PIXELWORKS, INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations (“MD&A”) should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this document. In addition to historical information, the MD&A contains forward-looking statements that reflect our plans, estimates, and beliefs that involve significant risks and uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to those differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in “Risk Factors,” and “Note Regarding Forward-Looking Statements.” Overview Pixelworks is a leading provider of high-performance and power-efficient visual processing semiconductor and software solutions that enable consistently high-quality and authentic viewing experiences in a wide variety of applications. We define our primary target markets as Mobile (smartphone and tablet), Home & Enterprise (projectors, personal video recorders ("PVR"), and over-the-air ("OTA") streaming devices), and Cinema (creation, remastering, and delivery of digital video content). Previously we classified our primary target markets as Mobile, Projector, Video Delivery and Cinema, but have since aggregated the Projector and Video Delivery categories into one market called "Home & Enterprise". Pixelworks has been a pioneer in visual processing technology for over 20 years. We were one of the first companies to commercially launch a video System on Chip ("SoC") capable of deinterlacing 1080i HDTV signals and one of the first companies with a commercial dual-channel 1080i deinterlacer integrated circuit. We launched one of the industry’s first single-chip SoCs for digital projection. We were the first company to integrate motion estimation / motion compensation technology ("MEMC") as a mobile-optimized solution for smartphones. In 2019, we introduced our Hollywood award-winning TrueCut® video platform, the industry’s first motion grading technology that allows fine tuning of motion appearance in cinematic content. As of June 30, 2023, we had an intellectual property portfolio of 280 patents related to the visual display of digital image data. We focus our research and development efforts on developing video algorithms that improve quality, and architectures that reduce system power, cost, bandwidth and increase overall system performance and device functionality. We seek to expand our technology portfolio through internal development and co-development with business partners, and we continually evaluate acquisition opportunities and other ways to leverage our technology into other high-value markets. Our core visual processing technology intelligently processes digital images and video from a variety of sources and optimizes the content for a superior viewing experience. Rapid growth in video and gaming consumption, combined with the move towards bright, high resolution, high frame rate and high refresh rate displays, especially in mobile, is increasing the demand for our solutions. Our technologies can be applied across a wide range of applications: cinema theaters, low-power mobile tablets, smartphones, streaming devices, and digital projectors for the home, school, or the workplace. Our products are designed and optimized for power, cost, bandwidth, viewer experience, and overall system performance, according to the requirements of the specific application. On occasion, we have also licensed our technology. During the third quarter of 2021, we engaged in a strategic plan to re-align our Mobile and Home & Enterprise businesses to improve their focus on their Asia-centered customers and employee stakeholders. Our subsidiary, Pixelworks Semiconductor Technology (Shanghai) Co., Ltd. (or "PWSH"), now operates these businesses as a full profit-and-loss center underneath Pixelworks. In connection with this strategic plan, the Company and PWSH closed three separate financing transactions in 2021 and 2022, which are further described in "Note 13: Redeemable Non-Controlling Interest and Equity Interest of PWSH Sold to Employees" and "Note 14: Non-Controlling Interest", which are incorporated by reference into this section. PWSH is in the process of preparing to file an application for an initial public offering of PWSH shares on the Shanghai Stock Exchange’s Science Technology Innovation Board, known as the STAR Market (the “Listing”). We believe that the Listing will have many benefits, including improved access to new capital markets and the funding of PWSH’s growth worldwide. We presently intend to qualify PWSH to apply for the Listing in the second half of 2023. The process of going public on the STAR Market is lengthy and includes several periods of review by various government agencies of the People’s Republic of China (“PRC”), such as the Shanghai Stock Exchange and the China Securities Regulatory Commission (“CSRC”). There is no guarantee that PWSH will be approved for a Listing at any point in the future. The listing of PWSH on the STAR Market will not change the status of PXLW as a U.S. public company. We are neither a PRC operating company nor do we conduct our operations in China through the use of variable interest entities. Pixelworks was founded in 1997 and is incorporated under the laws of the state of Oregon. On August 2, 2017, we acquired ViXS Systems, Inc., a corporation organized in Canada ("ViXS"). 26 Table of Contents Results of Operations Revenue, net Net revenue for the three and six months ended June 30, 2023 and 2022, was as follows (dollars in thousands): Three Months Ended Six Months Ended June 30, June 30, 2023 2022 % Change 2023 2022 % Change Revenue, net $ 13,605 $ 19,078 (29) % $ 23,571 $ 35,706 (34) % Net revenue decreased $5.5 million, or 29%, in the second quarter of 2023 compared to the second quarter of 2022 and decreased $12.1 million, or 34%, in the first half of 2023 compared to the first half of 2022. Revenue recorded in the second quarter of 2023 consisted of $13.5 million in revenue from the sale of integrated circuit ("IC") products and $0.1 million in revenue related to engineering services, license revenue and other. Revenue recorded in the second quarter of 2022 consisted of $18.7 million in revenue from the sale of IC products and $0.4 million in revenue related to engineering services, license revenue and other. Revenue recorded in the first half of 2023 consisted of $23.2 million in revenue from the sale of IC products and $0.4 million in revenue related to engineering services, license revenue and other. Revenue recorded in the first half of 2022 consisted of $35.1 million in revenue from the sale of IC products and $0.6 million in revenue related to engineering services, license revenue and other. The decrease in IC revenue in the second quarter of 2023 compared to the second quarter of 2022 is due to the following factors: • Sales into the Mobile market decreased $0.4 million or 5%. • Sales into the Home & Enterprise market decreased $4.8 million or 42%, primarily due to a decrease in customer demand as well as implementing an end-of-life in 2022 on some of our legacy products sold into what we previously referred to as the video delivery market. The decrease in IC revenue in the first half of 2023 compared to the first half of 2022 is due to the following factors: • Sales into the Mobile market decreased $2.8 million or 22%, primarily due to a decrease in customer demand. • Sales into the Home & Enterprise market decreased $9.1 million or 41%, primarily due to a decrease in customer demand as well as implementing an end-of-life in 2022 on some of our legacy products sold into what we previously referenced as the video delivery market. 27 Table of Contents Cost of revenue and gross profit Cost of revenue and gross profit for the three and six months ended June 30, 2023 and 2022, were as follows (dollars in thousands): Three Months Ended June 30, Six Months Ended June 30, 2023 % of revenue 2022 % of revenue 2023 % of revenue 2022 % of revenue Direct product costs and related overhead 1 $ 8,037 59 % $ 9,671 51 % $ 13,611 58 % $ 17,447 49 % Stock-based compensation 22 0 59 0 47 0 67 0 Amortization of acquired intangible assets — 0 — 0 — 0 72 0 Inventory charges 2 62 0 — 0 62 0 9 0 Total cost of revenue $ 8,121 60 % $ 9,730 51 % $ 13,720 58 % $ 17,595 49 % Gross profit $ 5,484 40 % $ 9,348 49 % $ 9,851 42 % $ 18,111 51 % 1 Includes purchased materials, assembly, test, labor, employee benefits and royalties. 2 Includes charges to reduce inventory to lower of cost or market and a benefit for sales of previously written down inventory. Gross profit margin decreased to 40% in the second quarter of 2023 compared to 49% in the second quarter of 2022, primarily due to product mix. The decrease in sales into the Home & Enterprise market unfavorably impacted gross profit margin. The decrease was also due to lower absorption of fixed overhead costs. Gross profit margin decreased to 42% in the first half of 2023 compared to 51% in the first half of 2022, primarily due to product mix. The decrease in sales into the Home & Enterprise market unfavorably impacted gross profit margin. The decrease was also due to lower absorption of fixed overhead costs. Pixelworks’ gross profit margin is subject to variability based on changes in revenue levels, product mix, average selling prices, startup costs, amortization related to acquired intangible assets, and the timing and execution of manufacturing ramps as well as other factors. 28 Table of Contents Research and development Research and development expense includes compensation and related costs for personnel, development-related expenses, including non-recurring engineering expenses and fees for outside services, depreciation and amortization, expensed equipment, facilities and information technology expense allocations and travel and related expenses. Co-development agreement During the third quarter of 2021, we entered into a best efforts co-development agreement with a customer to defray a portion of the research and development expenses we expect to incur in connection with our development of an integrated circuit product. We expect our development costs to exceed the amounts received from the customer, and although we expect to sell units of the product to the customer, there is no commitment or agreement from the customer for such sales at this time. Additionally, we retain ownership of any modifications or improvements to our pre-existing intellectual property and may use such improvements in products sold to other customers. Under the co-development agreement, $5.8 million was payable by the customer within 60 days of the date of the agreement and three additional payments of $2.5 million, $1.9 million and $1.3 million are each payable upon completion of certain development milestones. As amounts become due and payable, they are offset against research and development expense on a pro rata basis. We recognized offsets to research and development expense of $1.9 million and $0.9 million, during the three months ended June 30, 2023 and 2022, respectively and $1.9 million and $1.8 million during the six months ended June 30, 2023 and 2022, respectively. During the remainder of 2023, we expect to record offsets to research and development expense of approximately $1.3 million for the remaining payment milestone. Research and development expense for the three and six months ended June 30, 2023 and 2022, was as follows (dollars in thousands): Three Months Ended Six Months Ended June 30, June 30, 2023 2022 % Change 2023 2022 % Change Research and development $ 6,507 $ 8,521 (24) % $ 15,173 $ 15,681 (3) % Research and development expense decreased $2.0 million, or 24% in the second quarter of 2023 compared to the second quarter of 2022 due to the following factors: • A $1.9 million benefit related to the co-development agreement was recognized in the second quarter of 2023 compared to a $0.9 million benefit recognized in the second quarter of 2022. • Non-recurring engineering expense decreased $1.0 million primarily due to the timing of development activities. Research and development expense decreased $0.5 million, or 3% in the first half of 2023 compared to the first half of 2022 due to the following factors: • Non-recurring engineering expense decreased $0.6 million primarily due to the timing of development activities. • Stock-based compensation expense decreased $0.2 million primarily due to the change in our stock price. • These decreases were partially offset by a $0.3 million increase in compensation expense primarily due to annual merit salary increases. 29 Table of Contents Selling, general and administrative Selling, general and administrative expense includes compensation and related costs for personnel, sales commissions, facilities and information technology expense allocations, travel, outside services and other general expenses incurred in our sales, marketing, customer support, management, legal and other professional and administrative support functions. Selling, general and administrative expense for the three and six months ended June 30, 2023 and 2022, was as follows (dollars in thousands): Three Months Ended Six Months Ended June 30, June 30, 2023 2022 % Change 2023 2022 % Change Selling, general and administrative $ 5,468 $ 6,024 (9) % $ 11,540 $ 11,508 0 % Selling, general and administrative expense decreased $0.6 million, or 9% in the second quarter of 2023 compared to the second quarter of 2022 due to the following factors: • Foreign currency gains and losses decreased $0.4 million primarily due to weakening in the CNY compared to USD. • Stock-based compensation expense decreased $0.3 million primarily due to the change in our stock price. • These decreases were partially offset by a $0.1 million increase in travel related expense due to increased travel in Shanghai as COVID-19 restrictions have been lifted. Selling, general and administrative expense had a negligible increase in the first half of 2023 compared to the first half of 2022 due to the following factors: • Compensation expense increased primarily due to an increased management bonus accrual due to the timing of achievement of corporate bonus objectives. • This increase was partially offset by a foreign currency gain due to weakening in the CNY compared to USD. Provision for income taxes The provision for income taxes during the 2023 and 2022 periods is primarily comprised of current and deferred tax expense in profitable cost-plus foreign jurisdictions, accruals for tax contingencies in foreign jurisdictions and benefits for the reversal of previously recorded foreign tax contingencies due to the expiration of the applicable statutes of limitation. We recorded a negligible benefit for the reversal of previously recorded foreign tax contingencies during the first six months of 2023 and a benefit of $0.1 million for the reversal of previously recorded foreign tax contingencies during the first six months of 2022. Liquidity and Capital Resources Cash and cash equivalents Total cash and cash equivalents decreased $2.3 million to $54.5 million at June 30, 2023 from $56.8 million at December 31, 2022. The net decrease during the first six months of 2023 was the result of $13.8 million used in operating activities, $2.7 million used for purchases of property and equipment and $0.5 million used for payments on other asset financings. These decreases were partially offset by increases of $14.6 million received in net proceeds from issuance of equity interest to non-controlling interest and $0.1 million in proceeds from the issuances of common stock under our employee equity incentive plans. As of June 30, 2023, our cash and cash equivalents balance consisted of $39.8 million in cash, $11.0 million held in U.S. dollar denominated certificates of deposit and $3.7 million in cash equivalents held in U.S. dollar denominated money market funds. Although we did not hold short- or long-term investments as of June 30, 2023, our investment policy requires that our portfolio maintain a weighted average maturity of less than 12 months. Additionally, no maturities can extend beyond 24 months and concentrations with individual securities are limited. At the time of purchase, the short-term credit rating must be rated at least A-2 / P-2 / F-2 by at least two Nationally Recognized Statistical Rating Organizations ("NRSRO") and securities of issuers with a long-term credit rating must be rated at least A or A3 by at least two NRSRO. Our investment policy is reviewed at least annually by our Audit Committee. Accounts receivable, net Accounts receivable, net decreased to $7.4 million as of June 30, 2023 from $10.0 million as of December 31, 2022. The average number of days sales outstanding decreased to 52 days as of June 30, 2023 from 54 days as of December 31, 2022. 30 Table of Contents Inventories Inventories were $5.5 million as of June 30, 2023 compared to $1.8 million at December 31, 2022. Inventory turnover decreased to 8.3 as of June 30, 2023 from to 13.7 as of December 31, 2022 primarily due to higher average inventory balances during the second quarter of 2023 compared to the fourth quarter of 2022. Inventory turnover is calculated based on annualized quarterly operating results and average inventory balances during the quarter. Capital resources At the Market Offering On June 5, 2020, we entered into a sales agreement (the "Sales Agreement") with Cowen and Company, LLC ("Cowen"), pursuant to which we may issue and sell shares of the Company's common stock, par value $0.001 per share, having an aggregate offering price of up to $25.0 million, from time to time, through an "at the market" equity offering program under which Cowen will act as sales agent. Under the Sales Agreement, Cowen may sell the shares by methods deemed to be an "at the market offering" as defined in Rule 415(a)(4) promulgated under the Securities Act of 1933, as amended, including sales made by means of ordinary brokers’ transactions on the Nasdaq Global Market or on any other existing trading market for the common stock or otherwise at market prices prevailing at the time of sale, in block transactions, or as otherwise directed by us. We pay Cowen a commission equal to three percent (3.0%) of the gross sales proceeds of any common stock sold through Cowen under the Sales Agreement. The Sales Agreement may be terminated by us upon prior notice to Cowen or by Cowen upon prior notice to us, or at any time under certain circumstances, including but not limited to the occurrence of a material adverse change in the Company. We are not obligated to sell any shares under the Sales Agreement. There was no activity under this at the market offering during the six months ended June 30, 2023 or June 30, 2022. Capital Increase Agreements We have entered into a Capital Increase Agreement pursuant to which our subsidiary PWSH, received net proceeds from the sale of its securities pursuant thereto in an amount of 279.7 million RMB ($42.3 million USD). Additional information is provided in "Note 13: Redeemable Non-Controlling Interest and Equity Interest of PWSH Sold to Employees", which is incorporated by reference into this section. We have entered into a Capital Increase Agreement pursuant to which our subsidiary PWSH, received net proceeds from the sale of its securities pursuant thereto in an amount of 99.0 million RMB ($14.6 million USD). Additional information is provided in "Note 14: Non-Controlling Interest", which is incorporated by reference into this section. Equity Transfer Agreement We have entered into an Equity Transfer Agreement pursuant to which we received net proceeds of $10.7 million in exchange for a 2.73% equity interest in PWSH. Additional information is provided in "Note 14: Non-Controlling Interest", which is incorporated by reference into this section. 31 Table of Contents Liquidity As of June 30, 2023, our cash and cash equivalents balance of $54.5 million was highly liquid. We anticipate that our existing working capital will be adequate to fund our operating, investing and financing needs for the next twelve months and beyond. We may pursue financing arrangements including the issuance of debt or equity securities or reduce expenditures, or both, to meet our cash requirements, including in the longer term. There is no assurance that, if required, we will be able to raise additional capital or reduce discretionary spending to provide the required liquidity which, in turn, may have an adverse effect on our financial position, results of operations and cash flows. From time to time, we evaluate acquisitions of businesses, products or technologies that complement our business. Any transactions, if consummated, may consume a material portion of our working capital or require the issuance of equity securities that may result in dilution to existing shareholders. Our ability to generate cash from operations is also subject to substantial risks described in Part II, Item 1A., "Risk Factors". If any of these risks occur, we may be unable to generate or sustain positive cash flow from operating activities. We would then be required to use existing cash and cash equivalents to support our working capital and other cash requirements. If additional funds are required to support our working capital requirements, acquisitions or other purposes, we may seek to raise funds through debt financing, equity financing or from other sources. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our shareholders could be significantly diluted, and these newly-issued securities may have rights, preferences or privileges senior to those of existing shareholders. If we raise additional funds by obtaining loans from third parties, the terms of those financing arrangements may include negative covenants or other restrictions on our business that could impair our operating flexibility and would also require us to incur interest expense. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain additional financing on terms favorable to us. Other than as set forth above, there were no material changes to our liquidity and capital resources during the six month period ended June 30, 2023 from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission on March 8, 2023. 32 Table of Contents