Penguin Solutions, Inc. 10-Q

Item 2. 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 Quarterly Report on Form 10-Q, and with the consolidated financial statements and management’s discussion and analysis of our financial condition and results of operations in our Annual Report on Form 10-K for our fiscal year ended August 28, 2020 (our “Annual Report”). 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 under the caption “Risk Factors” in our Annual Report and elsewhere in this report. See also “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report. Overview SMART Global Holdings businesses are leading designers and manufacturers of electronics for computing, memory and specialty LED solutions. The Company specializes in application-specific product development and support for customers in enterprise, government, OEM and other distribution and sales channels. Customers rely on SMART as a strategic partner with the highest quality technology products, customer service, technical support, and worldwide supply chain and logistics excellence. The Company targets customers in markets such as computing, including edge computing and high performance computing, communications, storage, networking, mobile, industrial automation, internet of things, industrial internet of things, government, military and lighting. The Company operates in four segments: Specialty, Brazil, IPS, and LED. Recent Developments Acquisition of LED Business On March 1, 2021, pursuant to the CreeLED Purchase Agreement, the Company acquired the Cree LED Business and assumed certain liabilities related to Cree’s LED Business. The purchase price for the LED Business consisted of (i) a payment of $50 million in cash, subject to customary adjustments, (ii) the Purchase Price Note, (iii) an earn-out payment of up to $125 million based on the revenue and gross profit performance of the LED Business in Cree’s first four full fiscal quarters following the closing, with a minimum payment of $2.5 million, payable in the form of an unsecured promissory note to be issued by the Company, and (iv) the assumption of certain liabilities. The Purchase Price Note bears interest at LIBOR plus 3.0% and is due on August 15, 2023. The Earnout Note will begin to bear interest upon completion of the Earnout Period at LIBOR plus 3.0% and is due on March 27, 2025. In connection with this transaction, Cree and the Company also entered into certain ancillary and related agreements, including (i) an Intellectual Property Assignment and License Agreement, (ii) a Transition Services Agreement, (iii) a Wafer Supply and Fabrication Services Agreement, and (iv) a Real Estate License Agreement. COVID-19 The outbreak of coronavirus disease 2019 (“COVID-19”) has resulted in substantial loss of life, economic disruption, and government intervention worldwide. While we have not yet experienced a significant disruption of our operations as a result of the COVID-19 pandemic, the pandemic resulted in reduced sales volumes of certain product lines within IPS in the second half of fiscal 2020 as well as in the first three quarters of fiscal 2021. COVID-19 also disrupted our product development, marketing and corporate development activities. Our recently acquired LED Business experienced similar impacts from the pandemic from early in calendar 2020. If these conditions continue, or if we have an outbreak in any of our facilities, such reduced sales volumes may continue or worsen and we may, among other issues, experience, in any or all product lines, delays in product development, a decreased ability to support our customers, disruptions in sales and manufacturing activities and overall reduced productivity each of which could have a negative impact on our ability to meet customer commitments and on our revenue and profitability. The reduction of investment in new capacity due to the pandemic, coupled with strong demand to expand delivery and logistics, internet and cloud services as well as a rebound in economic conditions and general demand at a pace faster than expected, has resulted in significant supply shortages that may impact our ability to manufacture products for our customers and may result in rising prices of the materials we need to manufacture our products. We may not be able to pass on these rising costs to our customers which could result in a negative impact to our gross margins. Furthermore, if there is a significant outbreak or if travel restrictions or stay-at-home or work remote or from home conditions or other governmental or voluntary restrictions relating to the COVID-19 pandemic significantly impact our suppliers’ ability to manufacture or deliver raw materials or provide key components or services, we could experience more delays or reductions in our ability to manufacture and ship products to our customers. While certain segments of our customer base are experiencing strong demand, the pandemic may negatively impact the demand for other segments for our customer base or those customers’ ability to manufacture their products, which could reduce their demand for our products or services. The COVID-19 pandemic also disrupted our product development, marketing and corporate development activities. 44 Results of Operations The following is a summary of our results of operations for the three and nine months ended May 28, 2021 and May 29, 2020: Three Months Ended Nine Months Ended May 28, 2021 % of sales* May 29, 2020 % of sales* May 28, 2021 % of sales* May 29, 2020 % of sales* (in thousands, other than percentages and per share data) (in thousands, other than percentages and per share data) Condensed Consolidated Statements of Operations: Net sales $ 437,728 100 % $ 281,287 100 % $ 1,033,433 100 % $ 825,347 100 % Cost of sales (1)(2) 353,241 81 % 227,054 81 % 842,847 82 % 665,288 81 % Gross profit 84,487 19 % 54,233 19 % 190,586 18 % 160,059 19 % Operating expenses: Research and development (1) 16,718 4 % 14,436 5 % 32,534 3 % 44,023 5 % Selling, general and administrative (1) (2) 48,475 11 % 29,733 11 % 118,195 11 % 91,935 11 % Change in estimated fair value of acquisition-related contingent consideration 16,400 4 % — — 16,400 2 % — — Total operating expenses 81,593 19 % 44,169 16 % 167,129 16 % 135,958 16 % Income from operations 2,894 1 % 10,064 4 % 23,457 2 % 24,101 3 % Other expense, net: Interest expense, net (5,049 ) (1 %) (3,094 ) (1 %) (12,568 ) (1 %) (11,736 ) (1 %) Other expense, net (489 ) 0 % (3,445 ) (1 %) (1,187 ) 0 % (16,671 ) (2 %) Total other expense (5,538 ) (1 %) (6,539 ) (2 %) (13,755 ) (1 %) (28,407 ) (3 %) Income (loss) before income taxes (2,644 ) (1 %) 3,525 1 % 9,702 1 % (4,306 ) (1 %) Provision for income taxes 4,010 1 % 2,700 1 % 8,485 1 % 4,365 1 % Net income (loss) (6,654 ) (2 %) 825 0 % 1,217 0 % (8,671 ) (1 %) Net income attributable to noncontrolling interest 557 0 % — — 557 0 % — — Net income (loss) attributable to SGH $ (7,211 ) (2 %) $ 825 0 % $ 660 0 % $ (8,671 ) (1 %) Earnings per share: Basic $ (0.30 ) $ 0.03 $ 0.03 $ (0.36 ) Diluted $ (0.30 ) $ 0.03 $ 0.03 $ (0.36 ) Shares used in computing earnings per share: Basic 24,035 24,066 24,843 23,895 Diluted 24,035 24,431 25,902 23,895 * Summations may not compute precisely due to rounding. (1) Includes share-based compensation expense as follows: Cost of sales $ 1,166 $ 699 $ 2,807 $ 2,161 Research and development 1,468 780 3,056 2,306 Selling, general and administrative 5,747 3,428 19,004 11,043 (2) Includes amortization of intangible assets expense as follows: Cost of sales $ 2,937 $ 647 $ 4,231 $ 1,941 Selling, general and administrative 3,247 2,767 8,780 8,299 Three and Nine Months Ended May 28, 2021 as Compared to the Three and Nine Months Ended May 29, 2020 Net Sales Net sales increased by $156.4 million, or 55.6%, during the three months ended May 28, 2021 compared to the same period in the prior year, and by $208.1 million, or 25.2%, during the nine months ended May 28, 2021 compared to the same period in the prior year. The increase was due in large part to $101.8 million of revenue from our LED business acquired in March 2021. Net sales were positively impacted by an increase in IPS product sales of $35.0 million, or an increase of 57.4%, and $48.9 million, or an increase of 24.7%, for the three- and nine-month periods, respectively, primarily due to increased volume of sales with one of our largest customers in the IPS segment. In addition, our sales of Brazil products increased by $25.8 million and $42.4 million, or 27.8% and 14.9%, respectively, for the three- and nine- month periods, primarily due to higher volume of mobile memory and DRAM revenue and higher average selling prices for mobile memory of 28.7% and 48.3%, respectively, resulting from a change in product mix. Cost of Sales Cost of sales increased by $126.2 million, or 55.6%, during the three months ended May 28, 2021 compared to the same period in the prior year, and by $177.6 million, or 26.7%, during the nine months ended May 28, 2021 compared to the same period in the prior year. The increase in the three- and nine-month periods was primarily due to higher cost of materials of $92.4 million and $140.7 45 million or 48% and 25%, respectively, due to the higher level of sales, as well as additional costs for the new LED business, as well as higher production costs related to the increased revenue. Included in the cost of sales increases were favorable foreign exchange impacts of $ 1.4 million and $ 6.3 million for the three and nine-month periods, respectively, due to locally sourced cost of sales in Brazil . Gross Profit Gross margin remained level at 19.3% during both three-month periods, and decreased to 18.4% during the nine months ended May 28, 2021 compared to 19.4% for the same period in the prior year, primarily due to higher material costs for our Brazil and IPS products. Research and Development Expense Research and development (“R&D”) expense increased $2.3 million, or 15.8%, during the three months ended May 28, 2021 compared to the same period in the prior year, and decreased $11.5 million, or 26.1%, during the nine months ended May 28, 2021 compared to the same period in the prior year. The change during the three- and nine-month periods was primarily due to $7.5 million additional costs from our new LED business, as well as higher personnel-related expenses and depreciation. The higher expense was partially offset by $8.2 million and $22.2 million in the three- and nine-month periods, respectively, of Brazil financial credits resulting from amendments to the IT law implemented in April 2020. For additional information, see Note 1(i) in our Notes to Unaudited Condensed Consolidated Financial Statements. Included in the R&D expense increases/decreases were unfavorable foreign exchange impacts of $0.2 million and $2.7 million for the three- and nine-month periods, respectively. Selling, General and Administrative Expense Selling, general and administrative (“SG&A”) expense increased by $18.7 million, or 63.0%, during the three months ended May 28, 2021 compared to the same period in the prior year, and $26.3 million, or 28.6%, during the nine months ended May 28, 2021 compared to the same period in the prior year. The increases were primarily $9.7 million additional costs from our new LED business, as well as higher share-based compensation expense of $2.3 million and $8.0 million in the three- and nine-month periods, respectively, resulting from additional grants, as well as higher personnel-related expenses, professional services, acquisition expenses and intangible amortization expense. For additional information on share-based compensation expense, see Note 9 in our Notes to Unaudited Condensed Consolidated Financial Statements. Included in the SG&A expense increases were favorable foreign exchange impacts of $0.2 million and $1.3 million for the three- and nine-month periods, respectively. Other Income (Expense) Interest expense, net increased $2.0 million, or 63.2%, during the three months ended May 28, 2021 compared to the same period in the prior year, and $0.8 million, or 7.1%, during the nine months ended May 28, 2021 compared to the same period in the prior year, primarily due to higher interest expense resulting from the issuance of the Purchase Price Note resulting from the LED acquisition, as well as our convertible senior notes. For additional information, see Notes 2 and 7 in our Notes to Unaudited Condensed Consolidated Financial Statements. Other income (expense), net decreased by $3.0 million and $15.5 million for the three- and nine-month periods, respectively. The decrease in the nine-month period was primarily due to $6.8 million extinguishment loss of long-term debt and $7.7 million mark-to-market losses on our Capped Calls in the second quarter of fiscal 2020, as well as foreign currency losses. Provision for Income Taxes Income tax expense includes a provision for federal, state and foreign taxes based on the annual estimated effective tax rate applicable to SMART, adjusted for certain discrete items which are fully recognized in the period they occur. Provision for income taxes increased by $1.3 million and $4.1 million for the three and nine months ended May 28, 2021, respectively, compared to the same period in the prior year, primarily due to the profits and related taxes in non-U.S. jurisdictions. As of May 28, 2021, SMART has a full valuation allowance for our net deferred tax assets associated with our U.S. operations. The amount of the deferred tax asset considered realizable could be adjusted if significant positive evidence increases. Determining the consolidated provision for income tax expense, income tax liabilities and deferred tax assets and liabilities involves judgment. SMART calculates and provides for income taxes in each of the tax jurisdictions in which it operates, which involves estimating current tax exposures as well as making judgments regarding the recoverability of deferred tax assets in each jurisdiction. The estimates used could differ from actual results, which may have a significant impact on operating results in future periods. 46 Liquidity and Capital Resources Nine Months Ended May 28, 2021 May 29, 2020 (in thousands) Cash provided by operating activities $ 105,328 $ 62,227 Cash used in investing activities (68,408 ) (16,735 ) Cash provided by financing activities 1,295 12,751 Effect of exchange rate changes on cash and cash equivalents (34 ) (24,537 ) Net increase in cash and cash equivalents $ 38,181 $ 33,706 At May 28, 2021, we had cash and cash equivalents of $189.0 million, of which approximately $164.2 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 extinguishment of long-term debt and $21.8 million for purchasing privately-negotiated Capped Calls. For additional information, see Note 7 in our Notes to Unaudited Condensed Consolidated Financial Statements. On March 1, 2021, as part of the acquisition of the LED Business, we paid Cree $50.0 million in cash and issued Cree a $125 million Purchase Price Note. Cree also has the potential to receive an earn-out payment of up to $125 million based on the revenue and gross profit performance of the LED Business during the Earnout Period with a minimum payment of $2.5 million, payable in the form of an Earnout Note. The Purchase Price Note and the Earnout Note, if earned and issued, will accrue interest at a rate of three-month LIBOR plus 3.0% with interest paid every three months, and one bullet payment of principal and all accrued and unpaid interest will be payable on each of the notes’ respective maturity dates. The Purchase Price Note will mature on August 15, 2023, and the Earnout Note will mature on March 27, 2025. 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 . During the nine months ended May 28, 2021, cash provided by operating activities was $105.3 million. The primary factors affecting our cash flows during this period were $82.6 million of non-cash related expenses, $21.5 million change in our net operating assets and liabilities, and $1.2 million of net income. The $21.5 million change in net operating assets and liabilities consisted of increases of $15.4 million in accounts receivable, $66.5 million in inventory and $14.2 million in prepaid expenses and other assets and a decrease of $4.5 million of operating lease liabilities, offset by increases of $116.2 million of accounts payable and $5.9 million in other current and long-term liabilities. The increase in accounts receivable was due to higher gross sales, and increases in both inventory and accounts payable were primarily due to higher inventory along all business areas. During the nine months ended May 29, 2020, cash provided by operating activities was $62.2 million. The primary factors affecting our cash flows during this period were $65.3 million of non-cash related expenses and $5.6 million change in our net operating assets and liabilities, partially offset by $8.7 million of net loss. The $5.6 million change in net operating assets and liabilities consisted of increases of $17.9 million in accounts receivable, $72.5 million in inventory and $1.1 million in prepaid expenses and other assets, and a decrease of $3.5 million of operating lease liabilities, offset by increases of $95.7 million of accounts payable and $4.9 million in accrued expense and other liabilities. 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 inventory from contract manufacturers to the company due to our recent acquisitions, as well as higher purchases for certain programs. Net cash used in investing activities during the nine months ended May 28, 2021 was $68.4 million consisting primarily of $40.0 million of purchases of property and equipment and deposits and $28.6 million for the LED acquisition, net of cash acquired. Net cash used in investing activities during the nine months ended May 29, 2020 was $16.7 million consisting primarily of purchases of property and equipment. Net cash provided by financing activities during the nine months ended May 28, 2021 was $1.3 million, consisting primarily of $25.0 million net proceeds from borrowings under our revolving line of credit, $13.2 million proceeds from issuance of ordinary shares from share option exercises and employee share purchase plans and $11.4 million proceeds from issuance of the FINEP loan, partially offset by $44.3 million payment for repurchase of ordinary shares and $4.0 million for withholding tax on restricted stock units. Net cash provided by financing activities during the nine months ended May 29, 2020 was $12.8 million, consisting primarily of $243.1 million proceeds from issuance of convertible notes and $4.9 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, $7.9 million long-term debt payments for both the Amended Credit Agreement and the BNDES Credit Agreement and $0.6 million for withholding tax on restricted stock units. 47 There have been no material changes to contractual obligations previously disclosed in our Annual Report. Off -Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial conditions, net sales or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Recent Accounting Pronouncements See Note 1 of our Notes to Unaudited Condensed Consolidated Financial Statements for information regarding the effect of recent accounting pronouncements on our financial statements. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates. Our critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain. Except for the critical accounting estimates associated with revenue recognition and business acquisitions as discussed below, there have been no material changes to our critical accounting policies and estimates disclosed in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” and Note 1, Overview, Basis of Presentation and Significant Accounting Policies, in each case in our Annual Report. Business Acquisitions Accounting for acquisitions requires us to estimate the fair value of consideration paid and the individual assets and liabilities acquired, which involves a number of judgments, assumptions and estimates that could materially affect the amount and timing of costs recognized in subsequent periods. We typically obtain independent third-party valuation studies to assist in determining fair values, including assistance in determining future cash flows, discount rates and comparable market values. Items involving significant assumptions, estimates and judgments include the following: • Fair value of consideration paid or transferred (including contingent consideration); • Inventory, including estimated future selling prices, timing of product sales, and completion costs for work in process; • Property, plant and equipment, including determination of values in a continued-use model; • Debt, including discount rate and timing of payments; • Intangible assets, including valuation methodology, estimates of future revenues and costs, profit allocation rates attributable to the acquired technology and discount rates; and • Deferred tax assets, including projections of future taxable income and tax rates. The valuation of contingent consideration in connection with an acquisition is inherently challenging due to dependence on the occurrence of future events and often complex payment provisions. Estimating the fair value of contingent consideration at an acquisition date and in subsequent periods involves significant judgments, including projecting future average selling prices, future sales volumes, manufacturing costs and gross margins. To project average selling prices and sales volumes, we review recent sales volumes, existing customer orders, current prices and other factors such as industry analyses of supply and demand, seasonal factors, general economic trends and other information. To project manufacturing costs, we must estimate future production levels and costs of production, including labor, materials and other overhead costs. Actual selling prices and sales volumes, as well as levels, and costs, of production, can often vary significantly from projected amounts. 48 Revenue Recognition Revenue is primarily recognized at a point in time when control of the promised goods or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. Contracts with our customers are generally short-term in duration at fixed, negotiated prices with payment generally due shortly after delivery. We estimate a liability for returns using the expected value method based on historical rates of return. In addition, we generally offer price protection to our distributors, which is a form of variable consideration that decreases the transaction price. We use the expected value method, based on historical price adjustments and current pricing trends, to estimate the amount of revenue recognized from sales to distributors. Differences between the estimated and actual amounts are recognized as adjustments to revenue. 49