Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Executive Summary
We are an innovative manufacturer of semiconductor process equipment. Our proven ion beam, laser annealing, lithography, MOCVD and single wafer wet processing technologies play an integral role in the fabrication and packaging of advanced semiconductor devices. With equipment designed to optimize performance, yield and cost of ownership, Veeco holds leading technology positions in the markets we serve. To learn more about Veeco’s systems and service offerings, visit www.veeco.com.
We categorize our revenue by the end-markets into which we sell. Our four end-markets are: Semiconductor; Compound Semiconductor; Data Storage; and Scientific & Other.
Sales in the Semiconductor market were driven by our laser annealing systems, lithography systems for Advanced Packaging, as well as Low Defect Density IBD systems for EUV Mask Blank Production. We continue to build momentum for our laser annealing solutions with advanced node logic customers. We recently announced that Veeco won an additional application with a leading manufacturer. We have evaluation systems at a DRAM manufacturer and are working with new and existing customers on their next manufacturing nodes. Our lithography systems for Advanced Packaging are aligned with longer-term growth of FOWLP and other Advanced Packaging applications. Additionally, the ongoing adoption of EUV Lithography for advanced node, semiconductor manufacturing continues to drive requirements for our mask blank systems. Overall, our technology and market strategy is well aligned with trends such as artificial intelligence, mobile connectivity and high performance computing that drive the Semiconductor market.
We address the Compound Semiconductor market with a broad portfolio of technologies including Wet Processing, MOCVD, MBE, and Ion Beam, which have been developed to support emerging applications such as 5G driven RF device manufacturing, photonics applications including 3D sensing laser diodes and micro-LEDs, and GaN-based power electronics. Sales in the Compound Semiconductor market improved in 2020, and were driven by equipment shipments for RF Filters, RF Devices, and power electronics, as well as sales to the Photonics market. The Photonics market was driven by the monetization of slow moving MOCVD inventory, as well as shipments of MOCVD, Ion Beam, and MBE equipment for specialty LED and display applications.
Sales in the Data Storage market have been growing for several years, primarily driven by shipments of Ion Beam systems for data storage applications. Demand for our Ion Beam products for data storage is being driven by big data and cloud-based storage growth. In order to be successful, hard disk drive manufacturers are required to improve areal density of magnetic heads for hard disk drives and are manufacturing drives with an increasing number of thin film magnetic heads. These two factors taken together, along with new innovations by HDD manufacturers such as heat assisted magnetic recording and microwave assisted magnetic recording, are driving additional capacity requirements and equipment upgrades. Additionally, recent trends in the work from home environment and the importance of cloud computing are also providing tailwinds to this market. We have good visibility in this market, which we believe will remain healthy through 2021.
Sales in the Scientific & Other market are largely driven by sales to governments, universities, and research institutions. While sales were lower in 2020 compared to 2019, which we attribute to COVID-19 impacts to purchasing decisions, revenues did increase in the second half of 2020 which may be indicative of a recovery.
Overall, our laser annealing, 5G RF, and data storage products are all performing well for us today, and we expect them to provide growth in the near term, through 2021. Long term growth for 2022 and beyond is expected to come from the Semiconductor and Compound Semiconductor markets. As such, we have been making strategic investments in R&D and inventory, including evaluation systems, in these markets, as well as improving our service capabilities to support these anticipated growth opportunities.
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Results of Operations
Years Ended December 31, 2020 and 2019
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations for 2020 and 2019 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment.
For the year ended December 31,
Change
2020
2019
Period to Period
(dollars in thousands)
Net sales
$
454,163
100
%
$
419,349
100
%
$
34,814
8
%
Cost of sales
259,863
57
%
261,155
62
%
(1,292)
—
%
Gross profit
194,300
43
%
158,194
38
%
36,106
23
%
Operating expenses, net:
Research and development
78,994
17
%
90,557
22
%
(11,563)
(13)
%
Selling, general, and administrative
76,251
17
%
79,749
19
%
(3,498)
(4)
%
Amortization of intangible assets
15,333
3
%
17,085
4
%
(1,752)
(10)
%
Restructuring
1,097
—
6,403
2
%
(5,306)
(83)
%
Asset impairment
281
—
4,020
1
%
(3,739)
*
Other operating expense (income), net
(221)
—
(42)
—
(179)
*
Total operating expenses, net
171,735
38
%
197,772
47
%
(26,037)
(13)
%
Operating income (loss)
22,565
5
%
(39,578)
(9)
%
62,143
*
Interest income (expense), net
(23,188)
(5)
%
(17,405)
(4)
%
(5,783)
33
%
Other income (expense), net
(7,841)
(2)
%
(20,973)
(5)
%
13,132
(63)
%
Income (loss) before income taxes
(8,464)
(2)
%
(77,956)
(19)
%
69,492
*
Income tax expense (benefit)
(73)
—
777
—
(850)
*
Net income (loss)
$
(8,391)
(2)
%
$
(78,733)
(19)
%
$
70,342
*
* Not meaningful
Net Sales
The following is an analysis of sales by end-market and by region:
Year ended December 31,
Change
2020
2019
Period to Period
(dollars in thousands)
Sales by end-market
Semiconductor
$
165,909
36
%
$
175,608
42
%
$
(9,699)
(6)
%
Compound Semiconductor
107,922
24
%
85,877
21
%
22,045
26
%
Data Storage
123,288
27
%
84,075
19
%
39,213
47
%
Scientific & Other
57,044
13
%
73,789
18
%
(16,745)
(23)
%
Total
$
454,163
100
%
$
419,349
100
%
$
34,814
8
%
Sales by geographic region
United States
$
145,353
32
%
$
126,160
30
%
$
19,193
15
%
EMEA
73,124
16
%
57,351
14
%
15,773
28
%
China
57,589
13
%
71,078
17
%
(13,489)
(19)
%
Rest of APAC
177,569
39
%
164,363
39
%
13,206
8
%
Rest of World
528
—
397
—
131
33
%
Total
$
454,163
100
%
$
419,349
100
%
$
34,814
8
%
Total sales increased for the year ended December 31, 2020 against the comparable prior year period in the Data Storage and Compound Semiconductor markets, partially offset by decreases in the Semiconductor and Scientific & Other
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markets. Pricing did not have a significant impact on the change in total sales. By geography, sales increased in the United States, EMEA, and Rest of APAC regions, partially offset by a decrease in the China region. Sales in the United States and EMEA regions were largely driven by increased sales in the Data Storage market, while sales in the Rest of APAC region were largely driven by increased sales in the Compound Semiconductor market. Included within the Rest of APAC region for the year ended December 31, 2020 were sales in Singapore and Taiwan of $49.4 million and $40.0 million, respectively, while sales in Japan and Taiwan were $48.1 million and $48.8 million for the year ended December 31, 2019. We expect there will continue to be year-to-year variations in our future sales distribution across markets and geographies. In light of the global nature of our business, we are impacted by conditions in the various countries in which we and our customers operate. Several markets continue to remain challenged in light of ongoing restrictions on business and travel, and decreased business and consumer spending generally, resulting from the COVID-19 pandemic.
Gross Profit
In 2020, gross profit increased compared to 2019 primarily due to an increase in sales volume, as well as increased gross margins. Gross margins increased principally due to higher production activity, as well as reductions in inventory reserves and warranty expenses. We expect our gross margins to fluctuate each period due to product mix and other factors.
Research and Development
The markets we serve are characterized by continuous technological development and product innovation, and we invest in various research and development initiatives to maintain our competitive advantage and achieve our growth objectives. Research and development expenses decreased in 2020 compared to 2019 primarily from reductions to personnel-related expenses, project materials, and professional fees as a result of our initiative to streamline operations, enhance efficiency, and reduce costs. In the second half of 2019, we executed an initiative to reorganize various functions along product lines and created a central research and development organization to better allocate our resources to our highest priority projects. Additionally, we had a decrease in travel-related expenses as a result of COVID-19 related restrictions.
Selling, General, and Administrative
Selling, general, and administrative expenses decreased in 2020 compared to 2019 primarily related to personnel-related expenses and professional fees as a result of our initiative to streamline operations, enhance efficiency, and reduce costs. Additionally, we had a decrease in travel-related expenses as a result of COVID-19 related restrictions. Given the uncertainty regarding the impacts on our business resulting from the COVID-19 pandemic, we are focused on the proactive management of expenses. In future periods, we may incur additional selling, general and administrative expenses to support our responses to the COVID-19 pandemic.
Amortization Expense
Amortization expense decreased in 2020 compared to 2019 primarily due to the sale of a non-core product line, including related intangible assets, as well as changes in amortization expense to reflect expected cash flows of certain intangible assets.
Restructuring Expense
We continued to record restructuring charges in 2019 as a result of our efforts to further streamline operations, enhance efficiencies, and reduce costs. In the second half of 2019, we executed an initiative to reorganize various functions along product lines and created a central research and development organization to better allocate our resources to our highest priority projects. In addition, we delayered the organization while preserving our ability to execute. Collectively, these actions impacted approximately 60 employees. During the year ended December 31, 2020, additional accruals were recognized and payments were made related to these restructuring initiatives, which are largely completed at December 31, 2020.
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Asset Impairment
During the fourth quarter of 2019, we determined that one of our non-core product lines met the criteria for held for sale accounting treatment and recorded a non-cash impairment charge of $4.0 million to reduce these assets to their expected fair value upon sale. During the second quarter of 2020, we recorded additional impairment charges of $0.3 million related to the finalization of the sale of this product line.
Interest Income (Expense)
For the year ended December 31, 2020, we recorded net interest expense of $23.2 million, compared to $17.4 million for the comparable prior period. The increase in interest expense was primarily related to the issuance of the 2027 Notes in May 2020 and the 2025 Notes in November 2020, partially offset by the partial repurchase and exchange of the 2023 Notes. Included in interest expense for the year ended December 31, 2020 were non-cash charges of $13.8 million related to the amortization of debt discount and transaction costs of the 2023 Notes, 2025 Notes, and 2027 Notes, while the year ended December 31, 2019 included non-cash charges of $12.7 million related to the amortization of debt discount and transaction costs of the 2023 Notes. Additionally, interest income decreased approximately $3.1 million for the year ended December 31, 2020 as compared to the prior period, primarily as a result of lower interest rates, and we expect interest income to remain depressed as a result.
Other Income (Expense)
On May 18, 2020, in connection with the completion of a private offering of $125 million aggregate principal amount of 3.75% convertible senior notes, we repurchased and retired approximately $88.3 million in aggregate principal amount of our outstanding 2023 Notes, with a carrying amount of $78.1 million, for approximately $81.2 million of cash. Additionally, on November 11, 2020, we entered into a privately negotiated exchange agreement with a holder of our outstanding 2023 Notes, under which we agreed to retire $125.0 million in aggregate original principal amount of the 2023 Notes, with a carrying amount of $113.1 million, in exchange for the issuance of $132.5 million in aggregate principal amount of new 3.50% convertible senior notes. We accounted for both transactions as an extinguishment of the 2023 Notes, and as such, recorded a loss on extinguishment of approximately $7.8 million for the year ended December 31, 2020.
During the fourth quarter of 2019, we determined that our equity investment in Kateeva had indicators of impairment, and as such, we reviewed this investment for impairment. Based on this review, we recorded a non-cash impairment charge of $21.0 million.
Income Taxes
The 2020 income tax benefit of $0.1 million is comprised of: (i) a $0.8 million income tax benefit related to the amortization and subsequent sale of certain intangible assets during the year, which was partially offset by (ii) a $0.5 million income tax expense attributed to the profitable non-U.S. operations, as well as withholding tax to repatriate certain foreign earnings as a result of changes in tax laws under the 2017 Tax Act, and (iii) a $0.2 million income tax expense related primarily to U.S. tax amortization of our indefinite-lived intangible assets that is not available to offset existing deferred tax assets, as well as state and local income taxes.
The 2019 income tax expense of $0.8 million is comprised of: (i) a $1.0 million income tax expense attributed to the profitable non-U.S. operations, as well as withholding tax as we now expect to repatriate certain foreign earnings as a result of changes in tax laws under the 2017 Tax Act, (ii) a $0.3 million income tax expense related primarily to U.S. tax amortization of our indefinite-lived intangible assets that is not available to offset existing deferred tax assets, as well as state and local income taxes, which were partially offset by (iii) a $0.5 million income tax benefit related to the amortization and subsequent impairment of certain non-U.S. intangible assets during the year.
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Years Ended December 31, 2019 and 2018
See Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 21, 2020, for Management’s Discussions and Analysis of Financial Condition and Results of Operations for the fiscal year ended December 31, 2018. In addition, in order to align with our evolving strategy, we have changed the end-markets by which we categorize sales. Prior period sales have been reclassified to the new end-markets for comparative purposes. The following is an analysis of sales by end-market:
Year ended December 31,
Change
2019
2018
Period to Period
(dollars in thousands)
Sales by end-market
Semiconductor
$
175,608
42
%
$
137,797
26
%
$
37,811
27
%
Compound Semiconductor
85,877
20
%
260,323
48
%
(174,446)
(67)
%
Data Storage
84,075
20
%
69,141
12
%
14,934
22
%
Scientific & Other
73,789
18
%
74,821
14
%
(1,032)
(1)
%
Total
$
419,349
100
%
$
542,082
100
%
$
(122,733)
(23)
%
Total sales decreased for the year ended December 31, 2019 against the comparable prior year period principally in the Compound Semiconductor market, partially offset by increases in the Semiconductor and Data Storage markets. Pricing did not have a significant impact on the change in total sales. The decrease in sales in the Compound Semiconductor market was largely driven by our exit out of the low margin commoditized LED market. We expect there will continue to be year-to-year variations in our future sales distribution across markets.
Liquidity and Capital Resources
Our cash and cash equivalents, restricted cash, and short-term investments are as follows:
December 31,
December 31,
2020
2019
(in thousands)
Cash and cash equivalents
$
129,625
$
129,294
Restricted cash
658
657
Short-term investments
189,771
115,252
Total
$
320,054
$
245,203
A portion of our cash and cash equivalents is held by our subsidiaries throughout the world, frequently in each subsidiary’s respective functional currency, which is typically the U.S. dollar. At December 31, 2020 and 2019, cash and cash equivalents of $40.2 million and $73.0 million, respectively, were held outside the United States. As of December 31, 2020, we had $12.6 million of accumulated undistributed earnings generated by our non-U.S. subsidiaries for which the U.S. repatriation tax has been provided and did not require the use of cash due to the use of net operating loss carryforwards. Approximately $6.0 million of undistributed earnings would be subject to foreign withholding taxes if distributed back to the United States. We believe that our projected cash flow from operations, combined with our cash and short-term investments, will be sufficient to meet our projected working capital requirements, contractual obligations, and other cash flow needs for the next twelve months, including scheduled interest payments on our convertible senior notes.
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A summary of the cash flow activity for the year ended December 31, 2020 and 2019 is as follows:
Cash Flows from Operating Activities
For the year ended December 31,
2020
2019
(in thousands)
Net income (loss)
$
(8,391)
$
(78,733)
Non-cash items:
Depreciation and amortization
30,697
34,399
Non-cash interest expense
13,792
12,676
Deferred income taxes
(299)
360
Share-based compensation expense
12,703
15,270
Loss on extinguishment of debt
7,841
—
Asset impairment
281
4,020
Impairment of equity investments
—
20,973
Provision for bad debts
140
392
Changes in operating assets and liabilities
(13,743)
(16,773)
Net cash provided by (used in) operating activities
$
43,021
$
(7,416)
Net cash provided by operating activities was $43.0 million for the year ended December 31, 2020 and was due to the net loss of $8.4 million plus a decline in cash flow from operating activities due to changes in operating assets and liabilities of $13.7 million, being more than offset by adjustments for non-cash items of $65.2 million. The changes in operating assets and liabilities was largely attributable to increases in accounts receivable and inventories and decreases in deferred revenue, partially offset by increases in accounts payable and customer deposits.
Net cash used in operating activities was $7.4 million for the year ended December 31, 2019 and was due to the net loss of $78.7 million plus a decline in cash flow from operating activities due to changes in operating assets and liabilities of $16.8 million, partially offset by adjustments for non-cash items of $88.1 million. The changes in operating assets and liabilities was largely attributable to decreases in accounts payable and accrued expenses and customer deposits and deferred revenue, partially offset by decreases in inventories and deferred cost of sales, accounts receivable and contract assets, and prepaid expenses and other current assets.
Cash Flows from Investing Activities
For the year ended December 31,
2020
2019
(in thousands)
Capital expenditures
$
(6,802)
$
(10,873)
Changes in investments, net
(74,493)
(65,639)
Proceeds from held for sale assets, net of costs to sell
9,503
645
Net cash provided by (used in) investing activities
$
(71,792)
$
(75,867)
The net cash used in investing activities during the year ended December 31, 2020 was attributable to capital expenditures and net change in investments, partially offset by the proceeds from the sale of a non-core product line. As discussed in Note 20 to the Consolidated Financial Statements, we have entered into a new lease agreement in San Jose, California, and as such, capital expenditures associated with the build-out of the new facility are expected to total between $30 million and $40 million over the next two years. In addition, we expect a period of duplicate operating expenses until the transition from our existing facility to our new facility is completed over the next two years. The net cash used in investing activities during the year ended December 31, 2019 was attributable to net change in investments as well as capital expenditures.
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Cash Flows from Financing Activities
For the year ended December 31,
2020
2019
(in thousands)
Proceeds from issuance of 2025 Notes and 2027 Notes, net of issuance costs
$
120,095
$
—
Purchase of capped calls
(10,313)
—
Repurchase of 2023 Notes
(81,240)
—
Settlement of equity awards, net of withholding taxes
556
126
Net cash provided by (used in) financing activities
$
29,098
$
126
The net cash provided by financing activities for the year ended December 31, 2020 was primarily related to the net cash proceeds received from the issuance of the 2025 Notes and 2027 Notes, net of issuance costs, partially offset by the cash used to repurchase the 2023 Notes as well as the purchase of capped calls.
Convertible Senior Notes
2023 Notes
On January 10, 2017, we issued $345.0 million of 2.70% convertible senior notes. On May 18, 2020, in connection with the completion of a private offering of $125 million aggregate principal amount of 3.75% convertible senior notes described below, we repurchased and retired approximately $88.3 million in aggregate principal amount of our outstanding 2023 Notes. Additionally, on November 11, 2020, we entered into a privately negotiated exchange agreement with a holder of our outstanding 2023 Notes, under which we agreed to retire $125.0 million in aggregate original principal amount of the 2023 Notes, in exchange for the issuance of $132.5 million in aggregate principal amount of new 3.50% convertible senior notes described below. The remaining 2023 Notes bear interest at a rate of 2.70% per year, payable semiannually in arrears on January 15 and July 15 of each year. The 2023 Notes mature on January 15, 2023, unless earlier purchased by the Company, redeemed, or converted.
2025 Notes
On November 17, 2020, as part of the privately negotiated exchange agreement described above, we issued $132.5 million of 3.50% convertible senior notes. The 2025 Notes bear interest at a rate of 3.50% per year, payable semiannually in arrears on January 15 and July 15 of each year, commencing on July 15, 2021. The 2025 Notes mature on January 15, 2025, unless earlier purchased by the Company, redeemed, or converted.
2027 Notes
On May 18, 2020, we completed a private offering of $125.0 million of 3.75% convertible senior notes. We received net proceeds of approximately $121.9 million, after deducting underwriting discounts and fees and expenses payable by the Company. Additionally, we used approximately $10.3 million of cash to purchase the capped calls. The 2027 Notes bear interest at a rate of 3.75% per year, payable semiannually in arrears on June 1 and December 1 of each year, commencing on December 1, 2020. The 2027 Notes mature on June 1, 2027, unless earlier purchased by the Company, redeemed, or converted.
We believe that we have sufficient capital resources and cash flows from operations to support scheduled interest payments on these debts.
Contractual Obligations and Commitments
We have commitments under certain contractual arrangements to make future payments for goods and services. These contractual arrangements secure the rights to various assets and services to be used in the future in the normal course of business. We expect to fund these contractual arrangements with cash generated from operations in the normal course of business, as well as existing cash and cash equivalents and short-term investments. In addition, we have bank guarantees and letters of credit issued by a financial institution on our behalf as needed. At December 31, 2020, outstanding bank
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guarantees and letters of credit totaled $9.5 million and unused bank guarantees and letters of credit of $23.2 million were available to be drawn upon.
The following table summarizes our contractual arrangements at December 31, 2020 and the timing and effect that those commitments are expected to have on our liquidity and cash flow in future periods.
Payments due by period
Less than
1 – 3
3 – 5
More than
Total
1 year
years
years
5 years
(in thousands)
Principal payments on long-term debt
$
389,195
$
—
$
131,695
$
132,500
$
125,000
Cash interest on debt
57,450
10,104
23,984
16,331
7,031
Operating leases
11,364
4,671
6,627
66
—
Purchase commitments (1)
126,415
126,415
—
—
—
Total
$
584,424
$
141,190
$
162,306
$
148,897
$
132,031
(1) Purchase commitments are generally for inventory used in the manufacturing of our products. We generally do not enter into purchase commitments extending beyond one year. At December 31, 2020, we have $7.2 million of offsetting supplier deposits that will be applied against these purchase commitments.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, expenses, results of operations, liquidity, capital expenditures, or capital resources other than bank guarantees and purchase commitments reflected in the preceding “Contractual Obligations and Commitments” table.
Application of Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires a high degree of judgment, either in the application and interpretation of existing accounting literature or in the development of estimates that affect the reported amounts of assets, liabilities, revenues, and expenses. We continuously evaluate our estimates and judgments based on historical experience, as well as other factors that we believe to be reasonable under the circumstances. The results of our evaluation form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates may change in the future if underlying assumptions or factors change, and actual results may differ from these estimates.
We consider the following significant accounting policies to be critical because of their complexity and the high degree of judgment involved in maintaining them.
Revenue Recognition
Revenue is recognized upon the transfer of control of the promised product or service to the customer in an amount that reflects the consideration we expect to receive in exchange for such product or service. Our contracts with customers generally do not contain variable consideration. In the rare instances where variable consideration is included, we estimate the amount of variable consideration and determine what portion of that, if any, has a high probability of significant subsequent revenue reversal, and if so, that amount is excluded from the transaction price. Our contracts with customers frequently contain multiple deliverables, such as systems, upgrades, components, spare parts, installation, maintenance, and service plans. Judgment is required to properly identify the performance obligations within a contract and to determine how the revenue should be allocated among the performance obligations. We also evaluate whether multiple transactions with the same customer or related parties should be considered part of a single contract based on an assessment of whether the contracts or agreements are negotiated or executed within a short time frame of each other or if there are indicators that the contracts are negotiated in contemplation of one another.
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When there are separate units of accounting, we allocate revenue to each performance obligation on a relative stand-alone selling price basis. The stand-alone selling prices are determined based on the prices at which we separately sell the systems, upgrades, components, spare parts, installation, maintenance, and service plans. For items that are not sold separately, we estimate stand-alone selling prices generally using an expected cost plus margin approach.
Most of our revenue is recognized at a point in time when the performance obligation is satisfied. We consider many facts when evaluating each of our sales arrangements to determine the timing of revenue recognition, including our contractual obligations and the nature of the customer’s post-delivery acceptance provisions. Our system sales arrangements, including certain upgrades, generally include field acceptance provisions that may include functional or mechanical test procedures. For many of these arrangements, a customer source inspection of the system is performed in our facility, test data is sent to the customer documenting that the system is functioning to the agreed upon specifications prior to delivery, or other quality assurance testing is performed internally to ensure system functionality prior to shipment. Historically, such source inspection or test data replicates the field acceptance provisions that are performed at the customer’s site prior to final acceptance of the system. When we objectively demonstrate that the criteria specified in the contractual acceptance provisions are achieved prior to delivery either through customer testing or our historical experience of our tools meeting specifications, transfer of control of the product to the customer is considered to have occurred and revenue is recognized upon system delivery since there is no substantive contingency remaining related to the acceptance provisions at that date. For new products, new applications of existing products, or for products with substantive customer acceptance provisions where we cannot objectively demonstrate that the criteria specified in the contractual acceptance provisions have been achieved prior to delivery, revenue and the associated costs are deferred. We recognize such revenue and costs upon obtaining objective evidence that the acceptance provisions can be achieved, assuming all other revenue recognition criteria have been met.
In certain cases, our contracts with customers contain a billing retention which is billed by us and payable by the customer when field acceptance provisions are completed. Revenue recognized in advance of the amount that has been billed is recorded as a contract asset on the Consolidated Balance Sheets.
We recognize revenue related to maintenance and service contracts over time based upon the respective contract term. Installation revenue is recognized over time as the installation services are performed. We recognize revenue from the sales of components, spare parts, and specified service engagements at a point in time, which is typically consistent with the time of delivery in accordance with the terms of the applicable sales arrangement.
We may receive customer deposits on system transactions. The timing of the transfer of goods or services related to the deposits is either at the discretion of the customer or expected to be within one year from the deposit receipt. As such, we do not adjust transaction prices for the time value of money. Incremental direct costs incurred related to the acquisition of a customer contract, such as sales commissions, are expensed as incurred since the expected performance period is one year or less.
We have elected to treat shipping and handling costs as a fulfillment activity, and we include such costs in cost of services when we recognize revenue for the related goods. Taxes assessed by governmental authorities that are collected by us from a customer are excluded from revenue.
Inventory Valuation
Inventories are stated at the lower of cost or net realizable value, with cost determined on a first-in, first-out basis. Each quarter we assess the valuation and recoverability of all inventories: materials (raw materials, spare parts, and service inventory); work-in-process; and finished goods. Obsolete inventory or inventory in excess of our estimated usage requirements is written down to its estimated net realizable value if less than cost. We evaluate usage requirements by analyzing historical usage, anticipated demand, alternative uses of materials, and other qualitative factors. Unanticipated changes in demand for our products may require a write down of inventory that could materially affect our operating results.
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Goodwill and Intangible Assets
Goodwill is tested for impairment at least annually in the beginning of the fourth quarter of our fiscal year. We may first perform a qualitative assessment of whether it is more likely than not that the reporting unit’s fair value is less than its carrying amount, and, if so, we then quantitatively compare the fair value of our reporting unit to its carrying amount. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not impaired. If the carrying amount of the reporting unit exceeds its fair value, we then record an impairment loss equal to the difference, up to the carrying value of goodwill.
We determine the fair value of our reporting unit based on a reconciliation of the aggregate fair value of our reporting unit to our adjusted market capitalization. The adjusted market capitalization is calculated by multiplying the average share price of our common stock for the last ten trading days prior to the measurement date by the number of outstanding common shares and adding a control premium. The control premium is estimated using historical transactions in similar industries.
The carrying values of long-lived assets, including identifiable intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, a recoverability test is performed utilizing undiscounted cash flows expected to be generated by that asset or asset group compared to its carrying amount. If the carrying amount of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent the carrying amount exceeds its fair value. Fair value is determined through various valuation techniques including discounted cash flow models or, when available, quoted market values and third-party appraisals. It is not possible for us to predict the likelihood of any possible future impairments or, if such an impairment were to occur, the magnitude of any impairment.
Intangible assets with finite useful lives, including purchased technology, customer-related intangible assets, patents, trademarks, backlog, and software licenses, are subject to amortization over the expected period of economic benefit to us. We evaluate whether events or circumstances have occurred that warrant a revision to the remaining useful lives of intangible assets. In cases where a revision is deemed appropriate, the remaining carrying amounts of the intangible assets are amortized over the revised remaining useful life.
Intangible assets related to in-process research and development (“IPR&D”) projects are considered to be indefinite-lived until the completion or abandonment of the associated R&D efforts. If and when development is complete, the associated assets would be deemed long-lived and would then be amortized based on their respective estimated useful lives at that point in time. Indefinite-lived intangible assets are tested for impairment at least annually in the beginning of the fourth quarter of our fiscal year. In testing indefinite-lived intangible assets for impairment, we may first perform a qualitative assessment of whether it is more likely than not that the fair value of the indefinite-lived intangible asset is less than its carrying amount, and, if so, we then quantitatively compare the fair value of the indefinite-lived intangible asset to its carrying amount. We determine the fair value of our indefinite-lived intangible assets using a discounted cash flow method.
Income Taxes
We estimate our income taxes in each of the jurisdictions in which we operate. Deferred income taxes reflect the net tax effect of temporary differences between the asset and liability balances recognized for financial reporting purposes and the balances used for income tax purposes, as well as the tax effect of carry forwards. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Realization of our net deferred tax assets is dependent on future taxable income.
We recognize the effect of income tax positions for only those positions which are estimated to more likely than not be sustained if challenged. We reflect changes in recognition or measurement in the period in which our change in judgment occurs. We record interest and penalties related to uncertain tax positions in income tax expense. Income taxes related to the global intangible low-taxed income (“GILTI”) rules are expensed as incurred.
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Recent Accounting Pronouncements
We adopted ASC 842 as of January 1, 2019 and ASU 2019-12 in the second quarter of 2020. Additionally, we are currently evaluating the impact of ASU 2020-06 on our consolidated financial statements, which will be effective for us starting January 1, 2022, with early adoption permitted. Refer to Note 1, “Significant Accounting Policies,” for additional information.
We are also evaluating other pronouncements recently issued but not yet adopted. The adoption of these pronouncements is not expected to have a material impact on our consolidated financial statements.