discounts and unamortized debt issuance cost are amortized over the remaining useful life, using an effective interest rate of 7.06%.
As of August 28, 2020, the carrying value of the equity component was $50.8 million, net of the issuance costs of $1.7 million.
The following table sets forth the total interest expense recognized related to the Notes (in thousands):
August 28,
2020
Contractual interest expenses
$
3,078
Amortization of debt discount
3,914
Amortization of debt issuance costs
471
Total interest cost recognized
$
7,463
The total estimated fair value for the Notes was determined to be $221.5 million based on the closing trading price per $100 of the Notes as of the last day of trading for the period.
There are no future minimum principal payments under the Notes until the full amount of $250.0 million is due in fiscal 2026
Off-Balance Sheet Arrangements
As of August 28, 2020 and August 30, 2019, we did not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Critical Accounting Policies
We believe the following critical accounting policies are the most significant to the presentation of our financial statements and they at times require the most difficult, subjective and complex estimates.
Revenue Recognition
The Company’s revenues include products and services. The Company’s product revenues are predominantly derived from the sale of memory modules, flash memory cards, compute products and storage products, which the Company designs and manufactures. The Company’s service revenues are derived from procurement, logistics, inventory management, temporary warehousing, kitting and packaging services. Also, a small portion of the Company’s product sales include extended warranty and on-site services, subscriptions to the Company’s high performance computing environment, professional services, software and related support.
The Company determines revenue recognition through the following steps: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract; and (5) recognition of revenue when, or as, a performance obligation is satisfied.
76
The Company’s contracts are executed through a combination of written agreements along with purchase orders with all customers including certain general terms and conditions. Generally, purchase orders entail products, quantities and prices, which define the performance obligations of each party and are approved and accepted by the Company. The Company’s contracts with customers do not include extended payment terms. Payment terms vary by contract type and type of customer and generally range from 30 to 45 days from invoice. Additionally, taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer and deposited with the relevant government authority, are excluded from revenue.
The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods or services to the customer adjusted for estimated variable consideration. Variable consideration may include discounts, rights of return, refunds, and other similar obligations. The Company allocates the transaction price to each distinct product and service based on its relative standalone selling price. The standalone selling price for products primarily involves the cost to produce the deliverable plus the anticipated margin and for services is estimated based on the Company’s approved list price.
In the normal course of business, the Company does not accept product returns unless the items are defective as manufactured. The Company establishes provisions for estimated returns and warranties. In addition, the Company does not typically provide customers with the right to a refund and does not transact for noncash consideration.
Standard Products
The Company’s main performance obligations are to deliver the requested goods to customers according to the agreed-upon shipping terms. The Company recognizes revenue when control transfers to the customer (i.e., when the Company’s performance obligation is satisfied). The Company invoices the customer and recognizes revenues for such delivery when control transfers based on shipping terms.
Customized Products
For customized product sales with terms that require the customer to purchase 100% of all parts built to fulfill the customers forecast, the Company recognizes revenue when control of the underlying assets passes to the customer, as the customer is able to both direct the use of, and obtain substantially all of the remaining benefit from the assets; the customer has the significant risks and rewards associated with ownership of the assets; and the Company has a present right to payment. For these sales, control passes when the Company has made these products available to the customer and under the terms of the agreement cannot repurpose them without the customer’s express consent. Accordingly, the Company will recognize revenue at the point in time when products made to the customer’s order or forecast are completed and made available to the customer.
Non-cancellable nonrefundable, or NCNR, customized product sales are recognized over time on a cost incurred basis. The customer obtains control and benefits from the services as they are performed over the period based on the cost input measure in the production process for the NCNR customized product. The terms within the NCNR sales orders provide the Company with a legally enforceable right to receive payment including a reasonable profit margin upon customer cancellation for performance completed to date. Accordingly, the Company recognizes revenue over time as customized products listed within the NCNR orders are completed.
Computing Products and Services
A small portion of the Company’s product sales includes extended warranty and on-site services, subscriptions to the Company’s high performance computing environment, professional consulting services including installation and other services, and hardware and software related support. Each contract may contain multiple performance obligations, which requires the transaction price to be allocated to each performance obligation. The Company allocates the consideration to each performance obligation based on the relative selling price. The Company uses best-estimated selling price, determined as the best estimate of the price at which the Company would transact if it sold the deliverable regularly on a stand-alone basis.
For services provided to the customers over a period of time, such revenues are recognized over time in line with when the customer receives and consumes the benefit of the services. Extended warranty and on-site services,
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hardware support, software support, and subscription revenue for access to the Company’s high performance computing environment is deferred and recognized ratably over the contractual period as the Company transfers control as it satisfies its performance obligations over time as the services are rendered. These services contracts are typically one to three years in length. Subscription revenue for certain customers is recognized based on the contractual fee to use the high-performance-computing environment. Professional consulting services revenue is recognized as the service is performed and the customer obtains control and benefits from the services as they are performed over the period. The methods of recognizing revenue for each of these products and services were selected because they reflect a faithful depiction of the transfer of control.
Agency Services
The Company has service performance obligations for agency related services such as procurement, logistics, inventory management, temporary warehousing, kitting and packaging services for certain agency basis customers. The agency services are also known as supply chain services and the performance obligations for these services consist of customized, integrated supply chain services management to assist customers in the planning, execution and overall management of the procurement processes.
For these customers that are accounted for on an agency basis, the Company recognizes as revenue the amount billed less the material procurement costs of products serviced as an agent with the cost of providing these services embedded with the cost of sales. The Company has separate agent performance obligations as follows: (a) procurement, logistics, and inventory management, (b) temporary warehousing, and (c) kitting and packaging services for these customers. Revenue from these arrangements is recognized as service revenue and is determined by a fee for services based on material procurement costs (i.e. fee as a percentage of the associated material being procured, warehoused, kitted or packaged). The Company recognizes revenue for procurement, logistics and inventory management upon the completion of the services or performance obligation, typically upon shipment of the product, as the criteria for over time recognition is not met. For temporary warehousing, kitting and packaging services, revenue is recognized over time, but the period of performance is typically very short in duration. There are no obligations subsequent to shipment of the product under the agency arrangements.
Contract Costs
As a practical expedient, the Company recognizes the incremental costs of obtaining a contract, specifically commission expenses that have an amortization period of less than twelve months, as an expense when incurred. Additionally, the Company has adopted an accounting policy to recognize shipping and handling costs that occur after control transfers, if any, to the customer as a fulfillment activity. The Company records shipping and handling costs related to revenue transactions within cost of sales as a period cost.
Gross Billings and Net Sales
The following is a summary of our gross billings to customers and net sales for services and products (in thousands):
Fiscal Year Ended
August 28,
August 30,
August 31,
2020
2019
2018 (2)
Service revenue, net
$
32,204
$
42,527
$
42,978
Cost of purchased materials - service (1)
604,698
946,303
1,013,393
Gross billings for services
636,902
988,830
1,056,371
Product net sales
1,090,173
1,169,472
1,245,843
Gross billings to customers
$
1,727,075
$
2,158,302
$
2,302,214
Product net sales
$
1,090,173
$
1,169,472
$
1,245,843
Service revenue, net
32,204
42,527
42,978
Net sales
$
1,122,377
$
1,211,999
$
1,288,821
(1)
Represents material procurement costs of products provided as an agent reported on a net basis.
(2)
Amounts for fiscal 2018 are accounted for under ASC 605 (refer to Note 1(u)).
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Inventory Valuation
At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence. This evaluation includes analysis of sales levels by product family. Among other factors, we consider historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and net realizable value. We adjust the carrying values to approximate the lower of our manufacturing cost or net realizable value. Inventory cost is determined on a specific identification basis and includes material, labor and manufacturing overhead. From time to time, our customers may request that we purchase and maintain significant inventory of raw materials for specific programs. Such inventory purchases are evaluated for excess quantities and potential obsolescence and could result in a provision at the time of purchase or subsequent to purchase. Inventory levels may fluctuate based on inventory held under service arrangements. Our provisions for excess and obsolete inventory are also impacted by our arrangements with our customers and/or suppliers, including our ability or inability to re-sell such inventory to them. If actual market conditions or our customers’ product demands are less favorable than those projected or if our customers or suppliers are unwilling or unable to comply with any arrangements related to their purchase or sale of inventory, additional provisions may be required and would have a negative impact on our gross margins in that period. We have had material inventory write-downs in the past for reasons such as obsolescence, excess quantities and declines in market value below our costs, and we may be required to do so from time to time in the future. Our inventory write-downs were $4.7 million, $9.0 million and $5.2 million for fiscal 2020, 2019 and 2018, respectively.
Income Taxes
We use the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and net operating loss and credit carryforwards. When necessary, a valuation allowance is recorded or reduced to value tax assets to amounts expected to be realized. The effect of changes in tax rates is recognized in the period in which the rate change occurs.
The calculation of our tax liabilities involves accounting for uncertainties in the application of complex tax rules, regulations and practices. We recognize benefits for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition of a benefit (or the absence of a liability) by determining if the weight of available evidence indicates that it is more likely than not that the position taken will be sustained upon audit, including resolution of related appeals or litigation processes, if any. If it is not, in our judgment, more likely than not that the position will be sustained, then we do not recognize any benefit for the position. If it is more likely than not that the position will be sustained, a second step in the process is required to estimate how much of the benefit we will ultimately receive. This second step requires that we estimate and measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts. We reevaluate these uncertain tax positions on a quarterly basis. The total amount of unrecognized tax benefits that would affect the effective tax rate, if recognized, is $1.7 million as of August 28, 2020. This evaluation is based on a number of factors including, but not limited to, changes in facts or circumstances, changes in tax law, new facts, correspondence with tax authorities during the course of an audit, effective settlement of audit issues and commencement of new audit activity. Such a change in recognition or measurement could result in the recognition of a tax benefit or an additional charge to the tax provision in the period.
Goodwill Valuation
We perform a goodwill impairment test annually during the fourth quarter of our fiscal year and more frequently if events or circumstances indicate that impairment may have occurred. Such events or circumstances may, among others, include significant adverse changes in the general business climate. When conducting the annual impairment test for goodwill, we compare the estimated fair value of a reporting unit containing goodwill to its carrying value. If the fair value of the reporting unit is determined to be more than its carrying value, no goodwill impairment is recognized. We determine the fair value of the our reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as the market approach which includes the guideline company method. These approaches use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy and require us to make significant management judgments and assumptions including, but not limited to, future net sales, earnings before interest, and the selection of the discount rate. These assumptions consider our budgets, business plans and economic projections, and are believed to reflect market participant views. Some of the inherent estimates and assumptions used in determining fair value of the reporting units are outside the control of management. While we believe we have made reasonable estimates and assumptions
79
to calculate the fair value of the reporting units, it is possible a material change could occur. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, it could result in material impairments of our goodwill. For additional information, s ee Note 1(k), Goodwill , in our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K .
Based on the results of the impairment test, the fair values exceed the respective carrying values for each reporting unit. Accordingly, no impairment of goodwill was recognized through August 28, 2020. The estimated forecasted results used in the discounted cash flow portion of the impairment analysis reflect our best estimates as of August 28, 2020.
Long-Lived Assets Valuation
We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.
Share-Based Compensation
We recognize compensation costs related to share-based awards granted to employees based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value of options, and the resulting share-based compensation expense, using the Black-Scholes option-pricing model. The grant date fair value of the share-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards.
The Black-Scholes model requires the use of subjective and highly complex assumptions which determine the fair value of share-based option awards. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. The expected volatility is based on the historical volatilities of the common stock of comparable publicly traded companies. The expected term of options granted represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and the historical exercise patterns. The risk-free interest rate for the expected term of the option is based on the average U.S. Treasury yield curve at the end of the quarter in which the option was granted.
We used the following assumptions to value options granted under the SGH Plan during fiscal 2020, 2019 and 2018:
Fiscal Year Ended
August 28,
August 30,
August 31,
2020
2019
2018
Stock options:
Expected term (years)
6.25
6.25
6.25
Expected volatility
46.10% - 57.10%
41.68% - 48.15%
39.00% - 46.27%
Risk-free interest rate
0.40% - 1.68%
1.42% - 2.88%
2.15% - 2.82%
Expected dividends
—
—
—
The following table sets forth our total share-based compensation expense during fiscal 2020, 2019 and 2018 (in thousands):
Fiscal Year Ended
August 28,
August 30,
August 31,
2020
2019
2018
Share-based compensation expense by category
(in thousands):
Cost of sales
$
3,022
$
2,485
$
1,335
Research and development
3,069
2,654
1,460
Selling, general and administrative
12,625
13,060
7,763
Total
$
18,716
$
18,199
$
10,558
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Item 7A. Quantitative and Qualita tive Disclosures About Market Risk
Our exposure to market rate risk includes risk of foreign currency exchange rate fluctuations, changes in interest rates and translation risk.
Foreign Exchange Risks
We are subject to inherent risks attributed to operating in a global economy. Our international sales and our operations in foreign countries subject us to risks associated with fluctuating currency values and exchange rates. Because a portion of our sales are denominated in United States dollars, increases in the value of the United States dollar could increase the price of our products so that they become relatively more expensive to customers in a particular country, possibly leading to a reduction in sales and profitability in that country. A significant portion of the sales of our products are denominated in reais. In addition, we have certain costs that are denominated in foreign currencies, and decreases in the value of the U.S. dollar could result in increases in such costs that could have a material adverse effect on our results of operations.
We utilize foreign exchange forward contracts to mitigate foreign currency exchange rate risk associated with foreign-currency-denominated assets and liabilities, primarily third party payables in Brazil. We do not use foreign currency contracts for speculative or trading purposes. Foreign exchange forward contracts outstanding at August 28, 2020 are not designated as hedging instruments for hedge accounting purposes. We do not currently purchase financial instruments to hedge foreign exchange risk, but may do so in the future.
As a result of our international operations, we generate a portion of our net sales and incur a portion of our expenses in currencies other than the U.S. dollar, particularly the reais. Approximately 35%, 44% and 62% of our net sales during fiscal 2020, 2019 and 2018, respectively, originated in reais. We present our consolidated financial statements in U.S. dollars, and we must translate the assets, liabilities, net sales and expenses of a substantial portion of our foreign operations into U.S. dollars at applicable exchange rates. Consequently, increases or decreases in the value of the U.S. dollar may affect the value of these items with respect to our non-U.S. dollar businesses in our combined financial statements, even if their value has not changed in their local currency. Our customer pricing and material cost of sales are based on U.S. dollars, as is the global market for memory products. Accordingly, the impact of currency fluctuations to our consolidated statement of operations is primarily to our other costs of sales (i.e., non-material components) and our operating expenses as those items are typically denominated in local currency. Our consolidated statement of operations is also impacted by foreign currency gains and losses recorded in Other Income (Expense) arising from transactions denominated in a currency other than the functional currency of the respective subsidiary. These translations could significantly affect the comparability of our results between financial periods or result in significant changes to the carrying value of our assets, liabilities and equity. As a result, changes in foreign currency exchange rates impact our reported results.
During fiscal 2020, 2019 and 2018, we recorded $3.4 million, $3.1 million, and $13.2 million, respectively, of foreign exchange losses.
Interest Rate Risk
We are subject to interest rate risk in connection with our short-term debt under the Amended Credit Agreement as of May 29, 2020. Although we did not have any revolving balances outstanding as of August 28, 2020, the revolving facility under the Amended Credit Agreement provides for borrowings of up to $50 million that would also bear interest at variable rates. Assuming that we will satisfy the financial covenants required to borrow and that the revolving loans under the Amended Credit Agreement were fully drawn and other variables are held constant, each 1.0% increase in interest rates on our variable rate borrowings would result in an increase in annual interest expense and a decrease in our cash flow and income before taxes of $0.5 million per year.