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.
The Veeco United team executed well in a challenging environment during 2022, accomplishing a number of milestones, including:
● Solidly executing our multi-year growth strategy, with progress advancing our product roadmaps for the Semiconductor and Compound Semiconductor markets, execution of our robust evaluation program with high customer acceptance rates, and completing our San Jose expansion
● Achieved 11% year-on-year revenue growth for the Company, including record revenue in the Semiconductor market, which grew 50% year-on-year
● Developed silicon carbide market strategy, culminating in the acquisition of Epiluvac, accelerating our SiC epitaxy equipment market penetration
● Reinforced our commitment to culture and corporate responsibility, including appointing an additional female Board member, publishing our third sustainability report, and implementing a leadership training program
● Positioned the Company for a solid performance expected in 2023, with an ending 2022 backlog of $500 million, and robust cash flow from operations of $108 million, strengthening our balance sheet
These accomplishments enabled us to exit 2022 well positioned to execute on our growth plans for 2023.
Business Update
Macroeconomic challenges across the industry have been well publicized, including supply chain constraints, an inflationary environment with a potential recession ahead, new China-export regulations, and a forecasted decline in the semiconductor and related markets due to softness in consumer, smartphone and PC applications, all of which are contributing to a difficult environment with increased uncertainty.
Longer lead times and parts shortages and allocations have required that we plan further ahead than usual, and we have undertaken efforts to increase our purchase commitments to secure critical components in a timely manner. Material lead times continue to be a challenge with respect to our supply chain, limiting our ability to fulfill some of our customers’ demands in a timely manner, as many of our peers have also been experiencing. We are also experiencing increasing labor, logistics, and material costs, creating additional gross margin pressures. We expect supply shortages and related challenges to persist into 2023, and we continue to monitor our supply chain and work with our suppliers to identify and mitigate potential gaps in an effort to ensure continuity of supply.
Additionally, we have seen a slow-down in certain shorter lead time products such as wet processing, advanced packaging lithography, and spare parts and upgrades, as well as instances where customers have requested order cancellations, delayed shipments, or delayed payments. Consequently, we are monitoring the situation very closely and have been taking early actions to limit the pace at which we increase spending while maintaining our growth trajectory.
Furthermore, the US Department of Commerce, Bureau of Industry and Security (“BIS”), issued additional China-export regulations on October 7, 2022, which broadened the requirements under which export licenses will be required, with a presumption of denial as to their issuance. In addition, certain China-based companies were added to the BIS Unverified
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List, and changes have been made to the BIS Entity List, further restricting sales to the named entities. Recent order activity has led to significant backlog in China, some of which may be subject to these regulations. While the export regulation landscape is fluid and evolving, we believe at this time that the substantial majority of this backlog will not be negatively affected by the new regulations.
Finally, like many in our industry, we continue to manage through the effects of the COVID-19 pandemic. While new variants of COVID-19 have emerged and additional variants may emerge in the future, we continue to proactively implement precautionary measures if and when necessary to keep our workplaces healthy and safe. Our top priority steadfastly remains protecting the health and safety of our employees, customers, suppliers and community.
While our actions have been effective so far, there could be additional challenges ahead that may impact either our operations or those of our customers, which could have a negative effect on our financial performance, including productivity and capacity impacts as a result of the ongoing pandemic. We expect these measures to continue until we determine that the COVID-19 pandemic is adequately contained for purposes of our operations, and we may take further actions as government authorities require or as we determine to be in the best interests of our employees, customers, suppliers and community. We may incur additional expenses in future periods in response to the pandemic, which could adversely affect our operations and financial condition.
While we work to overcome these macroeconomic challenges, we continue to serve our customers in the following four end-markets: Semiconductor; Compound Semiconductor; Data Storage; and Scientific & Other.
Sales in the Semiconductor market grew 50% in 2022 and were driven by our laser annealing systems for both advanced and trailing node logic devices, ion beam deposition systems for EUV mask blank production, and lithography systems for Advanced Packaging. We continue to build momentum for our laser annealing solutions with advanced node logic customers by winning application steps with leading manufacturers. We have also been receiving orders and shipping systems for trailing node applications in China and other regions. In addition to logic, we introduced laser annealing to the memory market and received an acceptance for an evaluation system at a DRAM manufacturer. Our lithography systems for Advanced Packaging are aligned with packaging approaches such as fan out wafer level packaging and other advanced packaging applications. Additionally, the ongoing adoption of EUV Lithography for advanced node semiconductor manufacturing continues to drive demand for our Ion Beam mask blank systems. Overall, our technology and market strategy are well aligned with trends such as artificial intelligence, mobile connectivity and high-performance computing that drive the Semiconductor market. Given recent order activity and current backlog in the Semiconductor market, we expect revenue in 2023 to outpace (“WFE”) spending growth, which is forecasted to be down 20% or more. Finally, we have completed our new San Jose leased facility buildout, and have fully transitioned to this new location.
We address the Compound Semiconductor market with a broad portfolio of technologies, including Wet Processing and MOCVD, along with MBE and Ion Beam, all of which have been developed to support emerging applications such as 5G driven RF device/filter manufacturing, GaN power electronics, and photonics applications including edge-emitting lasers, specialty LEDs and micro-LEDs. Sales in the Compound Semiconductor market grew 13% in 2022. We experienced growth in system shipments for photonics applications. We continue to invest for future growth in the Compound Semiconductor market in areas like power electronics and Micro-LEDs. Power electronics markets are served by GaN equipment, and also by SiC epitaxy equipment. We are working to penetrate the GaN power market, which is driven by applications such as wireless charging in consumer electronics. In addition to our GaN system offerings, on January 31 st , 2023 Veeco acquired SiC technology to address the high-growth SiC power epitaxy equipment market, which is driven by electric vehicles. With this acquisition, Veeco is accelerating its entry into this market, and expects revenue in 2024. The purchase price for the transaction, all payable in cash, was $30 million paid at the time of closing with a potential additional $35 million in performance based earn-outs.
After several years of growth, sales in the Data Storage market were down 48% in 2022. Demand for our Ion Beam products is driven by cloud-based storage. Hard disk drive manufacturers are manufacturing drives with an increasing number of magnetic heads and they are introducing advanced technologies which require increased capital intensity. With data proliferation forecasted to continue to grow, and based on orders we received in 2022, we feel optimistic about the long-term prospects of our data storage business.
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Sales in the Scientific & Other market are largely driven by sales to governments, universities, and research institutions. Revenue was up 12% in 2022 compared to 2021, and we expect sales in this market to grow modestly in the long run, in line with GDP.
Overall, given our strong backlog in the semiconductor, data storage and scientific markets, offset by near-term weakness in compound semiconductor, we expect total 2023 revenue to be in the range of $630 million to $670 million.
Results of Operations
Years Ended December 31, 2022 and 2021
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations for 2022 and 2021 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
2022
2021
Period to Period
(dollars in thousands)
Net sales
$
646,137
100
%
$
583,277
100
%
$
62,860
11
%
Cost of sales
382,989
59
%
341,003
58
%
41,986
12
%
Gross profit
263,148
41
%
242,274
42
%
20,874
9
%
Operating expenses, net:
Research and development
103,565
16
%
88,680
15
%
14,885
17
%
Selling, general, and administrative
88,952
14
%
84,536
14
%
4,416
5
%
Amortization of intangible assets
10,018
2
%
12,280
2
%
(2,262)
(18)
%
Other operating expense (income), net
317
—
%
68
—
%
249
366
%
Total operating expenses, net
202,852
31
%
185,564
32
%
17,288
9
%
Operating income
60,296
9
%
56,710
10
%
3,586
6
%
Interest income (expense), net
(9,311)
(1)
%
(26,020)
(4)
%
16,709
(64)
%
Other income (expense), net
—
—
%
(5,010)
(1)
%
5,010
*
Income before income taxes
50,985
8
%
25,680
4
%
25,305
99
%
Income tax expense (benefit)
(115,957)
—
%
(358)
—
%
(115,599)
*
Net income
$
166,942
26
%
$
26,038
4
%
$
140,904
541
%
* Not meaningful
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Net Sales
The following is an analysis of sales by end-market and by region:
Year ended December 31,
Change
2022
2021
Period to Period
(dollars in thousands)
Sales by end-market
Semiconductor
$
369,369
57
%
$
247,051
43
%
$
122,318
50
%
Compound Semiconductor
121,194
19
%
106,972
18
%
14,222
13
%
Data Storage
87,544
13
%
168,760
29
%
(81,216)
(48)
%
Scientific & Other
68,030
11
%
60,494
10
%
7,536
12
%
Total
$
646,137
100
%
$
583,277
100
%
$
62,860
11
%
Sales by geographic region
United States
$
197,433
31
%
$
217,209
38
%
$
(19,776)
(9)
%
EMEA
87,837
14
%
55,129
9
%
32,708
59
%
China
123,703
19
%
105,998
18
%
17,705
17
%
Rest of APAC
235,735
36
%
204,633
35
%
31,102
15
%
Rest of World
1,429
—
%
308
—
%
1,121
364
%
Total
$
646,137
100
%
$
583,277
100
%
$
62,860
11
%
Total sales increased for the year ended December 31, 2022 against the comparable prior year period in the Semiconductor, Compound Semiconductor, and Scientific & Other markets, partially offset by a decline in the Data Storage market. By geography, sales increased in the EMEA, China, and Rest of APAC regions, partially offset by a decrease in the United States. Included within the Rest of APAC region for the year ended December 31, 2022 were sales in Taiwan, South Korea, Singapore, and Japan of $105.0 million, $40.3 million, $38.4 million, and $30.8 million, respectively, while sales within Rest of APAC region for the year ended December 31, 2021 included sales in Taiwan and South Korea of $65.2 million and $50.4 million, respectively. 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.
Gross Profit
In 2022, gross profit increased compared to 2021 primarily due to an increase in sales volume, partially offset by decreased gross margins. Gross margins decreased principally due to increased logistics costs, as well as an increase in spending as we invested in service infrastructure and capacity expansion to meet the growing demands for our semiconductor product lines. 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 increased in 2022 compared to 2021 primarily due to personnel-related expenses as we invest in new research and development and additional applications for our technology in order to be well positioned to capitalize on emerging global megatrends and support longer term growth in Semiconductor and Compound Semiconductor markets.
Selling, General, and Administrative
Selling, general, and administrative expenses increased in 2022 compared to 2021 primarily due to higher variable expenses associated with the increase in revenue, profitability, and order in-take. 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
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responses to the COVID-19 pandemic. In addition, we experienced some duplicate operating expenses for the transition from our existing facility in San Jose, California to our new leased facility, which is substantially complete at this time.
Amortization Expense
Amortization expense decreased in 2022 compared to 2021 primarily due to changes in amortization expense to reflect expected cash flows of certain intangible assets, as well as certain other intangible assets becoming fully amortized in 2022.
Interest Income (Expense)
For the year ended December 31, 2022, we recorded net interest expense of $9.3 million, compared to $26.0 million for the comparable prior period. The decrease in interest expense was primarily related to the adoption of ASU 2020-06, as non-cash charges related to the amortization of debt discount and transaction costs of the 2023 Notes, 2025 Notes, and 2027 Notes decreased approximately $12.9 million for 2022 compared to 2021. Additionally, cash interest expense on the Notes decreased approximately $2.6 million from the comparable prior year due to the partial repurchase of the 2023 Notes in November 2021.
Other Income (Expense)
On November 5, 2021, we entered into a privately negotiated note purchase agreement with a holder of our outstanding 2023 Notes, under which we agreed to repurchase and retire approximately $111.5 million in aggregate original principal amount of the 2023 Notes, with a carrying amount of $105.5 million, for cash consideration of approximately $115.6 million, and approximately $1.0 million of accrued and unpaid interest. We accounted for the partial settlement of the 2023 Notes as an extinguishment, and as such, recorded a loss on extinguishment of approximately $4.0 million for the year ended December 31, 2021. In addition, we recorded a non-cash impairment charge of approximately $1.0 million related to an equity investment without a readily observable market price.
Income Taxes
At each reporting date, we consider new evidence, both positive and negative, that could affect our view of the future realization of our deferred tax assets. As of December 31, 2022, we achieved three years of cumulative pretax income for our United States (“domestic”) operations. In addition, we evaluated additional positive evidence and concluded that it is more likely than not our deferred tax assets are realizable on a more likely than not basis with the exception of certain state tax attributes.
The 2022 income tax benefit of $116.0 million was primarily comprised of a $117.0 million domestic tax benefit primarily in connection with release of $105.5 million valuation allowance, partially offset by a $1.0 million income tax expense related to our foreign operations.
The 2021 income tax benefit of $0.4 million is comprised of a $0.7 million income tax benefit related to the reduction of uncertain tax positions based upon settlements with tax authorities, partially offset by a $0.3 million income tax expense attributable to the foreign income taxes and foreign withholding taxes.
Years Ended December 31, 2021 and 2020
See Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on February 18, 2022, for Management’s Discussions and Analysis of Financial Condition and Results of Operations for the fiscal year ended December 31, 2020.
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Liquidity and Capital Resources
Our cash and cash equivalents, restricted cash, and short-term investments are as follows:
December 31,
December 31,
2022
2021
(in thousands)
Cash and cash equivalents
$
154,925
$
119,747
Restricted cash
547
725
Short-term investments
147,488
104,181
Total
$
302,960
$
224,653
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, 2022 and 2021, cash and cash equivalents of $28.4 million and $38.3 million, respectively, were held outside the United States. As of December 31, 2022, we had $17.8 million of accumulated undistributed earnings generated by our non-U.S. subsidiaries for which the U.S. repatriation tax has been provided. Approximately $7.8 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.
A summary of the cash flow activity for the year ended December 31, 2022 and 2021 is as follows:
Cash Flows from Operating Activities
For the year ended December 31,
2022
2021
(in thousands)
Net income
$
166,942
$
26,038
Non-cash items:
Depreciation and amortization
25,645
26,058
Non-cash interest expense
962
13,819
Deferred income taxes
(118,040)
(651)
Share-based compensation expense
22,994
15,249
Loss on extinguishment of debt
—
4,029
Impairment of equity investment
—
980
Changes in operating assets and liabilities
9,980
(17,780)
Net cash provided by (used in) operating activities
$
108,483
$
67,742
Net cash provided by operating activities was $108.5 million for the year ended December 31, 2022 and was due to net income of $166.9 million and an increase in cash flow from operating activities due to changes in operating assets and liabilities of $10.0 million, partially offset by adjustments for non-cash items of $68.5 million. The changes in operating assets and liabilities was largely attributable to an increase in customer deposits, partially offset by an increase in inventories and accounts receivables.
Net cash provided by operating activities was $67.7 million for the year ended December 31, 2021 and was due to net income of $26.0 million and adjustments for non-cash items of $59.5 million, partially offset by a decline in cash flow from operating activities due to changes in operating assets and liabilities of $17.8 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 cash received for landlord reimbursements for leasehold improvements.
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Cash Flows from Investing Activities
For the year ended December 31,
2022
2021
(in thousands)
Capital expenditures
$
(24,604)
$
(40,643)
Changes in investments, net
(44,276)
83,446
Proceeds from held for sale assets, net of costs to sell
—
1,725
Net cash provided by (used in) investing activities
$
(68,880)
$
44,528
The net cash used in investing activities during the year ended December 31, 2022 was attributable to the net change in investments, as well as capital expenditures. The net cash provided by investing activities during the year ended December 31, 2021 was attributable to the net change in investments, partially offset by capital expenditures. We experienced a high level of capital expenditures during 2021 associated with the continued build-out of our newly leased facility in San Jose, California, which is substantially complete at this time.
Cash Flows from Financing Activities
For the year ended December 31,
2022
2021
(in thousands)
Repurchase of 2023 Notes
$
—
$
(115,604)
Debt issuance costs
—
(835)
Settlement of equity awards, net of withholding taxes
(4,550)
(5,590)
Net cash provided by (used in) financing activities
$
(4,550)
$
(122,029)
The net cash used in financing activities for the year ended December 31, 2022 was primarily related to the settlement of equity awards. The net cash used in financing activities for the year ended December 31, 2021 was primarily related to the cash used to repurchase $111.5 million principal amount of our 2023 Notes as well as the settlement of equity awards.
Convertible Senior Notes and Revolving Credit Facility
We have $20.2 million outstanding principal balance of 2.70% convertible senior notes that bear interest at a rate of 2.70% per year, payable semiannually in arrears on January 15 and July 15 of each year, and mature on January 15, 2023, unless earlier purchased by the Company, redeemed, or converted. These notes matured on January 15, 2023 and were paid in cash and settled by the Company at that time. In addition, we have $132.5 million outstanding principal balance of 3.50% convertible senior notes that bear interest at a rate of 3.50% per year, payable semiannually in arrears on January 15 and July 15 of each year, and mature on January 15, 2025, unless earlier purchased by the Company, redeemed, or converted. Finally, we have $125.0 million outstanding principal balance of 3.75% convertible senior notes that bear interest at a rate of 3.75% per year, payable semiannually in arrears on June 1 and December 1 of each year, and mature on June 1, 2027, unless earlier purchased by the Company, redeemed, or converted. The 2027 Notes are currently convertible by shareholders until March 31, 2023.
We believe that we have sufficient capital resources and cash flows from operations to support scheduled interest payments on these debts. In addition, we have access to a $150.0 million revolving credit facility (including an ability to request an additional $75.0 million, for a total commitment of no more than $225.0 million) to provide for our working capital needs and reimburse drawings under letters of credit and for other general corporate purposes. The Company has no immediate plans to draw down on the facility, which expires in December of 2026. Interest under the Facility is variable based on the Company’s secured net leverage ratio and is expected to bear interest based on SOFR plus a range of 150 to 225 basis points, if drawn. There is a yearly commitment fee of 25 to 35 basis points, based on the Company’s secured net leverage ratio, charged on the unused portion of the Facility.
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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, 2022, outstanding bank guarantees and letters of credit totaled $8.2 million and unused bank guarantees and letters of credit of $14.1 million were available to be drawn upon.
The following table summarizes our contractual arrangements at December 31, 2022 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
$
277,673
$
20,173
$
132,500
$
125,000
$
—
Cash interest on debt
32,959
9,597
16,331
7,031
—
Operating leases
53,792
3,757
8,159
7,632
34,244
Purchase commitments (1)
289,168
250,119
39,049
—
—
Total
$
653,592
$
283,646
$
196,039
$
139,663
$
34,244
(1) Purchase commitments are generally for inventory used in the manufacturing of our products, as well as equipment and project materials used to support research and development activities. We generally do not enter into purchase commitments extending beyond one year. However, material shortages and supply chain challenges have caused some of these commitments to extend beyond one year. At December 31, 2022, we have $9.4 million of offsetting supplier deposits that will be applied against these purchase commitments.
Critical Accounting Policies and Estimates
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
We recognize revenue 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. We perform the following five steps to determine when to recognize revenue: (1) identification of the contract(s) with customers, (2) identification of the performance obligations in the contract, (3) determination of the transaction price, (4) allocation of the transaction price to the performance obligations in the contract, and (5) recognition of revenue when, or as, a performance obligation is satisfied. Judgment is used in the following areas in the determination of when to recognize revenue:
● Identification of performance obligations and allocation of contract price: Our contracts with customers frequently contain multiple deliverables, such as systems, upgrades, components, spare parts, installation,
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maintenance, and service plans. 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. 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.
● Combination of contracts: Judgment is required when evaluating whether multiple transactions with the same customer or related parties should be considered part of a single contract. This evaluation includes 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.
● Variable consideration: 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.
● Transfer of control: Judgment may be required in the determination of when transfer of control occurs. This judgment may include the interpretation of commercial terms and consideration 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. 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.
Any material changes in the identification of performance obligations, determination and allocation of the transaction price to performance obligations, and determination of when transfer of control occurs to the customer, could impact the timing and amount of revenue recognition, which could have a material effect on our financial condition and results of operations.
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.
Goodwill and Intangible Assets
Goodwill is tested for impairment at least annually in the beginning of the fourth quarter of our fiscal year, which may require significant judgment. 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.
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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 determination of a reasonable control premium may require significant judgment and 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.
Recent Accounting Pronouncements
We adopted ASU 2019-12 in the second quarter of 2020. We have also adopted ASU 2020-06 effective January 1, 2022. 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.
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