PHOTRONICS INC 10-Q

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Management’s discussion and analysis (“MD&A”) of the Company’s financial condition and results of operations should be read in conjunction with its condensed consolidated financial statements and related notes. Various segments of this MD&A contain forward-looking statements, all of which are presented based on current expectations, which may be adversely affected by uncertainties and risk factors (presented throughout this filing and in the Company’s Form 10-K for fiscal 2021), that may cause actual results to materially differ from these expectations. We sell substantially all of our photomasks to semiconductor designers and manufacturers, and manufacturers of FPDs. Photomask technology is also being applied to the fabrication of other higher-performance electronic products such as photonics, microelectronic mechanical systems and certain nanotechnology applications. Our selling cycle is tightly interwoven with the development and release of new semiconductor and display designs and applications, particularly as they relate to the semiconductor industry’s migration to more advanced product innovation, design methodologies, and fabrication processes. The demand for photomasks primarily depends on design activity rather than sales volumes from products manufactured using photomask technologies. Consequently, an increase in semiconductor or display sales does not necessarily result in a corresponding increase in photomask sales. However, the reduced use of customized ICs, reductions in design complexity, other changes in the technology or methods of manufacturing or designing semiconductors, or a slowdown in the introduction of new semiconductor or display designs could reduce demand for photomasks ‒ even if the demand for semiconductors and displays increases. Advances in semiconductor, display, and photomask design and production methods that shift the burden of achieving device performance away from lithography could also reduce the demand for photomasks. Historically, the microelectronics industry has been volatile, experiencing periodic downturns and slowdowns in design activity. These negative trends have been characterized by, among other things, diminished product demand, excess production capacity, and accelerated erosion of selling prices, with a concomitant effect on revenue and profitability. We are typically required to fulfill customer orders within a short period of time. This results in a minimal level of backlog, typically two to three weeks of backlog for FPD photomasks and one to two weeks for IC photomasks. However, the demand for some IC photomasks has expanded beyond the industry’s capacity to supply them within the traditional time period, thus the backlog in some cases can expand to as long as two to three months. The global semiconductor and FPD industries are driven by end markets which have been closely tied to consumer-driven applications of high-performance devices, including, but not limited to, mobile display devices, mobile communications, and computing solutions. While we cannot predict the timing of the industry’s transition to volume production of next-generation technology nodes, or the timing of up and down-cycles with precise accuracy, we believe that such transitions and cycles will continue into the future, beneficially and adversely affecting our business, financial condition, and operating results as they occur. We believe our ability to remain successful in these environments is dependent upon the achievement of our goals of being a service and technology leader and efficient solutions supplier, which we believe should enable us to continually reinvest in our global infrastructure. Impact of the COVID-19 Pandemic All of our facilities have continued to operate throughout the COVID-19 pandemic. The pandemic, particularly at its height, impacted our business in a number of ways including customer shutdowns, which led to delays in new photomask design releases, and travel restrictions, which delayed tool installations and servicing. To date we have not experienced significant raw material shortages, however, supply chain disruptions could potentially delay or prevent us from fulfilling customer orders. While our business has continued to grow over the course of the pandemic, we cannot predict its future impact on our business with a high level of certainty. 28 Table of Contents Results of Operations Three and Nine Months Ended July 31, 2022 The following table presents selected operating information expressed as a percentage of revenue. The columns may not foot due to rounding. Three Months Ended Nine Months Ended July 31, 2022 May 1, 2022 August 1, 2021 July 31, 2022 August 1, 2021 Revenue 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Cost of goods sold 61.9 65.7 73.4 65.2 76.1 Gross profit 38.1 34.3 26.6 34.8 23.9 Selling, general and administrative expenses 7.3 8.1 8.8 7.9 9.0 Research and development expenses 1.9 2.1 3.1 2.3 3.0 Other operating income, net - - 2.1 - 0.7 Operating income 29.0 24.2 16.7 24.6 12.7 Non-operating income, net 1.7 3.9 2.2 2.7 0.8 Income before income tax provision 30.6 28.1 18.9 27.3 13.4 Income tax provision 8.3 7.0 4.6 7.1 3.0 Net income 22.4 21.0 14.3 20.2 10.4 Net income attributable to noncontrolling interests 8.2 7.6 4.3 6.9 3.0 Net income attributable to Photronics, Inc. shareholders 14.2 % 13.4 % 10.0 % 13.3 % 7.4 % Note: All tabular comparisons included in the following discussion, unless otherwise indicated, are for the three month periods ended July 31, 2022 (Q3 FY22), May 1, 2022 (Q2 FY22), and August 1, 2021 (Q3 FY21), and for the nine month periods ended July 31, 2022 (YTD FY22) and August 1, 2021 (YTD FY21), in millions of dollars. The columns may not foot due to rounding. Revenue Our quarterly revenues can be affected by the seasonal purchasing practices of our customers. As a result, demand for our products is typically reduced during the first quarter of our fiscal year by the North American, European, and Asian holiday periods, as some of our customers reduce their development and, consequently, their buying activities during those periods. 29 Table of Contents The following tables present changes in disaggregated revenue in Q3 FY22 and YTD FY22 from revenue in prior reporting periods. Quarterly Changes in Revenue by Product Type Q3 FY22 from Q2 FY22 Q3 FY22 from Q3 FY21 YTD FY22 from YTD FY21 Revenue in Q3 FY22 Increase (Decrease) Percent Change Increase (Decrease) Percent Change Revenue in YTD FY22 Increase (Decrease) Percent Change IC High-end * $ 52.7 $ 1.3 2.6 % $ 10.3 24.4 % $ 151.0 $ 30.6 25.4 % Mainstream 108.6 14.1 15.0 % 33.1 43.9 % 285.8 71.5 33.4 % Total IC $ 161.3 $ 15.5 10.6 % $ 43.5 36.9 % $ 436.8 $ 102.1 30.5 % FPD High-end * $ 50.7 $ 4.1 8.8 % $ 10.1 24.7 % $ 143.6 $ 28.9 25.2 % Mainstream 8.0 (4.1 ) (33.9 )% (4.2 ) (34.6 )% 33.9 0.8 2.5 % Total FPD $ 58.7 $ 0.0 0.0 % $ 5.8 11.0 % $ 177.5 $ 29.7 20.1 % Total Revenue $ 219.9 $ 15.4 7.5 % $ 49.3 28.9 % $ 614.3 $ 131.8 27.3 % * High-end photomasks typically have higher average selling prices (ASPs) than mainstream products. Quarterly Changes in Revenue by Geographic Origin** Q3 FY22 from Q2 FY22 Q3 FY22 from Q3 FY21 YTD FY22 from YTD FY21 Revenue in Q3 FY22 Increase (Decrease) Percent Change Increase (Decrease) Percent Change Revenue in YTD FY22 Increase (Decrease) Percent Change Taiwan $ 77.4 $ 7.5 10.8 % $ 13.5 21.2 % $ 215.1 $ 35.6 19.9 % China 60.5 6.8 12.7 % 27.9 85.3 % 160.2 82.8 107.0 % Korea 37.9 (2.9 ) (7.0 )% (1.7 ) (4.2 )% 118.2 (0.4 ) (0.4 )% United States 34.7 4.4 14.3 % 10.0 40.5 % 92.2 13.7 17.5 % Europe 8.9 (0.6 ) (6.0 )% (0.5 ) (5.4 )% 27.4 0.1 0.3 % Other 0.5 0.2 49.8 % 0.1 25.6 % 1.3 (0.0 ) (0.8 )% Total Revenue $ 219.9 $ 15.4 7.5 % $ 49.3 28.9 % $ 614.3 $ 131.8 27.3 % ** This table disaggregates revenue by the location in which it was earned. Revenue in Q3 FY22 was $219.9 million, representing an increase of 7.5% compared with Q2 FY22 and 28.9% from Q3 FY21. Revenue in YTD FY22 was $614.3 million, representing an increase of 27.3% over YTD FY21. IC photomask revenue increased 10.6% and 36.9% in Q3 FY22, compared with Q2 FY22 and Q3 FY21, respectively, and increased 30.5% in YTD FY22, compared with YTD FY21. These increases were driven by continued strong demand growth in Asia and the U.S. for high-end products, and increased pricing and continued growth for mainstream products used for computer chips used in the production of consumer goods, products considered part of the “internet-of-things”, 5G wireless technology applications, and cryptocurrency mining. We expect this trend to continue in the near term, spurred by continued demand for products that support remote work and learning, advanced display technologies, and accelerated regional investments resulting from growing nationalism to insure local availability of computer chips 30 Table of Contents FPD revenue was $58.7 million in Q3 FY22, unchanged from Q2 FY22, and increased 11.0% from Q3 FY21. On a year-to-date basis, FPD revenue increased 20.1%. These increases were driven by strong demand for mobile AMOLED displays and G10.5+ large area masks used for ultra-large screen televisions. FPD mainstream revenue decreased from both the prior and prior year quarters, as we devoted capacity to producing higher-margin high-end products. Year over year FPD mainstream volume increased slightly, but ASP declined due to a less favorable product mix. We believe that the strong demand for AMOLED photomasks used in mobile devices will continue in the near term, as expected technology advances drives increasing overall demand for higher-value masks. Gross Margin Q3 FY22 Q2 FY22 Percent Change Q3 FY21 Percent Change YTD FY22 YTD FY21 Percent Change Gross profit $ 83.9 $ 70.2 19.4 % $ 45.3 85.0 % $ 213.9 $ 115.1 85.9 % Gross margin 38.1 % 34.3 % 26.6 % 34.8 % 23.9 % Gross margin increased by 3.8 percentage points in Q3 FY22, from Q2 FY22, primarily as a result of the increase in revenue from the prior quarter. Material costs increased 1.7% from the prior quarter, but decreased, as a percentage of revenue, by 140 basis points. Labor costs increased 2.8%, but decreased 50 basis points, as a percentage of revenue. Equipment and other overhead costs were essentially flat but decreased 190 basis points as a percentage of revenue. Gross margin increased by 11.5 percentage points in Q3 FY22, from Q3 FY21, primarily as a result of the increase in revenue from the prior year quarter. Material costs increased 10.2% from the prior year quarter, but decreased 420 basis points, as a percentage of revenue. Labor costs increased 15.3% from the prior year quarter but decreased 120 basis points as a percent of revenue, as labor increased in both the U.S. and at several Asia-based facilities, reflecting tight labor markets. Equipment and other overhead costs rose 4.8%, but decreased 620 basis points, as a percentage of revenue. Increased outsourced manufacturing costs, partially offset by decreased depreciation and equipment maintenance expenses, were the most significant contributors to the net increase in equipment and other overhead costs. Gross margin increased by 10.9 percentage points in YTD FY22, from YTD FY21, primarily as a result of the increase in revenue from the prior year. Material costs increased 11.3% from the prior year quarter, but decreased 370 basis points, as a percentage of revenue. Labor costs increased 13.5% from the prior year period but decreased 130 basis points as a percent of revenue as labor increased significantly at almost all of our locations, reflecting tight labor markets. Equipment and other overhead costs rose 5.4%, but decreased 590 basis points, as a percentage of revenue. Increased outsourced manufacturing costs, partially offset by decreased depreciation and amortization expenses, were the most significant contributors to the net increase in equipment and other overhead costs. Selling, General and Administrative Expenses Selling, general and administrative expenses were $16.0 million in Q3 FY22, compared with $16.6 million in Q2 FY22. The decrease of $0.6 million was primarily the result of decreased compensation and related expenses of $0.9 million, which were partially offset by increased professional fees of $0.3 million. The decrease in compensation and related expenses was primarily related to $0.7 million of severance costs incurred in Q2 FY22 in connection with the retirement of our former chief executive officer. Selling, general and administrative expenses increased $0.9 million in Q3 FY22, from $15.1 million in Q3 FY21, primarily as a result of increased compensation and related expenses of $0.5 million and increased professional fees of $0.3 million. Selling, general and administrative expenses were $48.3 million in YTD FY22, compared with $43.2 million in YTD FY21. The increase of $5.1 million was primarily the result of increased compensation and related expenses of $4.4 million, and increased travel expenses of $0.3 million. Research and Development Expenses Research and development expenses, which primarily consist of development and qualification efforts related to process technologies for high-end IC and FPD applications, were $4.2 million in Q3 FY22, essentially unchanged from Q2 FY22. Research and development expenses decreased by $1.2 million in Q3 FY22, from $5.3 million incurred in Q3 FY21, primarily driven by decreased development activities in the U.S. and China. Research and development expenses were $14.3 million in YTD FY22, down slightly from $14.4 million in YTD FY21, primarily as a result of increased development activities in the U.S. being offset by decreased activity in China. 31 Table of Contents Other Operating Income, Net In the third quarter of fiscal 2021, we recorded a $3.5 million gain on the trade-in of a lithography tool with a tool vendor as partial compensation for a more advanced tool. Non-operating Income (Expense) Q3 FY22 Q2 FY22 Q3 FY21 YTD FY22 YTD FY21 Foreign currency transactions impact, net $ 3.9 $ 7.8 $ 4.3 $ 17.0 $ 3.6 Interest expense, net (0.6 ) - (1.1 ) (1.5 ) (0.6 ) Interest income and other income (expense), net 0.4 0.2 0.5 0.9 0.7 Non-operating income (expense), net $ 3.6 $ 8.0 $ 3.7 $ 16.4 $ 3.6 Non-operating income (expense) decreased $4.4 million to $3.6 million in Q3 FY22, compared with $8.0 million in Q2 FY22, primarily due to reduced gains of the South Korean won and the New Taiwan dollar against the U.S. dollar exceeding reduced losses of the RMB against the U.S. dollar. In addition, less favorable movement of the RMB and unfavorable movement of the South Korean won against the Japanese yen, which were partially offset by favorable movement of the New Taiwan dollar against the Japanese yen, also contributed to the decrease. In Q2 FY22 interest expense on our debt was substantially offset by subsidies we received on our China-based debt; the absence of such subsidies in Q3 FY22 is the primary cause of our $0.6 million increase in interest expense in the current quarter. Non-operating income (expense) decreased $0.1 million to $3.6 million in Q3 FY22, compared with $3.7 million in Q3 FY21. Unfavorable movement of the RMB and less favorable movement of the South Korean won against the U.S. dollar exceeding favorable movements of the New Taiwan dollar and the Singapore dollar against the U.S. dollar were the primary drivers of the negative impact of foreign currency transactions. Interest expense decreased as a result of our lower average debt balance, which decreased significantly as a result of early repayments made in YTD FY22. Non-operating income (expense) increased $12.7 million to $16.4 million in YTD FY22, compared with $3.6 million in YTD FY21. The increase was primarily due to favorable movements of the South Korean won, the New Taiwan dollar, and the Singapore dollar against the U.S. dollar, which were partially offset by unfavorable movements of the RMB against the U.S. dollar. Interest expense increased $0.9 million in YTD FY22 as a result of lower subsidies received on our China-based debt. Income Tax Provision Q3 FY22 Q2 FY22 Q3 FY21 YTD FY22 YTD FY21 Income tax provision $ 18.1 $ 14.4 $ 7.8 $ 43.7 $ 14.5 Effective income tax rate 26.9 % 25.1 % 24.4 % 26.1 % 22.4 % The effective income tax rate is sensitive to the jurisdictional mix of earnings, due in part to the non-recognition of tax benefits on losses in jurisdictions with valuation allowances where the tax benefits of the losses are not available. The effective income tax rate increase in Q3 FY22, compared with Q2 FY22, is primarily due to changes in the jurisdictional mix of earnings and an increase in foreign taxes in Q3 FY22. The effective income tax rate increase in Q3 FY22, compared with Q3 FY21, is primarily due to an increase in foreign taxes and a decrease in credits in non-U.S. jurisdictions, in Q3 FY22, and the release of valuation allowance for a loss carryforward in a non-U.S. jurisdiction in Q3 FY21. 32 Table of Contents The effective income tax rate increase in YTD FY22, compared with YTD FY21, is primarily due to an increase in foreign taxes and a decrease in credits in non-U.S. jurisdictions, in Q3 FY22, and the release of valuation allowance for a loss carryforward in a non-U.S. jurisdiction in Q3 FY21. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests was $18.0 million in Q3 FY22, compared with $15.6 million in Q2 FY22, and $7.3 million in Q3 FY21. On a year-to-date basis, net income attributable to noncontrolling interests increased to $42.3 million in YTD FY22 from $14.5 million in YTD FY21. The increases from all prior periods resulted from increased net income at our Taiwan-based and China-based IC joint ventures. Liquidity and Capital Resources Cash and cash equivalents was $380.8 million and $276.7 million as of July 31, 2022, and October 31, 2021, respectively. As of the most recent balance sheet date, total cash and cash equivalents included $318.4 million held by foreign subsidiaries. Net Cash, a non-GAAP financial measure as defined and discussed in the Non-GAAP Financial Measures section below, was $323.5 million and $165.0 million as of July 31, 2022, and October 31, 2021, respectively. Our primary sources of liquidity are our cash on hand, cash we generate from operations, and borrowing capacity we have available from financial institutions. Our corporate credit agreement has a $50 million borrowing limit, with an expansion capacity to $100 million. Although we have not accessed funds under our corporate credit facilities since 2011, it continues to afford us financial flexibility. In addition, in China, we currently have approximately $21.2 million of borrowing capacity to support local operations. See Note 5 to the condensed consolidated financial statements for additional information on our currently available financing. We continually evaluate alternatives for efficiently funding our capital expenditures and ongoing operations. These reviews may result in our engagement in a variety of financing transactions, in the transfer of cash among subsidiaries, and/or the repatriation of cash to the U.S. The transfer of funds among subsidiaries could be subject to foreign withholding taxes; in certain jurisdictions, repatriation of these funds to the U.S. may subject them to U.S. state income taxes and/or local country withholding taxes. We believe that our liquidity, including available financing, is sufficient to meet our requirements through the next twelve months and thereafter for the foreseeable future. Through the utilization of our existing liquidity, cash we generate from operations, and (potentially) our borrowing capacity under our financing arrangements, we plan to continue to invest in our business, with our investments targeted to align with our customers’ technology road maps. We may also elect to use our cash to reduce our debt through early repayments. In addition, we stand ready to invest in mergers, acquisitions, or strategic partnerships, should a suitable opportunity arise. We estimate capital expenditures for the remainder of FY22 will be approximately $54 million; these investments will be targeted towards high-end and mainstream point tools that will increase our operating capacity and efficiency, and enable us to support our customers’ near-term demands. As of July 31, 2022, we had outstanding capital commitments of approximately $145.4 million and recognized liabilities related to capital equipment purchases of approximately $8.3 million. Although payment timing could vary, primarily as a result of the timing of tool delivery, installation, and testing, we currently estimate that we will fund $120.5 million of our total $153.7 million committed and recognized obligations for capital expenditures over the next twelve months. Please refer to Notes 5 and 7, respectively, to the condensed consolidated financial statements for information on our outstanding debt and lease commitments. In September 2020, the Company’s board of directors authorized the repurchase of up to $100 million of its common stock, pursuant to a repurchase plan under Rule 10b5-1 of the Securities Act. This authorization does not obligate the Company to repurchase any dollar amount or number of shares of common stock. As of July 31, 2022, our current share repurchase program had approximately $31.7 million remaining under its authorization. Depending on market conditions, we may utilize some or the entire remaining approved amount to reacquire additional shares. As discussed in Note 4 to the condensed consolidated financial statements, DNP, the noncontrolling interest in our China-based joint venture has, under certain circumstances, the right to put its interest in the joint venture to Photronics, or to purchase our interest in the joint venture. Under all such circumstances, the sale of DNP’s interest would be at its ownership percentage of the joint venture’s net book value, with closing to take place within three business days of obtaining required approvals and clearance. As of the date of issuance of this report, DNP had not indicated its intention to exercise this right. As of July 31, 2022, Photronics and DNP each had net investments in this joint venture of approximately $96.1 million. 33 Table of Contents Cash Flows YTD FY22 YTD FY21 Net cash provided by operating activities $ 195.9 $ 113.1 Net cash used in investing activities $ (45.1 ) $ (86.7 ) Net cash used in financing activities $ (25.4 ) $ (26.4 ) Operating Activities: Net cash provided by operating activities reflects net income adjusted for certain non-cash items, including depreciation and amortization, share-based compensation, and the impacts of cash from changes in operating assets and liabilities. Net cash provided by operating activities increased by $82.8 million in YTD FY22, compared with YTD FY21, due to increased net income and cash generated from changes in working capital. Free Cash Flow and LTM (“Last Twelve Months”) Free Cash Flow, which are non-GAAP financial measures as discussed in the “Non-GAAP Financial Measures” section below, increased by $124.4 and $114.6 million, respectively, compared with YTD FY21, primarily due to the increase in Net cash provided by operating activities discussed above and a reduction in spending on property, plant and equipment. Investing Activities: Net cash flows used in investing activities primarily consisted of purchases of property, plant and equipment of $46.3 million, which decreased $46.0 million in YTD FY22, compared with YTD FY21. The reduced spending on property, plant and equipment was partially offset by a $4.4 million decrease in investment related government incentives received in China. The reduction in expenditures resulted from timing of deliveries and payments on outstanding commitments. Financing Activities: Net cash flows used in financing activities primarily consist of share repurchases, proceeds from and repayments of debt, and contributions from noncontrolling interests. Net cash used in financing activities decreased by $1.0 million in YTD FY22, compared with YTD FY21, primarily due to contributions from noncontrolling interests in our majority owned subsidiaries in Taiwan and China of $25.0 million, decreased share repurchases of $33.2 million, and increased debt repayments of $38.6 million. In addition, we received debt proceeds of $20.9 million in YTD FY21 and did not incur debt in YTD FY22. The increase in our cash balance from the beginning of the year was reduced by the effects of exchange rate changes in the amount of $21.3 million in YTD FY22, which was in contrast to the $4.5 million positive impact the effects of exchange rate changes had on our cash balance in YTD FY21. Non-GAAP Financial Measures We consider Free Cash Flow, LTM Free Cash Flow, and Net Cash, which are “non-GAAP financial measures” (as such term is defined by the SEC), to be useful metrics in measuring our cash-generation performance. (Note that we may define these terms differently than other companies that use similarly-named non-GAAP financial measures.) These non-GAAP metrics are not intended to represent funds available for our discretionary use or to be used as a substitute for Cash and cash equivalents or Net cash provided by operating activities , as measured under GAAP. The following tables reconcile Net cash provided by operating activities to Free Cash Flow for YTD FY22 and YTD FY21, and present the calculations of LTM Free Cash Flow for Q3 FY22 and Q3 FY21. The columns may not foot due to rounding. YTD FY22 YTD FY21 Free Cash Flow Net cash provided by operating activities $ 195.9 $ 113.1 Purchases of property, plant and equipment (46.3 ) (92.3 ) Government incentives 1.4 5.8 Free cash flow $ 151.0 $ 26.6 34 Table of Contents Q3 FY22 Q3 FY21 LTM Free Cash Flow First nine months of the respective fiscal year $ 151.0 $ 26.6 Prior fiscal year 47.4 77.5 First nine months of the prior year (26.6 ) (46.8 ) LTM free cash flow $ 171.9 $ 57.2 The following table reconciles Cash and cash equivalents to Net Cash at the balance sheet dates. The increase in Net Cash was primarily driven by an increase in Net cash provided by operating activities and decreased spending on property, plant and equipment, as discussed above. The columns may not foot due to rounding. As of July 31, 2022 October 31, 2021 Net Cash Cash and cash equivalents $ 380.8 $ 276.7 Current portion of Long-term debt (10.7 ) (22.2 ) Long-term debt (46.6 ) (89.4 ) Net cash $ 323.5 $ 165.0 Business Outlook Our current business outlook and guidance was provided in the Photronics Q3 FY22 earnings release, Earnings Presentation, and financial results conference call, but is not incorporated herein. These can be accessed in the investor section of our website - www.photronics.com. Our future results of operations and the other forward-looking statements contained in this filing and in the Photronics Q3 FY22 Earnings Presentation and the related financial results conference call and slide deck involve a number of risks and uncertainties, some of which are discussed in Part I, Item 1A of our 2021 Form 10-K. A number of other unforeseeable factors could cause actual results to differ materially from our expectations. Critical Accounting Estimates Please refer to Part II, Item 7 of our 2021 Form 10-K for discussion of our critical accounting estimates. There have been no changes to our critical accounting estimates since the filing of our Form 10-K for the year ended October 31, 2021.