Penguin Solutions, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended August 27, 2021. 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.” Our fiscal year is the 52 or 53-week period ending on the last Friday in August. Fiscal 2022 and 2021 each contain 52 weeks. All period references are to our fiscal periods unless otherwise indicated. All financial information for our subsidiaries in Brazil is included in our consolidated financial statements on a one-month lag because their fiscal years end on July 31 of each year. All tabular dollar amounts are in millions, except per share amounts. Overview Since our inception over 30 years ago, SGH has grown into a diversified group of businesses focused on the design and manufacture of specialty solutions for the computing, memory and LED markets. Our success is based on a customer-focused approach characterized by a commitment to quality, advanced technical expertise, quick time-to-market, build-to-order flexibility and excellence in customer service. At SGH, we strive to achieve long-term growth by investing in our people, innovation, processes and new opportunities. Since the beginning of fiscal 2018, we have accelerated our growth through the completion of five acquisitions. With our most recent acquisition of the LED Business in 2021, we have organized the Company into three lines of business: Memory Solutions, Intelligent Platform Solutions (“IPS”) and LED Solutions. In addition to driving growth organically and through acquisitions, we use the SGH operating system to support and drive operational efficiency and performance. Our employees have always played a key role in our success. Today, SGH employs a diverse workforce of approximately 3,900 employees around the world who are focused on innovation and customer satisfaction. Acquisition of LED Business In March 2021, we completed the acquisition of the LED business (“LED Business”) of Cree, Inc., a corporation now known as Wolfspeed, Inc. (“Cree”). The acquisition of the LED Business, a leader in LED lighting technology, further enhances our growth and diversification strategy and fits well with our other specialty businesses in computing and memory. The purchase price for the LED Business consisted of cash payments of $72.4 million, the issuance of an unsecured promissory note issued in the amount of $125 million and the potential for Cree to receive an earn-out payment of up to $125 million based on the revenue and gross profit performance of the LED Business in the twelve-month period ended in March 2022. 23 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 significant disruptions of our operations as a result of the COVID-19 pandemic, the pandemic resulted in reduced sales volumes of certain product lines since early calendar 2020. COVID-19 also disrupted our product development, marketing and corporate development activities, and has more recently affected our supply chain. 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, sales volumes may be negatively impacted 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. Factors Affecting Our Operating Performance Our operating expenses have grown in recent periods as we drive innovation, expand our products and services portfolio and invest in greater operational capabilities to support our growth. Our total operating expenses grew in 2021, primarily as a result of the addition of the LED Solutions business. We expect to continue to see increased operating expenses in 2022 as we record a full year of operating expenses for the LED Solutions business, continue to increase our investment in new products and services for the IPS business and potentially experience the phase-out of certain Brazil financial tax credits, which would result in an increase in operating expense in Memory Solutions. Macro-economic Demand Factors. Our business segments each have their own unique set of demand factors. Demand in our Memory Solutions group is driven by end-market demand from OEMs for customer-specific solutions in vertical markets such as industrial, government, networking, high-performance compute and enterprise storage, as well as from OEMs for memory modules used in desktop and notebook computers, smartphones, IoT and SSD products in Brazil. In addition, macro-economic factors specific to the Brazil economy affect this segment, given our sales and operations in that market. Our IPS business is driven by demand for high compute solutions across AI and machine learning initiatives, as well as traditional workload optimization and efficiency applications. Finally, demand for our LED products is derived from targeted end-market applications, such as general high-power and mid-power lighting and specialty lighting, such as video and horticulture applications. We believe our diversified business segments may provide a natural hedge against downturns in any particular industry although broader macro-economic trends, such as the COVID-19 pandemic, can adversely affect all three segments concurrently. Shifts in the Mix of Our Revenue. Shifts in the mix of revenue from our operating segments, which can vary significantly from period to period, can impact our business and operating results, including gross and operating margins. For example, our Memory Solutions group, while not party to long-term fixed purchasing commitments, has nonetheless historically seen relatively stable demand and margins. By contrast, our IPS group has shown solid growth, but is subject to greater variability in its sales and margin profile from period to period, as recognition of revenue is tied to customer decisions as to the completion of delivery and system go-live events, and margin is driven by the extent to which higher margin software and managed services comprise IPS sales. In addition, while we have experienced favorable demand and overall margin uplift compared to the rest of our businesses from our LED Solutions group to date, this group is the newest segment of our business, and we may be subject to unforeseen changes in its business and operating results. Our resource commitments and planning for each segment are relatively fixed in the short term and, as such, variability in expected revenue mix will have direct implications for our operating income and margins. Our Ability to Identify, Complete and Successfully Integrate Acquisitions. A substantial portion of our growth over the last several years has been driven by acquisitions, and we intend to continue to use corporate development as an engine for growth. Within our existing segments, we plan to pursue acquisitions to expand features and functionality, expand into adjacent businesses and grow our customer base and geographic footprint. From time to time, we may seek to expand our addressable market by 24 entering new business segments where, as we did with our LED B usiness, we identify a business opportunity at scale with a path to being accretive to our overall operations in the near term. If we are unable to identify and complete attractive acquisitions, we may not be successful in growing our revenue and/or expanding our margins. Any acquisitions we do complete may require us to raise debt or equity financing or may subject us to unforeseen liabilities or operational challenges that in turn impede our ability to realize the expected returns on our investment. Disruptions in Our Supply Chain May Adversely Affect Our Businesses. We depend on third-party suppliers for key components of our products, such as commodity DRAM components from offshore foundries that we use in our specialty memory products and third-party wafers that we use in our memory and LED businesses. We have adopted this “fab-lite” business model to reduce our capital expenditures and operating expenses, while affording greater flexibility in adapting to shifts in demand and other market trends. In recent periods, our fab-lite business model has contributed significantly to margin expansion in our overall business. However, our reliance on third-party manufacturers exposes us to risk of supply chain disruption and lost business. For example, the current global semiconductor shortage has adversely affected our operating results. If such disruptions worsen or are prolonged, or if there is meaningful disruption in our supply arrangement with any of our third-party suppliers, our operating results and financial condition could be adversely affected. Results of Operations Three months ended November 26, 2021 % of net sales (1) November 27, 2020 % of net sales (1) Net sales: Memory Solutions $ 239,401 50.9 % $ 225,823 77.4 % Intelligent Platform Solutions 118,654 25.2 % 65,874 22.6 % LED Solutions 111,889 23.8 % — — Total net sales 469,944 100.0 % 291,697 100.0 % Cost of sales 347,743 74.0 % 239,053 82.0 % Gross profit 122,201 26.0 % 52,644 18.0 % Operating expenses: Research and development 17,657 3.8 % 6,964 2.4 % Selling, general and administrative 52,550 11.2 % 38,056 13.0 % Change in fair value of contingent consideration 17,200 3.7 % — — Total operating expenses 87,407 18.6 % 45,020 15.4 % Operating income 34,794 7.4 % 7,624 2.6 % Non-operating (income) expense: Interest expense, net 5,106 1.1 % 3,154 1.1 % Other non-operating (income) expense 1,235 0.3 % (832 ) (0.3 )% Total non-operating (income) expense 6,341 1.3 % 2,322 0.8 % Income before taxes 28,453 6.1 % 5,302 1.8 % Income tax provision 7,755 1.7 % 3,275 1.1 % Net income 20,698 4.4 % 2,027 0.7 % Net income attributable to noncontrolling interest 671 0.1 % — — Net income attributable to SGH $ 20,027 4.3 % $ 2,027 0.7 % (1) Summations of percentages may not compute precisely due to rounding. Net Sales, Cost of Sales and Gross Profit Net sales increased by $178.2 million, or 61.1 %, in the first quarter of 2022 compared to same period in the prior year, primarily due to $111.9 million of revenue in the first quarter of 2022 from our recent acquisition of the LED Business and to strong performance in our IPS and Memory Solutions businesses. IPS net sales increased by $52.8 million, or 80.1%, primarily due to higher volumes of sales in our Penguin Computing business. Memory Solutions sales increased by $13.6 million, or 6.0%, primarily due to a 13.5% higher volume of DRAM products and a 34.0% increase in average selling prices for Brazil DRAM products. 25 Cost of sales increased by $108.7 million, or 45.5%, in the first quarter of 202 2 compared to the same period in the prior year , primarily due to our acquisition of the LED Business and from higher cost of materials and production costs due to a higher level of sales for our IPS and Memory Solutions segments . Gross profit margin increased to 26.0% in the first quarter of 2022 compared to 18.0% in the first quarter of 2021 primarily due to inclusion of higher margin LED Solutions products in 2022 as well as process and efficiency improvement in the Memory Solutions and IPS segments compared to the prior year. Segment Operating Income Three months ended November 26, 2021 November 27, 2020 Segment operating income: (1) Memory Solutions $ 36,670 15.3 % $ 20,861 9.2 % Intelligent Platform Solutions 14,180 12.0 % 2,881 4.4 % LED Solutions 18,300 16.4 % — — Total segment operating income 69,150 14.7 % 23,742 8.1 % Unallocated: Share-based compensation expense (9,775 ) (11,088 ) Amortization of acquisition-related intangibles (6,343 ) (3,413 ) Change in fair value of contingent consideration (17,200 ) — Other (1,038 ) (1,617 ) Total unallocated (34,356 ) (16,118 ) Consolidated operating income $ 34,794 $ 7,624 (1) Percentages represent segment operating income as a percentage of segment net sales. In the fourth quarter of 2021, we reorganized SGH into three business units: Memory Solutions, Intelligent Platforms Solutions and LED Solutions. Two of our previous segments, specialty memory products and Brazil products, have been combined to become Memory Solutions. Intelligent Platform Solutions was formerly referred to as specialty compute and storage solutions. All prior year information in the table above has been revised to reflect the change to our three reportable segments. Memory Solutions operating income increased by $15.8 million, or 75.8%, in the first quarter of 2022 compared to the same period in the prior year, primarily due to higher sales and gross profit, partially offset by higher operating expenses mainly driven by higher research and development expense due to less Brazil financial credits. IPS operating income increased by $11.3 million, or 392.2%, in the first quarter of 2022 compared to same period in the prior year, primarily due to higher sales and gross profit, partially offset by higher operating expenses mainly driven by personnel-related expenses due to increased headcount to support the revenue growth. LED Solutions operating income of $18.3 million in the first quarter of 2022 was due to our acquisition of the LED Business in March 2021. Operating and Non-operating (Income) Expense Research and Development Research and development expense increased by $10.7 million, or 153.5%, in the first quarter of 2022 compared to the same period in the prior year, primarily due to additional costs from the acquisition of the LED Business as well as lower Brazil financial credits. We expect research and development expense to increase in absolute dollars in 2022 as compared to 2021 primarily because we will include the full year of operations for our LED Solutions segment and may include the effects of the termination of certain Brazil financial credits, currently scheduled to occur in January 2022. Selling, General and Administrative Selling, general and administrative expense increased by $14.5 million, or 38.1%, in the first quarter of 2022 compared to the same period in the prior year, primarily due to additional costs from the acquisition of the LED Business as well as higher personnel- 26 related expenses due to increased headcount , professional services and acquisition expenses associated with the acquisition. We expect selling, general and administrative expense to increase in absolute dollars in 2022 as we include the full year of operations for our LED Solutions segment. Change in Fair Value of Contingent Consideration Our acquisition of the LED Business included contingent consideration, which we estimated the fair value as of the date of acquisition to be $28.1 million. During the first quarter of 2022, we recorded a charge of $17.2 million to adjust the amount of contingent consideration to its fair value as of November 26, 2021. See “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Business Acquisition – LED Business.” Other Non-operating (Income) Expense Other non-operating (income) expense in the first quarters of 2022 and 2021 primarily reflected foreign currency (gains) and losses relate primarily to our Brazil operating subsidiaries, as well as higher interest expense mainly due to the seller note from the LED acquisition. Income Tax Provision Our provision for income taxes increased by $4.5 million in the first quarter of 2022 compared to the same period in the prior year, primarily due to higher income in non-U.S. jurisdictions subject to tax. Liquidity and Capital Resources At November 26, 2021, we had cash and cash equivalents of $233.1 million, of which $181.3 million was held outside of the United States. Our principal uses of cash and capital resources have been acquisitions, debt service requirements as described below, capital expenditures, research and development expenditures and working capital requirements. We expect that future capital expenditures will focus on expanding capacity of our operations, expanding our research and development 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. We expect that our existing cash and cash equivalents, borrowings available under our credit facilities and cash generated by operating activities will be sufficient to fund our operations for at least the next twelve months. We may from time to time seek additional equity or debt financing. Any future equity financing may be dilutive to our existing investors, and any future debt financing may include debt service requirements and financial and other restrictive covenants that may constrain our operations and growth strategies. In the event that we seek additional financing, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations and invest in continued product innovation, we may not be able to compete successfully, which would harm our business, operations and financial condition. In February 2020, we issued $250.0 million in aggregate principal amount of 2.25% convertible senior notes due 2026 (the “2026 Notes”). The initial conversion rate of the 2026 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 closing price of our ordinary shares exceeded 130% of the conversion price for our 2026 Notes for at least 20 trading days in the 30 consecutive trading days ended on November 26, 2021. As a result, the 2026 Notes are convertible by holders through February 25, 2022. For information regarding our debt obligations, see “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Debt.” For our operating lease obligations, see “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Leases.” For our purchase obligations, see “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Commitments and Contingencies.” 27 Cash Flows Three months ended November 26, 2021 November 27, 2020 Net cash provided by operating activities $ 15,146 $ 35,569 Net cash used for investing activities (13,377 ) (14,628 ) Net cash provided by (used for) financing activities 12,363 (378 ) Effect of changes in currency exchange rates (4,068 ) (7,277 ) Net increase in cash and cash equivalents $ 10,064 $ 13,286 Operating Activities : Cash flows from operating activities reflects net income adjusted for certain non-cash items, including depreciation and amortization expense, share-based compensation, adjustments for changes in the fair value of contingent consideration, gains and losses from investing or financing activities and from the effects of changes in operating assets and liabilities. Net cash provided by operating activities in the three months ended November 26, 2021 was $15.1 million, comprised primarily of net income of $20.7 million, adjusted for non-cash items of $47.5 million. Operating cash flows were also affected by a $53.1 million decrease in our net operating assets and liabilities, consisting primarily of an increase of $36.1 million in accounts receivable and a decrease of $53.8 million in accounts payable and accrued expenses, offset by a decrease of $39.6 million in inventories. The decrease in both inventories and accounts payable and accrued expenses was primarily due to lower inventory primarily in our Memory Solutions and IPS segments, and the increase in accounts receivable was primarily due to higher gross sales in the same segments. Net cash provided by operating activities in the three months ended November 27, 2020 was $35.6 million, comprised primarily of net income of $2.0 million, adjusted for non-cash items of $23.3 million. Operating cash flows were also affected by a $10.3 million increase in our net operating assets and liabilities, consisting primarily of a decrease of $12.9 million in inventories and an increase of $10.1 million in accounts payable and accrued expenses, partially offset by an increase of $9.3 million in other current assets. Investing Activities : Net cash used in investing activities in the first quarter of 2022 was $13.4 million, consisting primarily of purchases of property and equipment. Net cash used in investing activities during the three months ended November 27, 2020 was $14.6 million consisting primarily of purchases of property and equipment and deposits. Financing Activities : Net cash provided by financing activities in the first quarter of 2022 was $12.4 million, consisting primarily of $10.0 million in net proceeds from borrowing under our line of credit, $5.0 million in proceeds from issuance of ordinary shares from our equity plans, partially offset by $2.7 million for the repurchase of ordinary shares. Net cash used for financing activities in the first quarter of 2021 was $0.4 million, consisting primarily of $3.5 million for the repurchase of ordinary shares, partially offset by $3.1 million in proceeds from issuance of ordinary shares from our equity plans. Critical Accounting Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Estimates and judgments are based on historical experience, forecasted events and various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and judgments on an ongoing basis. Our management believes the accounting policies below are critical in the portrayal of our financial condition and results of operations and require management’s most difficult, subjective or complex judgments. There have been no material changes to our critical accounting estimates from those described in “PART II. Other Information – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Estimates” in our Annual Report on Form 10-K for the year ended August 27, 2021. 28