Item 2. Management’s Discussion and Analysis
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.
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 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 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.
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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 .
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 business to date, this is our newest segment, and it 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
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adjacent businesses and grow our customer base and geographic footprint. From time to time, we may seek to expand our addressable market by entering new business segments where, as we did with our LED Business, 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, third-party wafers that we use in our memory and LED businesses and electronic components and accessories used in our IPS business. 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.
The outbreak of hostilities in Ukraine may exacerbate certain risks we face. Russia’s invasion of Ukraine and the global response, including the imposition of sanctions by the United States and other countries, could create or exacerbate risks facing our business. We have evaluated our operations, vendor contracts and customer arrangements, and at present we do not expect the outbreak to directly have a material and adverse effect on our financial condition or results of operations. However, if the hostilities persist, escalate or expand, our operating results and financial condition could be adversely affected. For example, if our supply or customer arrangements are disrupted due to expanded sanctions or involvement of countries where we have operations or relationships, our business could be materially disrupted. Further, the use of state-sponsored cyberattacks could expand as part of the conflict, which could adversely affect our ability to maintain or enhance our cyber security and data protection measures.
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Results of Operations
Three Months Ended Six Months Ended
February 25, 2022 February 26, 2021 February 25, 2022 February 26, 2021
Net sales:
Memory Solutions $ 260,081 57.9 % $ 218,597 71.9 % $ 499,482 54.3 % $ 444,421 74.6 %
Intelligent Platform Solutions 82,257 18.3 % 85,412 28.1 % 200,911 21.9 % 151,284 25.4 %
LED Solutions 106,833 23.8 % — — % 218,722 23.8 % — — %
Total net sales 449,171 100.0 % 304,009 100.0 % 919,115 100.0 % 595,705 100.0 %
Cost of sales 336,458 74.9 % 250,553 82.4 % 684,201 74.4 % 489,606 82.2 %
Gross profit 112,713 25.1 % 53,456 17.6 % 234,914 25.6 % 106,099 17.8 %
Operating expenses:
Research and development 18,794 4.2 % 8,852 2.9 % 36,451 4.0 % 15,816 2.7 %
Selling, general and administrative 53,114 11.8 % 31,664 10.4 % 105,664 11.5 % 69,720 11.7 %
Change in fair value of contingent consideration 24,000 5.3 % — — % 41,200 4.5 % — — %
Total operating expenses 95,908 21.4 % 40,516 13.3 % 183,315 19.9 % 85,536 14.4 %
Operating income 16,805 3.7 % 12,940 4.3 % 51,599 5.6 % 20,563 3.5 %
Non-operating (income) expense:
Interest expense, net 4,462 1.0 % 4,365 1.4 % 9,568 1.0 % 7,518 1.3 %
Other non-operating (income) expense 1,785 0.4 % 1,531 0.5 % 3,020 0.3 % 699 0.1 %
Total non-operating (income) expense 6,247 1.4 % 5,896 1.9 % 12,588 1.4 % 8,217 1.4 %
Income before taxes 10,558 2.4 % 7,044 2.3 % 39,011 4.2 % 12,346 2.1 %
Income tax provision 7,586 1.7 % 1,200 0.4 % 15,341 1.7 % 4,475 0.8 %
Net income 2,972 0.7 % 5,844 1.9 % 23,670 2.6 % 7,871 1.3 %
Net income attributable to noncontrolling interest 514 0.1 % — — % 1,185 0.1 % — — %
Net income attributable to SGH $ 2,458 0.5 % $ 5,844 1.9 % $ 22,485 2.4 % $ 7,871 1.3 %
Percentages represent percentage of total net sales. Summations pf percentages may not compute precisely due to rounding.
Net Sales, Cost of Sales and Gross Profit
Net sales increased by $145.2 million, or 47.7%, in the second quarter of 2022 compared to the same period in the prior year, and by $323.4 million, or 54.3%, for the first six months of 2022 compared to the same period in the prior year. These increases were primarily due to $106.8 million and $218.7 million of revenue in the second quarter and six months of 2022, respectively, from our acquisition of the LED Business, and to strong performance in our Memory Solutions and IPS businesses. Memory Solutions sales increased by $41.5 million, or 19.0%, in the second quarter of 2022 compared to the same period in the prior year, primarily due to increases in average selling prices for Brazil DRAM and Specialty DRAM products of 77.5% and 13.2%, respectively. Memory Solutions sales increased by $55.1 million, or 12.4%, for the first six months of 2022 compared to the same period in the prior year, primarily due to a 4.1% higher volume of DRAM products, a 52.8% increase in average selling prices for Brazil DRAM products and higher logistics sales. IPS net sales increased by $49.6 million, or 32.8%, in the first six months of 2022 primarily due to higher volumes of sales in our Penguin Computing business.
Cost of sales increased by $85.9 million, or 34.3%, in the second quarter of 2022 compared to the same period in the prior year, and by $194.6 million, or 39.7%, for the first six months of 2022 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 margin increased to 25.1% in the second quarter of 2022 compared to 17.6% in the same period in the prior year, and also increased to 25.6% in the first six months of 2022 compared to 17.8% in the first six months 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.
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Non-GAAP Measure of Segment Operating Income
Below is a table of our operating income, measured on a non-GAAP basis, which SGH management uses to supplement SGH's financial results under GAAP to analyze its operations and make decisions as to future operational plans, and believes that this supplemental non-GAAP information is useful to investors in analyzing and assessing the Company's past and future operating performance. These non-GAAP measures exclude certain items, such as share-based compensation expense, amortization of acquisition-related intangible assets (consisting of amortization of developed technology, customer relationships, trademarks/trade names and backlog acquired in connection with business combinations), acquisition-related inventory adjustments, acquisition-related expenses, restructure charges and integration expenses, changes in the fair value of contingent consideration, and other infrequent or unusual items. While amortization of acquisition-related intangible assets is excluded, the revenues from acquired companies is reflected in our non-GAAP measures and these intangible assets contribute to revenue generation. See “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Segment and Other Information.”
Non-GAAP financial measures should not be considered as a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP, as they exclude important information about our financial results, as noted above. The presentation of these adjusted amounts varies from amounts presented in accordance with GAAP and therefore may not be comparable to amounts reported by other companies.
Three Months Ended Six Months Ended
February 25,
2022 February 26,
2021 February 25,
2022 February 26,
2021
GAAP operating income $ 16,805 $ 12,940 $ 51,599 $ 20,563
Share-based compensation expense 9,973 5,398 19,748 16,486
Amortization of acquisition-related intangibles 5,829 3,413 12,172 6,827
Change in fair value of contingent consideration 24,000 — 41,200 —
Out of period import tax expense — 4,345 — 4,345
Other 828 1,064 1,866 2,681
Non-GAAP operating income $ 57,435 $ 27,160 $ 126,585 $ 50,902
Non-GAAP operating income by segment:
Memory Solutions $ 32,496 $ 18,238 $ 69,166 $ 39,099
Intelligent Platform Solutions 7,702 8,922 21,882 11,803
LED Solutions 17,237 — 35,537 —
Total non-GAAP operating income by segment $ 57,435 $ 27,160 $ 126,585 $ 50,902
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, were 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 $14.3 million, or 78.2%, in the second quarter of 2022 compared to the same period in the prior year, and by $30.1 million, or 76.9%, in the first six months 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 $10.1 million, or 85.4%, in the first six months 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 $35.5 million in the first six months of 2022 was due to our acquisition of the LED Business in March 2021.
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Operating and Non-operating (Income) Expense
Research and Development
Research and development expense increased by $9.9 million, or 112.3%, in the second quarter of 2022 compared to the same period in the prior year, and by $20.6 million, or 130.5%, for the first six months 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 be higher in 2022 as compared to 2021 primarily because we will include the full year of operations for our LED Solutions segment. In addition, we expect to have lower Brazil financial credits in future periods resulting from a shift in sales mix to products sourced from our new Manaus, Brazil facility.
Selling, General and Administrative
Selling, general and administrative expense increased by $21.5 million, or 67.7%, in the second quarter of 2022 compared to the same period in the prior year, and by $35.9 million, or 51.6%, in the first six months 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-related expenses due to increased headcount and higher professional services. We expect selling, general and administrative expense to be higher in 2022 as compared to 2021 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. In 2021, and in the first and second quarters of 2022, we recorded charges of $32.4 million, $17.2 million and $24.0 million, respectively, to adjust the amount of contingent consideration to its fair value. See “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Business Acquisition – LED Business.”
Interest Expense, Net
Interest expense, net increased by $2.1 million in the first six months of 2022 compared to the same period in the prior year primarily due to interest incurred related to the LED Purchase Price Note from the LED acquisition.
In February 2022, we entered into a Credit Facility with a syndicate of banks pursuant to which we borrowed $275 million under a term loan, which matures in February 2027. In connection therewith, we repaid the $125 million outstanding balance of the LED Purchase Price Note and the outstanding balance under our previous line of credit. In addition, the LED Earnout Note will begin to bear interest in the third quarter of 2022. As a result of these items, we expect net interest expense to increase in future periods. See “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Business Acquisition” and “PART I. Financial Information – Item 1. Financial Statements – Notes to Consolidated Financial Statements – Debt.”
Other Non-operating (Income) Expense
Other non-operating (income) expense in the second quarter and first six months of both 2022 and 2021 primarily reflected foreign currency (gains) and losses related primarily to our Brazil operating subsidiaries.
Income Tax Provision
Our provision for income taxes increased by $10.9 million in the first six months 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 February 25, 2022, we had cash and cash equivalents of $365.8 million, of which $187.9 million was held outside of the United States. Our principal uses of cash and capital resources have been acquisitions, debt service requirements, 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.
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We expect that our existing cash and cash equivalents, borrowings available under our credit facility 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.
On February 7, 2022, we entered into a Credit Facility with a syndicate of banks that provides for (i) a term loan credit facility in an aggregate principal amount of $275.0 million (the "2027 TLA") and (ii) a revolving credit facility in an aggregate principal amount of $250.0 million (the "2027 Revolver"), in each case, maturing on February 7, 2027 (subject to certain earlier “springing maturity” dates upon certain conditions specified in the Credit Agreement). The Credit Agreement provides that up to $35.0 million of the revolving credit facility is available for issuances of letters of credit.
In February 2020, we issued $250.0 million in aggregate principal amount of 2.25% convertible senior notes due 2026 (the “2026 Notes”). The conversion rate of the 2026 Notes is 49.2504 ordinary shares per $1,000 principal amount of notes, which represents a conversion price of approximately $20.30 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 February 25, 2022. As a result, the 2026 Notes are convertible by holders through May 27, 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.”
Cash Flows
Six Months Ended February 25,
2022 February 26,
2021
Net cash provided by operating activities $ 47,311 $ 55,990
Net cash used for investing activities (20,834) (34,628)
Net cash provided by (used for) financing activities 117,726 (30,874)
Effect of changes in currency exchange rates (1,421) (1,496)
Net increase (decrease) in cash and cash equivalents $ 142,782 $ (11,008)
Operating Activities : Cash flows from operating activities reflects net income adjusted for certain 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 the effects of changes in operating assets and liabilities.
Net cash provided by operating activities in the first six months of 2022 was $47.3 million, comprised primarily of net income of $23.7 million, adjusted for non-cash items of $104.2 million. Operating cash flows were adversely affected by $80.6 million from changes in our net operating assets and liabilities, consisting primarily of an increase of $75.6 million in accounts receivable and a decrease of $31.6 million in accounts payable and accrued expenses, partially offset by a decrease of $26.4 million in inventories. The decrease in both inventories and accounts payable and accrued expenses was primarily due to lower inventories primarily in our Memory Solutions segment, 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 first six months of 2021 was $56.0 million, comprised primarily of net income of $7.9 million, adjusted for non-cash items of $41.8 million. Operating cash flows were also favorably affected by $6.3 million from changes in our net operating assets and liabilities, consisting primarily of a $45.9 million increase in accounts payable and accrued expenses and a $10.1 million decrease in accounts receivables, partially offset by increases of $28.1 million in inventories and $19.1 million in other assets.
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Investing Activities : Net cash used for investing activities in the first six months of 2022 was $20.8 million, consisting primarily of purchases of property and equipment. Net cash used for investing activities in the first six months of 2021 was $34.6 million, consisting primarily of purchases of property and equipment and deposits.
Financing Activities : Net cash provided by financing activities in the first six months of 2022 was $117.7 million, consisting primarily of $270.8 million in net proceeds from issuance of a term loan and $7.5 million in proceeds from the issuance of ordinary shares from our equity plans, partially offset by $125.0 million in principal repayment of the LED Purchase Price Note and $25.0 million in net repayments of borrowings under our line of credit. Net cash used for financing activities in the first six months of 2021 was $30.9 million, consisting primarily of $48.0 million for the repurchase of ordinary shares, partially offset by $11.4 million in proceeds from debt and $5.7 million in proceeds from the 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 these estimates and judgments 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.
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