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 consolidated financial statements and accompanying notes for the year ended August 26, 2022. 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, 2021 and 2020 each contained 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 amounts are in thousands.
Overview
For an overview of our business, including a discussion of our acquisition of our LED Solutions business from Cree and effects on us of COVID-19, see “PART I – Item 1. Business – Overview.”
As a result of our recent acquisitions and heightened focus on operational excellence over the past several years, we grew our net sales by 21% to $1.8 billion in 2022 compared to $1.5 billion in 2021. Over the same period, our consolidated GAAP operating income was $114.5 million, $55.2 million and $41.3 million for 2022, 2021 and 2020, respectively. Our total non-GAAP segment operating income grew by 41.6% to $227.6 million, or 12.5% operating margin, in 2022, compared to $160.8 million, or 10.7% operating margin, in 2021. See “Non-GAAP Measures of Segment Operating Income” below for further details.
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 2022, primarily as a result of a full year of operating expenses for the LED Solutions business. We expect to continue to see increased operating expenses in 2023 as we record operating expenses for our Stratus acquisition and continue to increase our investment in new products and services for the IPS business.
Acquisition of Stratus Technologies
Subsequent to our fiscal year 2022, on August 29, 2022, we completed the acquisition of Storm Private Holdings I Ltd., a Cayman Islands exempted company (“Stratus Holding Company” and together with its subsidiaries, “Stratus Technologies”). At the closing, SGH paid a cash purchase price of $225 million, subject to certain adjustments. In addition, the seller has the right to receive, and SGH will be obligated to pay, contingent consideration (if any) of up to $50 million (the “Earn-Out”) based on the gross profit performance of the Stratus business during the first full 12 fiscal months of Stratus following the closing. The Earn-Out, if any, will be payable in cash, ordinary shares of SGH, or a mix of cash and SGH Shares, at SGH’s election.
Stratus is a global leader in simplified, protected, and autonomous computing platforms and services in the data center and at the Edge. For more than 40 years, Stratus has provided high-availability, fault-tolerant computing to Fortune 500 companies and small-to-medium sized businesses enabling them to securely and remotely run critical applications with minimal downtime.
Factors Affecting Our Operating Performance
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
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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 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 and third-party wafers that we use in our memory and LED businesses. We have adopted this “Fab-Light” 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-Light 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.
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Results of Operations
Year ended August 26,
2022 % of net
sales (1)
August 27,
2021 % of net
sales (1)
August 28,
2020 % of net
sales (1)
Net sales:
Memory Solutions $ 975,181 53.6 % $ 931,818 62.1 % $ 857,237 76.4 %
Intelligent Platform Solutions 440,986 24.2 % 344,757 23.0 % 265,140 23.6 %
LED Solutions 403,185 22.2 % 224,567 15.0 % — — %
Total net sales 1,819,352 100.0 % 1,501,142 100.0 % 1,122,377 100.0 %
Cost of sales 1,366,132 75.1 % 1,192,762 79.5 % 905,981 80.7 %
Gross profit 453,220 24.9 % 308,380 20.5 % 216,396 19.3 %
Operating expenses:
Research and development 77,356 4.3 % 49,274 3.3 % 52,056 4.6 %
Selling, general and administrative 220,031 12.1 % 171,509 11.4 % 123,010 11.0 %
Change in fair value of contingent consideration 41,324 2.3 % 32,400 2.2 % — — %
Total operating expenses 338,711 18.6 % 253,183 16.9 % 175,066 15.6 %
Operating income 114,509 6.3 % 55,197 3.7 % 41,330 3.7 %
Non-operating (income) expense:
Interest expense, net 21,169 1.2 % 17,600 1.2 % 15,000 1.3 %
Other non-operating (income) expense 4,837 0.3 % (375) — % 16,970 1.5 %
Total non-operating (income) expense 26,006 1.4 % 17,225 1.1 % 31,970 2.8 %
Income before taxes 88,503 4.9 % 37,972 2.5 % 9,360 0.8 %
Income tax provision 19,911 1.1 % 15,466 1.0 % 10,503 0.9 %
Net income (loss) 68,592 3.8 % 22,506 1.5 % (1,143) (0.1) %
Net income attributable to noncontrolling interest 2,035 0.1 % 1,196 0.1 % — — %
Net income (loss) attributable to SGH $ 66,557 3.7 % $ 21,310 1.4 % $ (1,143) (0.1) %
(1) Summations of percentages may not compute precisely due to rounding.
Net Sales, Cost of Sales and Gross Profit
Net sales increased by $318.2 million, or 21.2%, in 2022 compared to the prior year, due to an increase of $178.6 million of revenue from our recent acquisition of the LED Business in March 2021 and to strong performance in our IPS and Memory Solutions businesses. IPS net sales increased by $96.2 million, or 27.9%, primarily due to higher volumes of sales in our Penguin Computing business. Memory Solutions sales increased by $43.4 million, or 4.7%, primarily due to a 12.2% higher volume of Specialty DRAM products, partially offset by a 34.5% lower volume of mobile memory.
Net sales increased by $378.8 million, or 33.7%, in 2021 compared to the prior year, due to $224.6 million of revenue from our recent acquisition of the LED Business in March 2021 and to strong performance in our IPS and Memory Solutions businesses. IPS net sales increased by $79.6 million, or 30.0%, primarily due to higher volumes of sales in our Penguin Computing business. Memory Solutions sales increased by $74.6 million, or 8.7%, primarily due to a 24.7% higher volume of DRAM products and a 39.1% increase in average selling prices for mobile memory.
Cost of sales increased by $173.4 million, or 14.5%, in 2022, and by $286.8 million, or 31.7%, in 2021 compared to the prior respective years, primarily due to our acquisition of the LED Business and from higher costs of materials and production costs due to higher sales for our Memory Solutions and IPS segments.
Gross margin increased to 24.9% in 2022 compared to 20.5% in 2021 primarily due to inclusion of higher margin LED Solutions products, as well as process and efficiency improvement in the Memory Solutions and IPS segments compared to the prior year. Gross margin increased to 20.5% in 2021, compared to 19.3% in 2020 primarily due to the inclusion of higher margin LED Solutions products in the second half of the 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 II – Item 8. Financial Statements and Supplementary Data – 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.
Year ended August 26, 2022 August 27, 2021 August 28, 2020
GAAP operating income $ 114,509 $ 55,197 $ 41,330
Share-based compensation expense 40,119 33,877 18,716
Amortization of acquisition-related intangibles 23,729 20,255 13,654
Flow-through of inventory step up — 7,090 —
Out of period import tax expense — 4,345 —
Acquisition and integration expenses 7,090 5,314 5,532
Change in fair value of contingent consideration 41,324 32,400 —
Other 858 2,316 4,997
Non-GAAP operating income $ 227,629 $ 160,794 $ 84,229
Non-GAAP operating income by segment:
Memory Solutions $ 119,849 $ 91,737 $ 71,867
Intelligent Platform Solutions 54,019 32,931 12,362
LED Solutions 53,761 36,126 —
Total non-GAAP operating income by segment $ 227,629 $ 160,794 $ 84,229
Memory Solutions operating income increased by $28.1 million, or 30.6%, in 2022 compared to the prior year primarily due to higher sales, partially offset by an increase of $16.4 million in operating expenses, mainly driven by higher research and development expense due to lower Brazil financial credits. Memory Solutions operating income increased by $19.9 million, or 27.6%, in 2021 compared to the prior year primarily due to higher sales, as well as a decrease of $10.8 million in operating expenses mainly driven by lower research and development expense due to higher Brazil financial credits.
IPS operating income increased by $21.1 million, or 64.0%, in 2022 compared to the prior year primarily due to higher sales, partially offset by $6.7 million higher operating expenses mainly driven by personnel-related expenses due to increased headcount to support the revenue growth. IPS operating income increased by $20.6 million, or 166.4%, in 2021 compared to the prior year primarily due to higher sales, partially offset by $4.4 million higher operating expenses mainly driven by personnel-related expenses due to increased headcount to support the revenue growth.
LED Solutions operating income increased by $17.6 million, or 48.8%, in 2022 compared to the prior year as 2022 included a full year of operations compared to half a year in 2021. LED Solutions operating income of $36.1 million in 2021 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 $28.1 million, or 57.0%, in 2022 compared to the prior year, primarily due to $17.0 million additional costs from the acquisition of the LED Business, as well as a decrease of $12.8 million in the Brazil financial credits that are reflected as a reduction of research and development expenses. The credits result from amendments to the IT law implemented in April 2020. We expect research and development expense to increase in absolute dollars in 2023 as we include the operations for our Stratus acquisition and lower Brazil financial credits.
Research and development expense decreased by $2.8 million, or 5.3%, in 2021 compared to the prior year, primarily due to an increase of $23.6 million in the Brazil financial credits in 2021, which are reflected as a reduction of research and development expenses. The credits result from amendments to the IT law implemented in April 2020. The increase in credits is partially offset by $16.0 million additional costs from the acquisition of the LED Business as well as higher personnel-related expenses and depreciation.
Selling, General and Administrative
Selling, general and administrative expense increased by $48.5 million, or 28.3%, in 2022 compared to the prior year, primarily due to $26.0 million of additional costs from the acquisition of the LED Business as well as higher personnel-related expenses, professional services and acquisition expenses associated with the acquisition. We expect selling, general and administrative expense to increase in absolute dollars in 2023 as we include the operations for our Stratus acquisition.
Selling, general and administrative expense increased by $48.5 million, or 39.4%, in 2021 compared to the prior year, primarily due to $21.5 million of additional costs from the acquisition of the LED Business as well as $14.1 million of higher share-based compensation expense, personnel-related expenses, professional services and acquisition expenses associated with the acquisition.
Change in Fair Value of Contingent Consideration
Our acquisition of the LED Business included contingent consideration, for which we estimated the fair value as of the date of acquisition to be $28.1 million. During 2022 and the second half of 2021, we recorded charges of $41.3 million and $32.4 million, respectively, to adjust the value. The changes in fair value reflected new information about the probability and timing of meeting the conditions of the revenue and gross profit targets of the LED Business. Based on the revenue and gross profit performance of the LED Business in Cree’s first four full fiscal quarters following the closing, the final calculated value of the contingent consideration was $101.8 million. See further information in “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Business Acquisition – LED Business.”
Other Non-operating (Income) Expense
Other non-operating (income) and expense primarily reflected gains and losses from changes in currency exchange rates, a loss in 2020 from the remeasurement of our Capped Calls and losses in 2020 from the extinguishment of debt. See “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Other Non-operating (Income) Expense.”
Income Tax Provision
Our provision for income taxes increased by $4.4 million in 2022, or 28.7%, compared to the prior year primarily due to higher income in non-U.S. jurisdictions subject to tax, including foreign withholding taxes. Our provision for income taxes increased by $5.0 million in 2021, or 47.3%, compared to the prior year primarily due to higher income in non-U.S. jurisdictions subject to tax.
Effective February 2011, SMART Brazil began to participate in PADIS. This program is specifically designed to promote the development of the local semiconductor industry. The Brazilian government has approved multiple applications for different products by SMART Brazil for certain beneficial tax treatment under the PADIS incentive. This beneficial tax treatment includes a reduction in the Brazil statutory income tax rate from 34% to 9% on taxable income for the Brazilian semiconductor operations of SMART Brazil. We have operations in Malaysia, where we have tax incentive arrangements for our pioneer status activities and our global supply chain business. The statutory tax rate for Malaysia is 24%. These Malaysia arrangements are scheduled to expire in August 2028 and are subject to certain conditions, for which we have complied in 2022, 2021 and 2020. In general, these future tax holidays will have tax rates greater than our prior approved tax holidays,
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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 “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Income Taxes.”
Liquidity and Capital Resources
At August 26, 2022, we had cash and cash equivalents of $363.1 million, of which $188.8 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.
Credit Facility
In February 2022, we entered into a credit agreement (the “Credit Agreement”) 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,” and together with the 2027 TLA, the “Credit Facility”), in each case, maturing in February 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 2027 Revolver is available for issuances of letters of credit. See “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Debt.”
On August 29, 2022, we entered into an incremental Amendment to the Credit Agreement that provides for incremental term loans in an aggregate amount of $300 million, on the same terms as the 2027 TLA and also maturing in February 2027 (together with the Credit Facility, the “Amended Credit Facility”). With the funds from the Amended Credit Facility, we paid a cash purchase price of $225 million for the Stratus acquisition and also repaid in full the $101.8 million outstanding under the Earnout Note. For more information, see “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Subsequent Events.”
Contractual Obligations
For information regarding our debt obligations, see “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Debt.” For our operating lease obligations, see “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Leases.” For our purchase obligations, see “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Commitments and Contingencies.”
Cash Flows
Year ended August 26,
2022 August 27,
2021 August 28,
2020
Net cash provided by operating activities $ 104,931 $ 153,350 $ 87,205
Net cash used for investing activities (38,970) (84,178) (32,041)
Net cash provided by financing activities 73,879 2,849 12,594
Effect of changes in currency exchange rates 239 154 (15,086)
Net increase in cash and cash equivalents $ 140,079 $ 72,175 $ 52,672
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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 2022 was $104.9 million, comprised primarily of net income of $68.6 million, adjusted for non-cash items of $158.0 million. Operating cash flows were also adversely affected by a $121.6 million net increase in our operating assets and liabilities, consisting primarily of an increase of $97.5 million in accounts receivable and a decrease of $61.7 million in accounts payable and accrued expenses and other liabilities, partially offset by a decrease of $39.7 million in inventories. The increase in accounts receivable was primarily due to higher gross sales in our Memory Solutions and IPS businesses. The decreases in both accounts payable and accrued expenses and inventories were primarily due to lower inventories in our Memory Solutions and IPS businesses.
Net cash provided by operating activities in 2021 was $153.4 million, resulting primarily from net income of $22.5 million, adjusted for non-cash items of $125.0 million. Operating cash flows also benefited from a $5.8 million net change in our operating assets and liabilities, consisting primarily of an increase of $208.1 million in accounts payable and accrued expenses and other liabilities, partially offset by increases of $137.9 million in inventories and $51.4 million in accounts receivable. The increases in accounts payable and accrued expenses and in inventories were primarily due to higher inventories among all business areas. The increase in accounts receivable was primarily due to higher gross sales primarily in our Memory Solutions and IPS segments.
Net cash provided by operating activities in 2020 was $87.2 million, comprised of a net loss of $1.1 million, adjusted for non-cash items of $78.0 million. Operating cash flows also benefited from a $10.3 million net change in our operating assets and liabilities, consisting primarily of an increase of $65.8 million in accounts payable and accrued expenses and other liabilities and a decrease of $10.8 million in other assets, partially offset by increases of $51.8 million in inventories and $12.3 million in accounts receivable. The increases in accounts payable and accrued expenses and in inventories were primarily due to the transition of manufacturing from contract manufacturers to the Company as well as higher purchases for certain programs. The increase in accounts receivable was primarily due to timing of sales.
Investing Activities : Net cash used in investing activities in 2022 was $39.0 million, consisting primarily of $38.2 million used for purchases of property and equipment. Net cash used in investing activities in 2021 consisted primarily of $47.6 million used for purchases of property and equipment and $35.7 million net cash used for the acquisition of the LED Business. Net cash used in investing activities in 2020 consisted primarily of purchases of property and equipment.
Financing Activities : Net cash provided by financing activities in 2022 was $73.9 million, consisting primarily of $278.7 million in net proceeds from issuance of a term loan and $12.1 million in proceeds from the issuance of ordinary shares from our equity plans, partially offset by $127.1 million in principal repayment of the LED Purchase Price Note, $57.2 million of payments to acquire ordinary shares (including $50.0 million under our share repurchase program) and $25.0 million in net repayments of borrowings under our line of credit. Net cash provided by financing activities in 2021 was $2.8 million, consisting primarily of $25.0 million in net proceeds from borrowings under our line of credit, $14.9 million in proceeds from the issuance of ordinary shares and $11.4 million in proceeds from the issuance of debt, partially offset by $48.5 million used to repurchase our ordinary shares. Net cash provided by financing activities in 2020 consisted primarily of $243.1 million proceeds from the issuance of our 2026 Notes and $5.5 million in proceeds from the issuance of ordinary shares, partially offset by $204.9 million in payments for the extinguishment of debt, $21.8 million for the purchase of our Capped Calls and payment of $8.5 million for debt.
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.
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-
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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 and other liabilities, 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 taxes, including projections of future taxable income and tax rates.
The valuation of contingent consideration in connection with an acquisition may be inherently challenging due to the dependence on the occurrence of future events and 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.
Income Taxes : We are required to estimate our provision for income taxes and amounts ultimately payable or recoverable in numerous tax jurisdictions around the world. These estimates involve significant judgment and interpretations of regulations and are inherently complex. Resolution of income tax treatments in individual jurisdictions may not be known for many years after completion of the applicable year. We are also required to evaluate the realizability of our deferred tax assets on an ongoing basis in accordance with U.S. GAAP, which requires the assessment of our performance and other relevant factors. Realization of deferred tax assets is dependent on our ability to generate future taxable income. Our income tax provision or benefit is dependent, in part, on our ability to forecast future taxable income in various jurisdictions. Such forecasts are inherently difficult and involve significant judgments including, among others, projecting future average selling prices and sales volumes, manufacturing and overhead costs and other factors that significantly impact our analyses of the amount of net deferred tax assets that are more likely than not to be realized.
Inventories : Inventories are stated at the lower of cost or net realizable value. In our LED segment, cost is determined on a first-in, first-out method or average cost method. For all other segments, inventory value is determined on a specific identification basis for material and an allocation of labor and manufacturing overhead. At each balance sheet date, we evaluate ending inventories for excess quantities and obsolescence, including analyses of sales levels by product family, historical demand and forecasted demand in relation to inventory on hand, competitiveness of product offerings, market conditions and product life cycles. 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 provision for excess and obsolete inventory are also impacted by our arrangements with our customers and/or suppliers, including our ability or inability to resell such inventory to them.
Goodwill and Intangible Assets : We test goodwill for impairment in our fourth quarter each year, or more frequently if indicators of an impairment exist, to determine whether it is more likely than not that the fair value of the reporting unit with goodwill is less than its carrying value. For reporting units for which we conclude that it is more likely than not that the fair value is more than its carrying value, goodwill is considered not impaired and we are not required to perform the goodwill impairment test. Qualitative factors considered in this assessment include industry and market considerations, overall financial performance and other relevant events and factors affecting the fair value of the reporting unit. For reporting units for which this assessment concludes that it is more likely than not that the fair value is below the carrying value, goodwill is tested for impairment by determining the fair value of the reporting unit and comparing it to the carrying value of the net assets assigned to the reporting unit. If the fair value of the reporting unit exceeds its carrying value, goodwill is considered not impaired. If the carrying value of the reporting unit exceeds its fair value, we would record an impairment loss up to the difference between the carrying value and implied fair value.
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Determining when to test for impairment, the reporting units, the assets and liabilities of the reporting unit and the fair value of the reporting unit requires significant judgment and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates, forecasted manufacturing costs, budgets and other expenses developed as part of our long-range planning process. We test the reasonableness of the output of our long-range planning process by calculating an implied value per share and comparing that to current share prices, analysts’ consensus pricing and management’s expectations. These estimates and assumptions are used to calculate projected future cash flows for the reporting unit, which are discounted using a risk-adjusted rate to estimate a fair value. We base fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.
We test other identified intangible assets with definite useful lives when events and circumstances indicate the carrying value may not be recoverable by comparing the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. Estimating fair values involves significant assumptions, including future sales prices, sales volumes, costs and discount rates.
Property and Equipment : We review the carrying value of property and equipment for impairment when events and circumstances indicate that the carrying value of an asset or group of assets may not be recoverable from the estimated future cash flows expected to result from its use and/or disposition. In cases where undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized equal to the amount by which the carrying value exceeds the estimated fair value of the assets. The estimate of future cash flows involves numerous assumptions which require significant judgment by us, including, but not limited to, future use of the asset(s) for our operations versus sale or disposal of the asset(s), future selling prices for our products and future production and sales volumes. In addition, significant judgment is required in determining the groups of assets for which impairment tests are separately performed.
Revenue Recognition : We recognize revenue based on the transfer of control of goods and services and apply the following five-step approach: (1) identification of a 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 as performance obligations are satisfied.
Applying the five step approach in determining whether to recognize revenue at a point in time or over time requires significant judgement. A portion of our revenue is from sales of customized product which, in some cases, are non-cancellable and/or non-refundable. Significant judgement is required to determine when control passes to the customer and whether and when our performance obligations have been satisfied. This determination can significantly affect the timing of recognizing revenue.
Product Revenue : Product revenue is generally recognized at a point in time when control of the promised goods is transferred to customers. Contracts with 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.
Non-cancellable, nonrefundable customized product sales are recognized over time on a cost incurred basis. In connection with these arrangements, customers obtain control and benefit from the services as they are performed. The terms for these arrangements provide us with a legally enforceable right to receive payment, including a reasonable profit margin upon customer cancellation, for performance completed to date. Accordingly, we recognize revenue over time as we complete the manufacture of these products.
A portion of our revenue is derived from the sale of customized products. In certain cases, we recognize revenue when control of the underlying assets passes to the customer when the customer is able to 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 we have a present right to payment. Under the terms of these arrangements, we cannot repurpose products without the customer’s consent and accordingly, we recognize revenue at the point in time when products are completed and made available to the customer.
Service Revenue : Our service revenue is derived from supply chain services as well as professional services. Supply chain services includes procurement, logistics, inventory management, temporary warehousing, kitting and packaging. Professional services include solution design, system installation, software automation and managed support services
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related to HPC and storage systems. A portion of our product sales include extended warranty and on-site services, subscriptions to our HPC environment, professional services, software and related support.
Agent Services : We provide certain supply chain services on an agent basis, whereby we procure materials on behalf of our customers and then resell such materials to our customers. Gross amounts invoiced to customers in connection with these agent services include amounts related to the services performed by us in addition to the cost of the materials procured. However, only the amount related to the agent component is recognized as revenue in our results of operations. We generally recognize revenue for these procurement, logistics and inventory management services upon the completion of such services, which typically occurs at the time of shipment of product to the customer. Amounts we invoice to customers for cost of materials related to services performed, which remain unpaid as of the end of a reporting period, are included in accounts receivable. Additionally, cost of materials procured for customers under these agent services, but which remain on hand as of the end of a reporting period, are included in inventories. Amounts in accounts receivable and inventories impact the determination of net cash provided by (or used in) operations.
Determining whether we are the principal or agent in these transactions requires significant judgement. This determination affects the amount of revenue we recognize; a principal recognizes revenues at the gross amount received for the goods and services, while an agent recognizes revenue at the net amount. The impact of this determination significantly impact the amount of revenue and cost of sales we recognize.
Transaction Price : The transaction price is determined based on the consideration to which we will be entitled in exchange for transferring goods or services to the customer. We allocate 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 our approved list price.
A portion of our service revenue is from professional 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. We allocate the consideration to each performance obligation based on the relative selling price, determined as the best estimate of the price at which we would transact if it sold the deliverable regularly on a stand-alone basis.
Contract Costs : As a practical expedient, we recognize 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, we account for shipping and handling costs, if any, that occur after control transfers to the customer as a fulfillment activity. We record shipping and handling costs related to revenue transactions within cost of sales as a period cost.
Share-Based Compensation : Share-based compensation is estimated at the grant date based on the fair value of the award and is recognized as expense using the straight-line amortization method over the requisite service period. For performance-based share awards, the expense recognized is dependent on our assessment of the likelihood of the performance measure being achieved. We utilize forecasts of future performance to assess these probabilities and this assessment requires significant judgment.
Determining the appropriate fair-value model and calculating the fair value of share-based awards at the grant date requires significant judgment, including estimating share price volatility and expected option life. We develop these estimates based on historical data and market information which can change significantly over time. A small change in the estimates used can result in a relatively large change in the estimated valuation. We use the Black-Scholes option valuation model to value employee options and awards granted under our employee share purchase plan. We estimate share price volatility based on an average of historical volatility and the implied volatility derived from traded options on our shares.