Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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 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.
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 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. One of our Chinese subsidiaries, 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 14: Redeemable Non-Controlling Interest and Equity Interest of PWSH Sold to Employees" and "Note 15: Non-Controlling Interest", which are incorporated by reference into this section. PWSH has a branch office located in Shenzhen, China (Pixelworks Semiconductor Technology (Shanghai) Co. Ltd. Shenzhen Branch Office No. 1), which is primarily for sales and customer support for PWSH, and a subsidiary located in Hong Kong (Pixelworks Hong Kong Limited), which has no employees and is used for distribution of PWSH products. Pixelworks has an additional subsidiary in China (Frame Shadow Technology (Shanghai) Co., Ltd. (formerly called Mucheng Huai Management Consulting (Shanghai) Co., Ltd)) which is a research and development center for our TrueCut business. This subsidiary does not operate under PWSH, but rather is owned by Pixelworks through our Oregon limited liability company, Pixelworks Semiconductor Technology Company, LLC.
We continue to prepare PWSH 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”) once market conditions in China are supportive. We believe that the Listing will have many benefits, including improved access to new capital markets and the funding of PWSH’s growth worldwide. 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 (“SSE”) and the China Securities Regulatory Commission (“CSRC”). The CSRC and the SSE have recently tightened the standards for the STAR Market and are currently advising companies that are not yet profitable under China GAAP standards against filing an IPO application in the present environment. The Company believes this is in large part due to the current economic conditions in China and the recent performance of companies already listed on the STAR Market that were not profitable at the time of their IPO. PWSH is not currently profitable under China GAAP standards. 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. More than a majority of our operations are in China, but our executive officers and all of our directors but one are located in the United States (and he resides in Singapore). We are neither a PRC operating company nor do we conduct our operations in China through the use of variable interest entities.
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As of December 31, 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.
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").
Historically, significant portions of our revenue have been generated by sales to a relatively small number of end customers and distributors. We sell our products worldwide through a direct sales force, distributors and manufacturers’ representatives. We sell to distributors in China, Japan and Taiwan. Our distributors often provide engineering support to our end customers and often have valuable and established relationships with our end customers. In certain countries in which we operate, it is customary to sell to distributors. While distributor payment to us is not dependent upon the distributor’s ability to resell the product or to collect from the end customer, the distributors may provide longer payment terms to end customers than those we would offer.
Significant portions of our products are sold overseas. Sales outside the U.S. accounted for approximately 99.7% and 95.1% of revenue in 2023 and 2022, respectively. Our integrators, branded manufacturers and branded suppliers incorporate our products into systems that are sold worldwide. The majority of our revenue to date has been denominated in U.S. dollars.
Seasonality
Our business is subject to seasonality related to the markets we serve and the location of our customers. We have typically experienced higher revenue from the digital projector component of the Home & Enterprise market in the third quarter, and lower revenue in the first quarter, as our Japanese customers reduce inventories in anticipation of their March 31 fiscal year end. We have typically experienced higher revenue from the mobile market in the fourth quarter, and lower revenue in the first quarter, as mobile phone OEMs ramp production in advance of Chinese New Year.
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Results of Operations
For the year ended December 31, 2023 compared with year ended December 31, 2022.
Revenue, net
Net revenue was as follows (in thousands):
Year ended December 31, 2023 v. 2022
2023 2022 $ change % change
Revenue, net $ 59,677 $ 70,146 $ (10,469) (15) %
Net revenue decreased $10.5 million, or 15%, from 2022 to 2023.
Revenue recorded in 2023 consisted of $58.6 million in revenue from the sale of integrated circuits ("IC") products and $1.1 million in revenue related to engineering services, license revenue and other. Revenue recorded in 2022 consisted of $68.2 million in revenue from the sale of IC products and $1.9 million in revenue related to engineering services, license revenue and other.
The decrease in IC revenue from 2022 compared to 2023 is due to the following factors:
• Sales into the Home & Enterprise market decreased $17.8 million or 38%, primarily due to a decrease in customer demand resulting from customers absorbing inventory purchased with long lead times during the supply shortage in 2022, 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.
• Sales into the Mobile market increased $8.3 million or 39%, primarily due to i ncreased average selling prices as our customers adopt and transition to our next generation mobile product.
Revenue related to engineering services, license revenue and other decreased $0.9 million or 46% primarily due to a decrease in licensing revenue in the Mobile market. Revenue related to the Cinema market was not material in 2023 or 2022 and was therefore included in the engineering services, license revenue and other category within the Mobile market.
Cost of revenue and gross profit
Cost of revenue and gross profit were as follows (in thousands):
Year ended December 31,
2023 % of
revenue 2022 % of
revenue
Direct product costs and related overhead 1
$ 33,599 56.3 % $ 34,070 48.6 %
Inventory charges 2
280 0.5 82 0.1
Stock-based compensation 89 0.1 41 0.1
Amortization of acquired developed technology — 0.0 72 0.1
Total cost of revenue $ 33,968 56.9 % $ 34,265 48.8 %
Gross profit $ 25,709 43.1 % $ 35,881 51.2 %
1 Includes purchased materials, assembly, test, labor, employee benefits and royalties.
2 Includes charges to reduce inventory to lower of cost or net realizable value and a benefit for sales of previously written down inventory.
Gross profit margin decreased to 43% in 2023 compared to 51% in 2022, primarily due to product mix. The decrease in sales into the Home & Enterprise market as well as the increase in sales into the Mobile market both 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 developed technology and the timing and execution of manufacturing ramps as well as other factors.
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Research and development
Research and development expense includes compensation and related costs for personnel, development-related expenses including non-recurring engineering 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 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 approximately $3.2 and $4.3 million during the years ended December 31, 2023 and 2022, respectively.
Research and development expense was as follows (in thousands):
Year ended December 31, 2023 v. 2022
2023 2022 $ change % change
Research and development $ 30,878 $ 30,521 $ 357 1 %
Research and development expense increased $0.4 million, or 1%, from 2022 to 2023 due to the following factors:
• Compensation expense increased $1.0 million due to an increase in headcount and annual merit salary increases.
• The credit recognized related to the co-development agreement decreased by $1.1 million in 2023 compared to the credit recognized in 2022.
• These increases were partially offset by a $1.7 million decrease in non-recurring engineering expense due to the timing of development activities.
Selling, general and administrative
Selling, general and administrative expense includes compensation and related costs for personnel, sales commissions, allocations for facilities and information technology expenses, 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 was as follows (in thousands):
Year ended December 31, 2023 v. 2022
2023 2022 $ change % change
Selling, general and administrative $ 23,467 $ 22,177 $ 1,290 6 %
Selling, general and administrative expense increased $1.3 million, or 6%, from 2022 to 2023 due to the following factors:
• Compensation expense increased $0.8 million due to an increased management bonus accrual and one time reversal of a payroll tax accrual in 2022.
• Accounting and other professional fees increased $0.5 million primarily due to fees incurred related to our strategic plan with our subsidiary, PWSH.
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Interest income and other, net
Interest income and other, net, consisted of the following (in thousands):
Year ended December 31,
2023 2022
Interest income $ 1,950 $ 670
Other income 125 80
Interest expense (25) (50)
Total interest income and other, net $ 2,050 $ 700
The increase in interest income in 2023 compared to 2022 is due to increased interest earned on our cash and cash equivalents balance due to the increase in the interest rate available throughout the full year in 2023 compared to the full year in 2022.
Provision (benefit) for income taxes
The benefit for income taxes was as follows (in thousands):
Year ended December 31,
2023 2022
Provision (benefit) for income taxes $ 357 $ (884)
The income tax expense of $0.4 million recorded for the year ended December 31, 2023 is primarily composed of tax expense of $0.1 million for our profitable cost-plus jurisdictions and deferred tax expense of approximately $0.3 million.
The income tax benefit of $0.9 million recorded for the year ended December 31, 2022 is primarily composed of $1.8 million of tax benefit for the reversal of tax contingencies in foreign jurisdictions, partially offset by tax expense of $0.3 million for our profitable cost-plus jurisdictions and deferred tax expense of approximately $0.6 million related to a change in the realizability of our Canadian deferred tax assets.
We continue to record a full valuation allowance against our U.S., Canada and China net deferred tax assets as of December 31, 2023 and 2022, as it is not more likely than not that we will realize a benefit from these assets in a future period. As of December 31, 2022, we were no longer more-likely-than-not to realize our remaining Canadian deferred tax assets and have recorded a full valuation allowance. We have not provided a valuation allowance against our other foreign net deferred tax assets as we have concluded it is more-likely-than-not that we will realize a benefit from these assets in a future period because our subsidiaries in these jurisdictions are cost-plus taxpayers. The net valuation allowance decreased $11.0 million for the year ended December 31, 2023 and decreased $4.4 million for the year ended December 31, 2022.
As of December 31, 2023, we have federal, state and foreign net operating loss carryforwards of approximately $154.5 million, $16.3 million, and $89.0 million respectively, which will begin expiring in 2024. As of December 31, 2023, we have available federal, state and foreign research and experimentation tax credit carryforwards of approximately $5.7 million, $5.4 million and $21.9 million respectively. The federal tax credits will begin expiring in 2024 while the state and foreign tax credits have an indefinite life. In addition, our Canadian subsidiary has unclaimed scientific and experimental expenditures to be carried forward and applied against future income in Canada of approximately $120.5 million. Our ability to utilize our federal net operating losses may be limited by Section 382 of the Internal Revenue Code of 1986, as amended, which imposes an annual limit on the ability of a corporation that undergoes an "ownership change" to use its net operating loss carryforwards to reduce its tax liability. An ownership change is generally defined as a greater than 50% increase in equity ownership by 5% shareholders in any three-year period.
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Liquidity and Capital Resources
Cash and cash equivalents
Total cash and cash equivalents decreased $9.3 million from $56.8 million at December 31, 2022 to $47.5 million at December 31, 2023. The net decrease was the result of $18.8 million used in operating activities, $4.0 million used for purchases of property and equipment and licensed technology and $1.4 million used for payments on other asset financings. These decreases were partially offset by increases of $14.6 million received in net proceeds from our non-controlling interest and certain entities owned by employees and $0.3 million in proceeds from the issuances of common stock under our employee equity incentive plans.
As of December 31, 2023, our cash and cash equivalents balance consisted of $36.5 million in cash and $1.0 million in cash equivalents held in U.S. dollar denominated money market funds and $10.0 million held in U.S. dollar denominated certificates of deposit. Our investment policy requires that our portfolio maintains 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, 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 NRSROs. Our investment policy is reviewed at least annually by our Audit Committee.
Accounts receivable, net
Accounts receivable, net increased to $10.1 million at December 31, 2023 from $10.0 million at December 31, 2022. Average number of days sales outstanding increased to 56 days at December 31, 2023 from 54 days at December 31, 2022.
Inventories
Inventories increased to $4.0 million at December 31, 2023 from $1.8 million at December 31, 2022. Inventory turnover decreased to 8.6 at December 31, 2023 from 16.6 at December 31, 2022 primarily due to higher average inventory balances in 2023 compared to 2022. Inventory turnover is calculated based on annual operating results and average inventory balances during the year.
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 years ended December 31, 2023 and December 31, 2022.
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Capital Increase Agreements
We have entered into a Capital Increase Agreement pursuant to which PWSH, one of our Chinese subsidiaries, received net proceeds from the sale of its securities pursuant thereto in an amount of RMB 279.7 million ($42.3 million USD). Additional information is provided in "Note 14: 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 PWSH, one of our Chinese subsidiaries, 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 15: 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 15: Non-Controlling Interest", which is incorporated by reference into this section.
Liquidity
As of December 31, 2023, our cash and cash equivalents balance of $47.5 million was highly liquid. We currently anticipate that our existing working capital will be adequate to fund our operating, investing and financing needs for the twelve months following our 2023 fiscal year end and beyond. We may pursue financing arrangements including the issuance of debt or equity securities or reduce expenditures, or both, to meet the Company’s 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 results of operations, financial position 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 I, “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.
Critical Accounting Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the amounts reported. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, inventories, property and equipment, impairment of long-lived assets, valuation of goodwill, valuation of share-based payments, income taxes, litigation and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:
Inventory Valuation. We value inventory at the lower of cost or net realizable value. In addition, we write down any obsolete, unmarketable or otherwise impaired inventory to net realizable value. The determination of obsolete or excess inventory requires us to estimate the future demand for our products. The estimate of future demand is compared to inventory levels to determine the amount, if any, of obsolete or excess inventory. If actual market conditions are less favorable than those we projected at the time the inventory was written down, additional inventory write-downs may be required. Inventory valuation is re-evaluated on a quarterly basis.
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Goodwill. Goodwill is not amortized, rather tested, at least annually, for impairment at a reporting unit level. Impairment of goodwill is the condition that exists when the carrying amount of a reporting unit that includes goodwill exceeds its fair value. A goodwill impairment loss is recognized for the amount that the carrying amount of the reporting unit, including goodwill, exceeds its fair value, limited to the total amount of goodwill allocated to that reporting unit. If the fair value of a reporting unit exceeds the carrying amount, goodwill of the reporting unit is not considered impaired.
We evaluate impairment using the guidance set forth in FASB Accounting Standards Update ("ASU") No. 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04") which states that an entity may first assess qualitative factors to determine whether it is necessary to perform the quantitative goodwill impairment test. If determined to be necessary, the quantitative impairment test shall be used to identify goodwill impairment and measure the amount of goodwill impairment loss to be recognized. An entity has an unconditional option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to the quantitative goodwill impairment test. We performed a qualitative assessment during the fourth quarter of 2023 and concluded that it was not more likely than not that the fair value of the reporting unit was less than its carrying amount. As a result, we concluded that a quantitative impairment test was not required and that goodwill was not impaired.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Not applicable.