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, CVD, 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 during 2023, accomplishing a number of milestones, including:
● Solidly executing our multi-year growth strategy, with progress made towards advancing our product roadmaps for the Semiconductor and Compound Semiconductor markets, including shipment of two next generation nanosecond annealing evaluation systems to Tier 1 logic customers, shipment of two IBD300 evaluation systems to Tier 1 memory customers, and the continued development of our CVD SiC technology;
● Achieved year-on-year revenue growth for the Company, including record revenue in the Semiconductor market, which grew 12% year-on-year despite a decline in Wafer Fabrication Equipment (“WFE”) spending;
● Shipped multiple Laser Annealing systems to a new Tier 1 logic customer and a new Tier 1 memory customer, and expanded adoption of Laser Annealing systems with mature node customers;
● Gross margin improvement enabled 16% growth in operating income year-over-year;
● Successfully refinanced a portion of our convertible notes in order to strengthen our balance sheet and financial profile by extending the average maturity of our notes, reducing future annual cash interest payments, and lowering share dilution;
● Capital allocation toward organic growth initiatives in the Semiconductor and Compound Semiconductor markets remained a top priority, including strategic R&D investment and investment in our evaluation program.
We believe these accomplishments enabled us to exit 2023 well positioned to execute on our growth plans for 2024.
Business Update
Macroeconomic challenges across the industry have been well publicized, including an inflationary and high-interest rate environment, heightened China export regulations, uncertainty in the banking industry, and an uncertain outlook in the semiconductor and related markets due to softness in consumer, smartphone and PC applications, all of which are contributing to increased uncertainty.
Furthermore, on October 17, 2023, the US Department of Commerce, Bureau of Industry and Security (“BIS”), issued an update to export regulations previously issued on October 7, 2022, to modify and reinforce the prior restrictions while placing additional entities on the BIS Entity List. While these new regulations have not had a material impact to our business, the export regulation landscape is fluid and evolving, and it is possible that the issuance of additional export controls could further restrict our ability to sell to customers in China and lead to future revenue loss. If we are not able to replace these sales with sales to other customers, it could have a material adverse impact on our business and financial position.
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Finally, we continue to see reduced demand for certain products such as advanced packaging lithography, spare parts, and upgrades due to low customer utilization rates, 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. We also have seen improvements in our supply chain, as evidenced by a significant decline in lead times and a further improvement to suppliers on time deliveries. Material lead times have improved significantly and have generally returned to pre-pandemic levels. We will continue to work with our suppliers to identify and mitigate potential gaps in an effort to ensure continuity of supply, as well as continue to focus our efforts on cost containment initiatives.
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 12% in 2023, driven by our laser annealing systems for both advanced and mature node devices. While our growth strategy is predominately focused on advanced node logic and memory applications, 2023 revenue has been strong for mature node applications in China. We continue to build momentum for our laser annealing solutions in advanced node logic by winning application steps and new customers. In 2023, we penetrated our 3 rd Tier 1 logic customer and shipped multiple systems to this customer. As it relates to the memory market, we announced that a Tier 1 memory customer placed several LSA orders for high volume production of High Bandwidth Memory (“HBM”) and advanced DRAM devices following a successful evaluation program, and we shipped several systems to this customer in 2023. Our Laser Annealing roadmap reached a key milestone during the fourth quarter upon shipment of our first two Nanosecond Annealing evaluation systems to Tier 1 logic customers. Nanosecond annealing provides Veeco with an opportunity to expand laser annealing adoption for new advanced node applications. The ongoing adoption of EUV Lithography for advanced node semiconductor manufacturing continues to drive demand for our Ion Beam mask blank deposition systems. We reached another significant milestone in the fourth quarter upon shipment of our first two IBD300 evaluation systems to Tier 1 memory customers for 300mm front end semiconductor applications. Additionally, our lithography systems for Advanced Packaging are used for packaging approaches such as fan out wafer level packaging and other advanced packaging applications, while our wet processing systems are used for Photoresist Strip, Solvent Cleans, and flux removal. 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 our current backlog and visibility, we expect Semiconductor revenue to be up in 2024.
We address the Compound Semiconductor market with a broad portfolio of technologies, including Wet Processing and MOCVD, along with MBE and Ion Beam, in 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 declined by 28% in 2023, driven by a decline in systems for 5G driven RF device/filter manufacturing. We continue to invest for future growth in the Compound Semiconductor market in areas like Power Electronics and Micro-LED. 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, 2023 Veeco acquired SiC technology to address the high-growth SiC power epitaxy equipment market, which is primarily driven by adoption of electric vehicles. With this acquisition, Veeco is accelerating its entry into this market. We expect revenue in the Compound Semi market to grow in 2024.
Sales in the Data Storage market increased slightly in 2023. Demand for our Ion Beam products is driven by cloud-based storage. As reported, the hard disk drive industry experienced contraction in exabyte shipments in 2022 and 2023 with uncertainty as to the timing of a recovery; however, recent analyst and industry forecasts predict nearline hard disk drive exabyte shipments to grow at an approximate 20% CAGR over the coming years from a lower base in 2023 due to long-term growth in the cloud. Despite current industry challenges, we expect revenue in the Data Storage market to be flat to up in 2024.
Sales in the Scientific & Other market are largely driven by sales to governments, universities, and research institutions. We address the Scientific & Other market with several technologies, including MBE, ALD, MOCVD, Wet Processing, & IBD/IBE, which support scientific, optical coating and other applications, such as Micro-Electromechanical Systems
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(MEMS) applications. Sales in this market increased as compared to the prior quarter and the prior year quarter. We expect sales in this market to grow in the long run, in line with GDP.
Results of Operations
Years Ended December 31, 2023 and 2022
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations for 2023 and 2022 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
2023
2022
Period to Period
(dollars in thousands)
Net sales
$
666,435
100
%
$
646,137
100
%
$
20,298
3
%
Cost of sales
381,376
57
%
382,989
59
%
(1,613)
(0)
%
Gross profit
285,059
43
%
263,148
41
%
21,911
8
%
Operating expenses, net:
Research and development
112,853
17
%
103,565
16
%
9,288
9
%
Selling, general, and administrative
92,756
14
%
88,952
14
%
3,804
4
%
Amortization of intangible assets
8,481
1
%
10,018
2
%
(1,537)
(15)
%
Other operating expense (income), net
1,029
—
%
317
—
%
712
225
%
Total operating expenses, net
215,119
32
%
202,852
31
%
12,267
6
%
Operating income (loss)
69,940
10
%
60,296
9
%
9,644
16
%
Interest income (expense), net
(1,187)
(0)
%
(9,311)
(1)
%
8,124
(87)
%
Other income (expense), net
(97,091)
(15)
%
—
—
%
(97,091)
*
Income (loss) before income taxes
(28,338)
(4)
%
50,985
8
%
(79,323)
*
Income tax expense (benefit)
2,030
—
%
(115,957)
—
%
117,987
*
Net income (loss)
$
(30,368)
(5)
%
$
166,942
26
%
$
(197,310)
*
* Not meaningful
Net Sales
The following is an analysis of sales by end-market and by region:
Year ended December 31,
Change
2023
2022
Period to Period
(dollars in thousands)
Sales by end-market
Semiconductor
$
412,724
62
%
$
369,369
57
%
$
43,355
12
%
Compound Semiconductor
87,258
13
%
121,194
19
%
(33,936)
(28)
%
Data Storage
88,473
13
%
87,544
13
%
929
1
%
Scientific & Other
77,980
12
%
68,030
11
%
9,950
15
%
Total
$
666,435
100
%
$
646,137
100
%
$
20,298
3
%
Sales by geographic region
United States
$
162,790
24
%
$
197,433
31
%
$
(34,643)
(18)
%
EMEA
76,697
12
%
87,837
14
%
(11,140)
(13)
%
China
217,942
33
%
123,703
19
%
94,239
76
%
Rest of APAC
208,693
31
%
235,735
36
%
(27,042)
(11)
%
Rest of World
313
—
%
1,429
—
%
(1,116)
(78)
%
Total
$
666,435
100
%
$
646,137
100
%
$
20,298
3
%
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Total sales increased for the year ended December 31, 2023 against the comparable prior year period in the Semiconductor and Scientific & Other markets, partially offset by a decline in the Compound Semiconductor market. By geography, sales increased in the China region, partially offset by a decrease in the United States, EMEA, and Rest of APAC regions. Included within the Rest of APAC region for the year ended December 31, 2023 were sales in Japan, Taiwan, and Singapore of $74.7 million, $62.7 million, and $32.2 million, respectively, while sales within Rest of APAC region for the year ended December 31, 2022 included sales in sales in Taiwan, South Korea, Singapore, and Japan of $105.0 million, $40.3 million, $38.4 million, and $30.8 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 2023, gross profit increased compared to 2022 primarily due to an increase in sales volume and higher gross margins. Gross margins increased due to product mix of sales in the period, as well as favorable service spending. 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 2023 compared to 2022 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 slightly in 2023 compared to 2022. However, expenses as a percentage of revenue have remained flat when compared to the prior period. Given the uncertainty regarding the impacts on our business resulting from the general macroeconomic environment, we are focused on the proactive management of expenses.
Amortization Expense
Amortization expense decreased in 2023 compared to 2022 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, 2023, we recorded net interest expense of $1.2 million, compared to $9.3 million for the comparable prior period. The decrease in net interest expense was primarily related to an increase of interest income of approximately $8.4 million due to higher interest rates for 2023 compared to 2022.
Other Income (Expense)
On May 19, 2023, in connection with the completion of a private offering of $230.0 million aggregate principal amount of 2.875% convertible senior notes, we repurchased and retired approximately $106.0 million in aggregate principal amount of our outstanding 2025 Notes, with a carrying amount of $105.4 million, for approximately $106.0 million of cash and 0.7 million shares of our common stock for the 2025 Notes. Also, we repurchased and retired approximately $100.0 million in aggregate principal amount of our outstanding 2027 Notes with a carrying amount of $98.5 million, for approximately $92.8 million of cash and 3.8 million shares of our common stock for the 2027 Notes. We accounted for the partial settlement of the 2025 Notes and 2027 Notes as an extinguishment, and as such, recorded a loss on extinguishment of approximately $16.5 million and $80.6 million, respectively, for the year ended December 31, 2023.
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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, 2023, 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 2023 income tax expense of $2.0 million was primarily comprised of 1) a $16.2 million income tax expense on pre-tax income from operations; and 2) a $2.0 million income tax expense related to share-based compensation, partially offset by 3) a $7.5 million tax benefit related to Foreign-Derived Intangible Income; 4) a $7.7 million tax benefit associated with research and development tax credits; and 5) a $1.0 million tax benefit associated with the loss on extinguishment of convertible notes under Section 249 of the Internal Revenue Code of 1986, as amended (Section 249).
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.
Years Ended December 31, 2022 and 2021
See Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, filed with the SEC on February 22, 2023, for Management’s Discussions and Analysis of Financial Condition and Results of Operations for the fiscal year ended December 31, 2021.
Liquidity and Capital Resources
Our cash and cash equivalents, restricted cash, and short-term investments are as follows:
December 31,
December 31,
2023
2022
(in thousands)
Cash and cash equivalents
$
158,781
$
154,925
Restricted cash
339
547
Short-term investments
146,664
147,488
Total
$
305,784
$
302,960
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, 2023 and 2022, cash and cash equivalents of $46.8 million and $28.4 million, respectively, were held outside the United States. As of December 31, 2023, we had $22.0 million of accumulated undistributed earnings generated by our non-U.S. subsidiaries for which the U.S. repatriation tax has been provided. Approximately $7.7 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, 2023 and 2022 is as follows:
Cash Flows from Operating Activities
For the year ended December 31,
2023
2022
(in thousands)
Net income (loss)
$
(30,368)
$
166,942
Non-cash items:
Depreciation and amortization
24,966
25,645
Non-cash interest expense
1,118
962
Deferred income taxes
(2,211)
(118,040)
Share-based compensation expense
28,558
22,994
Loss on extinguishment of debt
97,091
—
Provision for bad debts
316
—
Change in contingent consideration
701
—
Changes in operating assets and liabilities
(58,497)
9,980
Net cash provided by (used in) operating activities
$
61,674
$
108,483
Net cash provided by operating activities was $61.7 million for the year ended December 31, 2023 and was due to net loss of $30.4 million and adjustments for non-cash items of $150.5 million, partially offset by a decrease in cash flow from changes in operating assets and liabilities of $58.5 million. The changes in operating assets and liabilities were largely attributable to increases in inventories largely related to evaluation systems at customer facilities, contract assets, prepaid expenses and other current assets, and decreases in accounts payable, and contract liabilities.
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 contract liabilities, partially offset by an increase in inventories and accounts receivables.
Cash Flows from Investing Activities
For the year ended December 31,
2023
2022
(in thousands)
Acquisitions of businesses, net of cash acquired
$
(30,373)
$
—
Capital expenditures
(27,930)
(24,604)
Changes in investments, net
4,973
(44,276)
Net cash provided by (used in) investing activities
$
(53,330)
$
(68,880)
The cash used in investing activities during the year ended December 31, 2023 was primarily attributable to net cash used in the acquisition of Epiluvac, and capital expenditures, partially offset by changes in net investment activity. The 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.
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Cash Flows from Financing Activities
For the year ended December 31,
2023
2022
(in thousands)
Proceeds from issuance of 2029 Notes, net of issuance costs
$
223,202
$
—
Extinguishment of Convertible Notes
(218,991)
—
Contingent consideration payment
(2,500)
—
Settlement of equity awards, net of withholding taxes
(6,391)
(4,550)
Net cash provided by (used in) financing activities
$
(4,680)
$
(4,550)
The cash used in financing activities for the year ended December 31, 2023 was related to the partial repurchase of the 2025 Notes and 2027 Notes, repayment of the 2023 Notes, contingent consideration payment related to the Epiluvac acquisition, as well as cash used to settle taxes related to employee equity programs, partially offset by proceeds from issuance of the 2029 Notes. The net cash used in financing activities for the year ended December 31, 2022 was primarily related to the settlement of equity awards.
Convertible Senior Notes and Revolving Credit Facility
We have $26.5 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. In addition, we have $25.0 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, 2024. In addition, we have $230.0 million outstanding principal balance of 2.875% convertible senior notes that bear interest at a rate of 2.875% per year, payable semiannually in arrears on June 1 and December 1 of each year, and mature on June 1, 2029, 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. 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.
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, 2023, outstanding bank guarantees and letters of credit totaled $19.6 million and unused bank guarantees and letters of credit of $13.0 million were available to be drawn upon.
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The following table summarizes our contractual arrangements at December 31, 2023 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
$
281,500
$
—
$
26,500
$
25,000
$
230,000
Cash interest on debt
41,042
8,478
15,564
13,694
3,306
Operating leases
49,794
3,692
8,217
7,061
30,824
Purchase commitments (1)
200,425
177,026
23,399
—
—
Total
$
572,761
$
189,196
$
73,680
$
45,755
$
264,130
(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, 2023, we have $19.4 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, 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.
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● 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; finished goods; and evaluation inventory at customer facilities. 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.
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.
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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.
Accounting for Business Combinations
We allocate the fair value of the purchase price of our acquisitions to the tangible assets acquired, liabilities assumed, and intangible assets acquired based on their fair value at acquisition date. The excess of the fair value of the purchase price over the fair value of these net tangible and intangible assets acquired is recorded as goodwill. Management’s estimates of fair value are based on assumptions believed to be reasonable, but such estimates and assumptions are inherently uncertain and subject to refinement. We believe assumptions and estimates we have made in the past have been reasonable and appropriate, they are based, in part, on historical experience and information obtained from management of the acquired companies, and inherently uncertain. The Company uses a discounted cash flow model to estimate the fair value of acquired intangible assets. Additionally, the Company estimates the fair value of contingent consideration included as part of the purchase price by assigning probabilities and discount factors to each of the various defined performance milestones, while using a Monte-Carlo simulation model to determine the most likely outcome for payments to be based on value of orders received. These valuation models utilize critical estimates, including, but not limited to, estimates of future revenues, gross margins, operating expenses, and cash flows, as well as discount rates that reflect the risk factors associated with the projected cash flows. Unanticipated events and circumstances may occur that could affect either the accuracy or validity of such assumptions, estimates or actuals results.
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.
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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 2020-06 effective January 1, 2022. We are also evaluating other pronouncements recently issued but not yet adopted, including ASU 2023-09. The adoption of these pronouncements is not expected to have a material impact on our consolidated financial statements. Refer to Note 1, “Significant Accounting Policies,” for additional information.