Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Executive Summary
The following discussion is designed to provide a better understanding of our audited consolidated financial statements and notes thereto, including a brief discussion of our business and products, key factors that impacted our performance and a summary of our operating results. The following discussion should be read in conjunction with our consolidated financial statements included in Item 8 of this Annual Report. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods. Unless otherwise noted, the following information and discussion relates to the Company's continuing operations.
Industry Dynamics and Trends
There are a number of industry factors that affect our business which include, among others:
• COVID-19 Outbreak. COVID-19 has spread globally, including locations where we do business. While the financial impact of COVID-19 on our results is difficult to measure, we believe it has had an unfavorable impact on our operating income. The full extent of the outbreak, related business and travel restrictions and changes to behavior intended to reduce its spread are uncertain as of the date of this Annual Report as this continues to evolve globally. The potential effects of COVID-19 could impact us in a number of ways including, but not limited to, the impact on employees becoming ill, quarantined, or otherwise unable to work or travel due to illness or governmental restriction, the impact of customers and their related demand and/or purchases, the impact on our suppliers' ability to fulfill our orders, and the overall impact of the aforementioned items that could cause output challenges and increased costs. Additionally, COVID-19 could have a number of additional adverse effects, including additional laws and regulations affecting our business, fluctuations in foreign currency markets and the credit risks of our customers.
• Overall Demand for Products and Applications using silicon carbide power devices, GaN and silicon RF devices, and LEDs . Our potential for growth depends significantly on the adoption of silicon carbide and GaN materials and device products in the power and RF markets, the continued use of silicon devices in the RF telecommunications market, the continued adoption of LEDs and LED lighting, and our ability to win new designs for these applications. Demand also fluctuates based on various market cycles, continuously evolving industry supply chains, trade and tariff terms, as well as evolving competitive dynamics in each of the respective markets. These uncertainties make demand difficult to forecast for us and our customers.
• Governmental Trade and Regulatory Conditions . Our potential for growth, as with most multi-national companies, depends on a balanced and stable trade, political, economic and regulatory environment among the countries where we do business. Changes in trade policy such as the imposition or extension of tariffs or export bans to specific customers or countries could reduce or limit demand for our products in certain markets.
• Intense and Constantly Evolving Competitive Environment. Competition in the industries we serve is intense. Many companies have made significant investments in product development and production equipment. Product pricing pressures exist as market participants often undertake pricing strategies to gain or protect market share, increase the utilization of their production capacity and open new applications in the power, RF and LED markets we serve. To remain competitive, market participants must continuously increase product performance, reduce costs and develop improved ways to serve their customers. To address these competitive pressures, we have invested in research and development activities to support new product development, lower product costs and deliver higher levels of performance to differentiate our products in the market. In addition, we invest in systems, people and new processes to improve our ability to deliver a better overall experience for our customers.
• Technological Innovation and Advancement. Innovations and advancements in materials, power, RF, and LED technologies continue to expand the potential commercial application for our products. However, new technologies or standards could emerge or improvements could be made in existing technologies that could reduce or limit the demand for our products in certain markets.
• Intellectual Property Issues. Market participants rely on patented and non-patented proprietary information relating to product development, manufacturing capabilities and other core competencies of their business. Protection of intellectual property is critical. Therefore, steps such as additional patent applications, confidentiality and non-disclosure agreements, as well as other security measures are generally taken. To enforce or protect intellectual property rights, litigation or threatened litigation is common.
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Fiscal 2020 Overview
The following is a summary of our financial results for the year ended June 28, 2020:
• Our year-over-year revenue decreased by $176.1 million to $903.9 million.
• Gross margin decreased to 27.5% from 36.2%. Gross profit decreased to $248.3 million from $391.0 million.
• Operating loss from continuing operations was $209.4 million in fiscal 2020 compared to $15.9 million in fiscal 2019.
• Diluted loss per share from continuing operations attributable to controlling interest was $1.78 in fiscal 2020 compared to $0.56 in fiscal 2019.
• Combined cash, cash equivalents and short-term investments increased to $1,251.7 million at June 28, 2020 from $1,051.4 million at June 30, 2019. Cash used in operating activities of continuing operations was $29.0 million in fiscal 2020 compared to cash provided by operating activities of continuing operations of $220.2 million in fiscal 2019.
• Purchases of property and equipment were $237.1 million in fiscal 2020 compared to $131.3 million in fiscal 2019.
Business Outlook
We believe we are uniquely positioned as an innovator in both of our business segments. The strength of our balance sheet and ability to generate cash provides us the ability to invest in our businesses, as indicated by our planned construction of a state-of-the-art, automated 200mm capable silicon carbide fabrication facility and a large materials factory to expand our silicon carbide capacity, each of which was announced in May 2019. In September 2019, we announced our intent to build the new fabrication facility in Marcy, New York to complement the factory expansion already underway at our U.S. campus headquarters in Durham, North Carolina. Construction on the new fabrication facility commenced in the fourth quarter of fiscal 2020.
In addition, we are focused on improving the number of usable items in a production cycle (yield) as our manufacturing technologies become more complex. Despite increased complexities in our manufacturing process, we believe we are in a position to improve yield levels to support our future growth.
We are focused on the following priorities to support our goals of delivering higher revenue and shareholder returns over time:
• Wolfspeed - invest in the business to expand the scale, further develop the technologies, and accelerate the growth opportunities of silicon carbide materials, silicon carbide power devices and modules, and GaN and silicon RF devices.
• LED Products - focus our efforts where our best-in-class technology and application-optimized solutions are differentiated and valued.
In regards to COVID-19, our manufacturing facilities in the United States are currently operating as essential businesses. We have instituted strict measures designed to balance employee safety with meeting the needs of business operations. These measures include increased employee sick days, robust health screening, social distancing policies and cleaning protocols to ensure the safety of our employees and the protection of our customers, suppliers, and partners. Our manufacturing facilities in China briefly closed mid-third quarter of fiscal 2020 and have remained open since that time.
We believe the strength of our balance sheet and our ability to continue operations allow us to navigate the current environment while maintaining our capital expenditure plans to support future growth, including the construction of new facilities in New York and additional production capacity in North Carolina. Even so, our short-term impacts from COVID-19 to our financial position, results of operations and cash flows are uncertain.
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Results of Operations
Selected consolidated statement of operations data for the years ended June 28, 2020, June 30, 2019 and June 24, 2018 is as follows:
Fiscal Years Ended
June 28, 2020 June 30, 2019 June 24, 2018
(in millions of U.S Dollars, except share data) Amount % of Revenue Amount % of Revenue Amount % of Revenue
Revenue, net $903.9 100.0 % $1,080.0 100.0 % $924.9 100.0 %
Cost of revenue, net 655.6 72.5 % 689.0 63.8 % 622.9 67.3 %
Gross profit 248.3 27.5 % 391.0 36.2 % 302.0 32.7 %
Research and development 184.2 20.4 % 157.9 14.6 % 127.3 13.8 %
Sales, general and administrative 211.4 23.4 % 200.7 18.6 % 170.3 18.4 %
Amortization or impairment of acquisition-related intangibles 14.5 1.6 % 15.6 1.4 % 7.2 0.8 %
Loss on disposal or impairment of other assets 1.4 0.2 % 4.7 0.4 % 8.4 0.9 %
Other operating expense 46.2 5.1 % 28.0 2.6 % 16.8 1.8 %
Operating loss (209.4) (23.2) % (15.9) (1.5) % (28.0) (3.0) %
Non-operating (income) expense, net (19.0) (2.1) % 29.3 2.7 % (10.4) (1.1) %
Loss before income taxes (190.4) (21.1) % (45.2) (4.2) % (17.6) (1.9) %
Income tax expense (benefit) 0.2 — % 12.7 1.2 % (1.2) (0.1) %
Net loss from continuing operations (190.6) (21.1) % (57.9) (5.4) % (16.4) (1.8) %
Net loss from discontinued operations — — % (317.2) (29.4) % (263.5) (28.5) %
Net loss (190.6) (21.1) % (375.1) (34.7) % (279.9) (30.3) %
Net income attributable to noncontrolling interest 1.1 0.1 % — — % 0.1 — %
Net loss attributable to controlling interest ($191.7) (21.2) % ($375.1) (34.7) % ($280.0) (30.3) %
Basic and diluted loss per share
Continuing operations attributable to controlling interest ($1.78) ($0.56) ($0.17)
Net loss attributable to controlling interest ($1.78) ($3.62) ($2.81)
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Revenue
Revenue was comprised of the following:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Wolfspeed $470.7 $538.2 $328.6 ($67.5) (13) % $209.6 64 %
Percent of revenue 52 % 50 % 36 %
LED Products 433.2 541.8 596.3 (108.6) (20) % (54.5) (9) %
Percent of revenue 48 % 50 % 64 %
Total revenue $903.9 $1,080.0 $924.9 ($176.1) (16) % $155.1 17 %
Wolfspeed Segment Revenue
The decrease in Wolfspeed segment revenue for fiscal 2020 compared to fiscal 2019 was primarily due to the ongoing trade dispute between the United States and China, weakening demand in Asia, and customer demand limitations due to the COVID-19 outbreak.
The increase in Wolfspeed segment revenue for fiscal 2019 compared to fiscal 2018 was primarily due to strong organic growth combined with revenue from the RF Power business acquisition and increased revenues from products with high average selling prices.
LED Products Segment Revenue
The decrease in LED Products Segment revenue for fiscal 2020 compared to fiscal 2019 was primarily due to overall market softness in global LED demand as well as supply, labor and output challenges due to the COVID-19 outbreak.
The decrease in LED Products Segment revenue for fiscal 2019 compared to fiscal 2018 was primarily due to global market uncertainty with China in light of the United States and China tariff and trade dispute and current market dynamics, which was partially offset by an increase in license and royalty income.
Gross Profit and Gross Margin
Gross profit and gross margin were as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Wolfspeed gross profit $184.6 $258.7 $158.5 ($74.1) (29) % $100.2 63 %
Wolfspeed gross margin 39 % 48 % 48 %
LED Products gross profit 91.1 150.0 157.9 (58.9) (39) % (7.9) (5) %
LED Products gross margin 21 % 28 % 26 %
Unallocated costs (1)
(27.4) (17.7) (9.0) (9.7) (55) % (8.7) (97) %
COGS acquisition related costs — — (5.4) — — % 5.4 (100) %
Consolidated gross profit $248.3 $391.0 $302.0 ($142.7) (36) % $89.0 29 %
Consolidated gross margin 27 % 36 % 33 %
(1) Unallocated costs for the fiscal year ended June 28, 2020 include $8.5 million in incremental manufacturing costs relating to COVID-19.
Wolfspeed Segment Gross Profit and Gross Margin
Wolfspeed gross profit and gross margin for fiscal 2020 compared to fiscal 2019 decreased primarily due to changes in customer and product mix, higher costs driven by factory and technology transitions, underutilization at some of our facilities and higher inventory reserves related to product manufactured for Huawei in the second quarter of fiscal 2020.
Wolfspeed gross margin for fiscal 2019 compared to fiscal 2018 remained relatively flat primarily due to changes in product mix. Wolfspeed gross profit increased for fiscal 2019 compared to fiscal 2018 primarily due to higher revenues.
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LED Products Segment Gross Profit and Gross Margin
LED Products gross profit and gross margin decreased for fiscal 2020 compared to fiscal 2019 primarily due to the impacts of lower revenue and higher chip costs due to lower utilization.
LED Products gross profit decreased in fiscal 2019 compared to fiscal 2018 due to lower revenue and tariff costs. LED Products gross margin increased in fiscal 2019 compared to fiscal 2018 due to more favorable product mix, higher license and royalty revenue, and better factory costs for the first half of the year, partially offset by tariff costs.
Unallocated Costs
Unallocated costs primarily consist of manufacturing employees' stock-based compensation, expenses for annual incentive plans, and matching contributions under our 401(k) plan. These costs were not allocated to the reportable segments' gross profit because our CODM does not review them regularly when evaluating segment performance and allocating resources.
For fiscal 2020, unallocated costs also include incremental costs relating to operating our manufacturing operations during the COVID-19 pandemic. The majority of these incremental costs comprise additional labor costs paid to our manufacturing employees, increased cleaning costs, cleaning supplies and protective equipment, and the costs of implementing preventative safety measures, including increased wellness checks.
Unallocated costs increased in fiscal 2020 compared to fiscal 2019 primarily due to incremental costs relating to operating our manufacturing operations during the COVID-19 pandemic and increased stock-based compensation, offset by decreased annual incentive expense.
Unallocated costs increased in fiscal 2019 compared to fiscal 2018, primarily due to higher annual incentive expenses which resulted from improved company performance and increased stock-based compensation incurred as a result of our higher average share price.
COGS Acquisition Related Costs Adjustment
The COGS acquisition related cost adjustment includes inventory fair value amortization of the fair value increase to inventory recognized at the date of acquisition, and other RF Power acquisition costs, impacting cost of revenue for fiscal 2018. These costs were not allocated to the reportable segments’ gross profit for fiscal 2018 because they represent an adjustment which does not provide comparability to the corresponding prior period and therefore were not reviewed by our CODM when evaluating segment performance and allocating resources.
Research and Development
Research and development expenses include costs associated with the development of new products, enhancements of existing products and general technology research. These costs consisted primarily of employee salaries and related compensation costs, occupancy costs, consulting costs and the cost of development equipment and supplies.
Research and development expenses were as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Research and development $184.2 $157.9 $127.3 $26.3 17 % $30.6 24 %
Percent of revenue 20 % 15 % 14 %
The increases in research and development expenses for all periods presented are primarily due to our continued investment in our silicon carbide and GaN technologies, including the development of existing silicon carbide materials and fabrication technology for next generation platforms and continuing to expand our Power and RF product portfolio.
Our research and development expenses vary significantly from year to year based on a number of factors, including the timing of new product introductions and the number and nature of our ongoing research and development activities.
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Sales, General and Administrative
Sales, general and administrative expenses are comprised primarily of costs associated with our sales and marketing personnel and our executive and administrative personnel (for example, finance, human resources, information technology and legal) and consists of salaries and related compensation costs; consulting and other professional services (such as litigation and other outside legal counsel fees, audit and other compliance costs); marketing and advertising expenses; facilities and insurance costs; and travel and other costs.
Sales, general and administrative expenses were as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Sales, general and administrative $211.4 $200.7 $170.3 $10.7 5 % $30.4 18 %
Percent of revenue 23 % 19 % 18 %
The increase in sales, general and administrative expenses in fiscal 2020 compared to fiscal 2019 was primarily due to increases in salaries and benefits, stock-based compensation and professional service fees related to transition services from the sale of the Lighting Products business unit, offset by decreases in legal fees, sales commissions and travel costs.
The increase in sales, general and administrative expenses in fiscal 2019 compared to fiscal 2018 was primarily due to an increase in stock-based compensation and annual incentives.
Amortization or Impairment of Acquisition-Related Intangibles
As a result of our acquisitions, we have recognized various amortizable intangible assets, including customer relationships, developed technology, non-compete agreements and trade names.
Amortization of intangible assets related to our acquisitions was as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Customer relationships $6.1 $7.3 $3.0 ($1.2) (16) % $4.3 143 %
Developed technology 5.4 5.4 3.2 — 0 % 2.2 69 %
Non-compete agreements 3.0 2.9 1.0 0.1 3 % 1.9 190 %
Total $14.5 $15.6 $7.2 ($1.1) (7) % $8.4 117 %
Amortization of acquisition-related intangibles stayed fairly consistent in fiscal 2020 compared to fiscal 2019 due to the absence of significant intangible-related activity between the periods. The slight decrease was due to certain intangible assets relating to customer relationships reaching the end of their amortization period in fiscal 2019 and the reclassification of $0.9 million of developed technology, net to a right-of-use asset in accordance with our adoption of ASC 842, Leases, due to the value representing a favorable lease.
Amortization of acquisition-related intangibles increased in fiscal 2019 compared to fiscal 2018 due to the inclusion of a full year of the RF Power business intangible asset amortization.
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Loss on Disposal or Impairment of Other Assets
We operate a capital-intensive business. As such, we dispose of a certain level of our equipment in the normal course of business as our production processes change due to production improvement initiatives or product mix changes. Due to the risk of technological obsolescence or changes in our production process, we regularly review our long-lived assets and capitalized patent costs for possible impairment.
Loss on disposal or impairment of other assets were as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Loss on disposal or impairment of other assets $1.4 $4.7 $8.4 ($3.3) (70) % ($3.7) (44) %
The loss in fiscal 2020 primarily relates to write-offs of impaired or abandoned patents as well as the impairment of certain leasehold improvements.
The loss in fiscal 2019 primarily relates to an impairment of other assets in conjunction with our disposal of the Lighting Products business unit.
The loss in fiscal 2018 primarily relates to a fair value market write-down for a sold aircraft.
Other Operating Expense
Other operating expense was as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Factory optimization restructuring $8.5 $4.1 $— $4.4 107 % $4.1 100 %
Severance and other restructuring 0.6 4.2 3.8 (3.6) (86) % 0.4 11 %
Total restructuring costs 9.1 8.3 3.8 0.8 10 % 4.5 118 %
Project, transformation and transaction costs 25.5 16.9 8.5 8.6 51 % 8.4 99 %
Factory optimization start-up costs 9.5 1.5 — 8.0 533 % 1.5 100 %
Non-restructuring related executive severance 2.1 1.3 4.5 0.8 62 % (3.2) (71) %
Other operating expense $46.2 $28.0 $16.8 $18.2 65 % $11.2 67 %
Factory optimization restructuring costs relate to facility consolidations as well as disposals on certain long-lived assets. Severance and other restructuring costs relate to corporate restructuring plans. See Note 20, "Restructuring," in our consolidated financial statements included in Item 8 of this Annual Report for additional information on our restructuring costs.
Project, transformation and transaction costs primarily relate to professional services fees associated with completed and potential acquisitions and divestitures, as well as internal transformation programs focused on optimizing our administrative processes and upgrading our ERP system to support our expected future growth.
Factory optimization start-up costs are additional start-up costs as part of our factory optimization efforts, which began in the fourth quarter of fiscal 2019. These efforts are focused on expanding our production footprint to support expected growth in the Wolfspeed segment.
The increase in other operating expense in fiscal 2020 compared to fiscal 2019 was primarily due to increased project, transformation and transaction costs and a full year of factory optimization restructuring and start-up costs in fiscal 2020, offset by a decrease in severance and other restructuring.
The increase in other operating expense in fiscal 2019 compared to fiscal 2018 was primarily due to the addition of factory optimization restructuring and start-up costs, costs relating to restructuring our geographical sales team to realign our skills and experience needed to execute on our business objectives and transaction costs relating to the sale of our Lighting Products business unit.
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Non-Operating (Income) Expense, net
Non-operating (income) expense, net was comprised of the following:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
(Gain) loss on sale of investments, net ($2.0) $0.1 $0.1 ($2.1) (2,100) % $— — %
(Gain) loss on equity investment (14.2) 16.2 (7.1) (30.4) (188) % 23.3 328 %
Gain on partial debt extinguishment (11.0) — — (11.0) 100 % — — %
Gain on arbitration proceedings (7.9) — — (7.9) 100 % — — %
Interest income (16.4) (14.0) (9.1) (2.4) (17) % (4.9) (54) %
Interest expense 34.9 26.0 7.3 8.9 34 % 18.7 256 %
Foreign currency (gain) loss, net (1.9) 1.3 (1.8) (3.2) (246) % 3.1 172 %
Other, net (0.5) (0.3) 0.2 (0.2) (67) % (0.5) (250) %
Non-operating (income) expense, net ($19.0) $29.3 ($10.4) ($48.3) (165) % $39.7 382 %
(Gain) loss on equity investment. The (gain) loss on equity investment is due to changes in the fair value of our Lextar investment, respectively. Lextar’s stock is publicly traded on the Taiwan Stock Exchange and its share price increased from 18.40 New Taiwanese Dollars (TWD) per share at June 25, 2017 to 21.00 TWD per share at June 24, 2018 before decreasing to 14.75 TWD per share at June 30, 2019 and increasing to 19.90 TWD per share at June 28, 2020.
This volatile stock price trend may continue in the future given the risks inherent in Lextar’s business and trends affecting the Taiwan and global equity markets. We have a 16% common stock ownership interest in Lextar and utilize the fair value option in accounting for the ownership interest. In June 2020, Lextar announced a plan to restructure under a holding company with EPISTAR Corporation (EPISTAR) via a share swap. As approved by the shareholders of Lextar and EPISTAR at the meetings held on August 7, 2020, we will receive 0.275 shares of common stock of the holding company, to be named ENNOSTAR Inc. (ENNOSTAR), for each share for Lextar common stock once the share swap is effected (currently scheduled for October 20, 2020), representing in the aggregate an approximately 3.3% common stock ownership interest in ENNOSTAR. The shares of ENNOSTAR will be listed on the Taiwan Stock Exchange. Any future stock price changes will be recorded as further gains or losses on equity investment based on the increase or decrease, respectively, in the fair value of the investment during the applicable fiscal period. Further losses could have a material adverse effect on our results of operations.
Gain on partial debt extinguishment . The gain on partial debt extinguishment relates to a gain recognized as a result of using $144.3 million towards repurchasing $150.2 million of the principal amount held on the 2023 Notes.
Gain on arbitration proceedings . The gain on arbitration proceedings primarily relates to an award from an arbitration proceeding in the third quarter of fiscal 2020 with a former vendor in which we were awarded damages for defective inventory. Additionally, a small legal settlement was paid in the fourth quarter of fiscal 2020.
Interest income . The increases in interest income in both comparative periods are due to higher balances on our short-term investments.
Interest expense . Interest expense in fiscal 2020 and fiscal 2019 reflect increased interest expense related to the Notes. The increase in fiscal 2020 compared to fiscal 2019 is primarily due to the addition of the 2026 Notes at the end of fiscal 2020, which were sold on April 21, 2020.
Foreign currency (gain) loss, net. Foreign currency (gain) loss, net, primarily consists of remeasurement adjustments resulting from our Lextar investment and from our international subsidiaries.
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Income Tax Expense (Benefit)
Income tax expense (benefit) and our effective tax rate was as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Income tax expense (benefit) $0.2 $12.7 ($1.2) (12.5) (98) % 13.9 1,158 %
Effective tax rate — % (28) % 7 %
The increase in the effective tax rate from (28)% in fiscal 2019 to 0% in fiscal 2020 was primarily due to the tax benefit related to net operating loss provisions of the CARES Act and a decrease in foreign tax expense due to lower income derived from foreign jurisdictions, where there is not a full valuation allowance, as a result of COVID-19.
The decrease in the effective tax rate from 7% in fiscal 2018 to (28)% in fiscal 2019 was primarily due to the tax benefit of remeasuring our U.S. deferred taxes as a result of the TCJA enacted on December 22, 2017.
In general, the variation between our effective income tax rate and the current U.S. statutory rate of 21.0% is primarily due to: (i) changes in our valuation allowances against deferred tax assets in the U.S. and Luxembourg, (ii) income derived from international locations with lower tax rates than the U.S., and (iii) tax credits generated.
Net Loss from Discontinued Operations
We recorded a net loss from discontinued operations of $317.2 million and $263.5 million in fiscal 2019 and 2018, respectively. The net loss from discontinued operations in each period relates to operational results of the discontinued operations of the Lighting Products business unit, with the addition of a $66.2 million loss on the sale of the Lighting Products business unit included in the net loss from discontinued operations for fiscal 2019. The net loss from discontinued operations for fiscal 2019 and 2018 includes $90.3 million and $247.5 million of goodwill impairment, respectively.
We did not have any discontinued operations related activity in fiscal 2020.
Liquidity and Capital Resources
Overview
We require cash to fund our operating expenses and working capital requirements, including outlays for research and development, capital expenditures, strategic acquisitions and investments. Our principal sources of liquidity are cash on hand, marketable securities, cash generated from operations and availability under our line of credit. We have a $125 million line of credit as discussed as discussed in Note 11, “Long-term Debt,” in our consolidated financial statements included in Item 8 of this Annual Report. The purpose of this facility is to provide short term flexibility to optimize returns on our cash and investment portfolio while funding capital expenditures and other general business needs. Additionally, on April 21, 2020, we issued and sold a total of $575.0 million aggregate principal amount of 2026 Notes, as discussed in Note 11, “Long-term Debt,” in our consolidated financial statements included in Item 8 of this Annual Report. The total net proceeds of the 2026 Notes was $561.4 million, of which we used $144.3 million to repurchase $150.2 million aggregate principal amount of our 2023 Notes. We expect to use the remainder of the net proceeds for general corporate purposes.
Based on past performance and current expectations, we believe our current working capital, availability under our line of credit and anticipated cash flows from operations will be adequate to meet our cash needs for our daily operations and capital expenditures for at least the next 12 months. With the strength of our working capital position, we believe that we have the ability to continue to invest in further development of our products and, when necessary or appropriate, make selective acquisitions or other strategic investments to strengthen our product portfolio, secure key intellectual properties and/or expand our production capacity.
From time to time, we evaluate strategic opportunities, including potential acquisitions, joint ventures, divestitures, spin-offs or investments in complementary businesses, and we have continued to make such evaluations. We may also access capital markets through the issuance of debt or additional shares of common stock in connection with the acquisition of complementary businesses or other significant assets or for other strategic opportunities.
We are currently building a new silicon carbide fabrication facility in Marcy, New York, to expand capacity for our silicon carbide device business. We expect to invest approximately $1.0 billion in construction, equipment and other related costs for the new facility through fiscal 2024, of which approximately $500 million is expected to be reimbursed by the State of New
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York through a grant program administered by Empire State Development. Given our current cash position, we believe we are in a good position to adequately fund the construction of the facility.
The full extent to which COVID-19 may impact our results of operations or liquidity is uncertain. Currently, the local governments in the locations in which we operate have designated our Company as an essential business, but our operations have, and likely will continue, to experience supply, labor, demand and output challenges. We continue to monitor the impact that the COVID-19 pandemic is having on our business, the semiconductor and LED industries, and the economies in which we operate. We anticipate our future results of operations, including the results for fiscal 2021, will be materially impacted by COVID-19, but at this time we do not expect the impact from the COVID-19 outbreak will have a material effect on our liquidity or financial position. However, given the speed and frequency of continuously evolving developments with respect to this pandemic, we cannot reasonably estimate the magnitude of the impact to our results of operations, and, if the outbreak continues on its current trajectory, such impacts could grow and become material to our liquidity or financial position. To the extent our suppliers continue to be materially and adversely impacted by COVID-19, this could reduce the availability, or result in delays, of materials or supplies to or from us, which in turn could materially interrupt our business operations.
Contractual Obligations
At June 28, 2020, payments to be made pursuant to significant contractual obligations are as follows:
Payments Due by Period
(in millions of U.S. Dollars) Total Less than
One Year One to
Three Years Three to
Five Years More Than
Five Years
Operating lease obligations 13.9 5.5 6.4 1.6 0.4
Finance lease obligations 15.0 2.6 1.6 0.9 9.9
Purchase obligations 451.6 451.1 0.5 — —
Long-term debt (1)
999.8 — — 424.8 575.0
Interest payments on long-term debt (2)
70.5 13.8 27.6 20.7 8.4
Other long-term liabilities (3)
1.9 — 1.9 — —
Total contractual obligations $1,552.7 $473.0 $38.0 $448.0 $593.7
(1) Long-term debt represents the principal due on the Notes, but does not include interest expense.
(2) Interest payments on long-term debt represent semi-annual interest payments on the Notes.
(3) Other long-term liabilities as of June 28, 2020 also includes customer deposits of $33.7 million, long-term tax contingencies and other tax liabilities of $2.4 million, LED supply agreements of $8.3 million and extended warranty liability of $0.4 million. These liabilities were not included in the table above as they will either not be settled in cash and/or the timing of payments is uncertain.
Operating lease obligations include rental amounts due on leases of certain office and manufacturing space under the terms of non-cancelable operating leases. These leases expire at various times through December 2027. Finance lease obligations primarily include Wolfspeed manufacturing space in Malaysia and a 49-year ground lease on a future silicon carbide fabrication facility in New York. The leases for our Wolfspeed manufacturing space in Malaysia expire in February 2027 and the 49-year ground lease in New York expires in March 2069.
Purchase obligations represent purchase commitments, including open purchase orders and contracts, and are generally related to the purchase of goods and services in the ordinary course of business such as raw materials, supplies and capital equipment.
Financial Condition
The following table sets forth our cash, cash equivalents and short-term investments:
(in millions of U.S. Dollars) June 28, 2020 June 30, 2019 Change
Cash and cash equivalents $448.8 $500.5 ($51.7)
Short-term investments 802.9 550.9 252.0
Total cash, cash equivalents and short-term investments $1,251.7 $1,051.4 $200.3
Our liquidity and capital resources primarily depend on our cash flows from operations and our working capital. The significant components of our working capital are liquid assets such as cash and cash equivalents, short-term investments, accounts receivable and inventories reduced by trade accounts payable.
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The following table presents the components of our cash conversion cycle:
Three Months Ended
June 28, 2020 June 30, 2019 Change
Days of sales outstanding (a) 37 34 3
Days of supply in inventory (b) 104 104 —
Days in accounts payable (c) (103) (72) (31)
Cash conversion cycle 38 66 (28)
a) Days of sales outstanding (DSO) measures the average collection period of our receivables. DSO is based on the ending net trade receivables less receivable related accrued contract liabilities and the revenue, net for the quarter then ended. DSO is calculated by dividing ending accounts receivable, less receivable related accrued contract liabilities, by the average net revenue per day for the respective 90-day period.
b) Days of supply in inventory (DSI) measures the average number of days from procurement to sale of our product. DSI is based on ending inventory and cost of revenue, net for the quarter then ended. DSI is calculated by dividing ending inventory by average cost of revenue, net per day for the respective 90-day period.
c) Days in accounts payable (DPO) measures the average number of days our payables remain outstanding before payment. DPO is based on ending accounts payable and cost of revenue, net for the quarter then ended. DPO is calculated by dividing ending accounts payable and accrued expenses (less accrued salaries and wages) by the average cost of revenue, net per day for the respective 90-day period.
The decrease in the cash conversion cycle was primarily driven by increased accounts payable balances relating to investment at our future silicon carbide fabrication facility in New York.
As of June 28, 2020, we had unrealized losses on our investments of less than $0.1 million. All of our investments had investment grade ratings, and any such investments that were in an unrealized loss position at June 28, 2020 were in such position due to interest rate changes, sector credit rating changes, company-specific rating changes or negative market conditions surrounding the COVID-19 outbreak. We intend and believe that we have the ability to hold such investments for a period of time that will be sufficient for anticipated recovery in market value, and we currently expect to receive the full principal or recover our cost basis in these securities. The declines in value of the securities in our portfolio are considered to be temporary in nature and, accordingly, we do not believe these securities are impaired as of June 28, 2020.
Cash Flows
In summary, our cash flows were as follows (in millions of U.S. Dollars):
Fiscal Years Ended Year-Over-Year Change
June 28, 2020 June 30, 2019 June 24, 2018 2019 to 2020 2018 to 2019
Cash (used in) provided by operating activities ($29.0) $202.3 $173.5 ($231.3) $28.8
Cash used in investing activities (486.9) (227.1) (423.9) (259.8) 196.8
Cash provided by financing activities 464.3 406.5 236.5 57.8 170.0
Effect of foreign exchange changes (0.1) (0.1) 0.2 — (0.3)
Net increase (decrease) in cash and cash equivalents ($51.7) $381.6 ($13.7) ($433.3) $395.3
Cash Flows from Operating Activities
Net cash (used in) provided by operating activities decreased in fiscal 2020 compared to fiscal 2019 primarily due to cash used from our increased operating loss and a larger annual incentive payment in the first quarter of fiscal 2020 compared to the previous year. Annual incentive payments are made in the first quarter of the subsequent fiscal year.
Net cash provided by operating activities increased in fiscal 2019 compared to fiscal 2018 primarily due to generating higher cash from earnings and improved working capital.
Total cash provided by operating activities in fiscal 2019 and 2018 includes ($17.9) million and $61.0 million of cash (used in) provided by operating activities of discontinued operations.
Cash Flows from Investing Activities
Our investing activities primarily relate to short-term investment transactions, purchases of property and equipment and payments for patents and licensing rights.
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The increase in net cash used in investing activities in fiscal 2020 compared to fiscal 2019 was primarily due to the net proceeds from the sale of the Lighting Products business unit of $219.0 million received in fiscal 2019. Excluding the proceeds from the sale, cash used in investing activities stayed relatively flat with an increase in purchases of property, equipment and patent rights of $106.7 million offset by a decrease in net purchases of short term investments of $48.2 million.
The decrease in net cash used in investing activities in fiscal 2019 compared to fiscal 2018 is primarily due to $429.2 million of net expenditures to acquire the Infineon RF Power business in fiscal 2018. Fiscal 2019 included $293.4 million of net purchases of short term investments as compared to a source of cash in fiscal 2018 of $200.5 million from the sale and maturity from short term investments. Other investing activities during fiscal 2019 compared to fiscal 2018 include a decrease in the purchase of property, equipment and patent rights of $42.8 million offset by net proceeds from the sale of the Lighting Products business unit of $219.0 million.
Total cash used in investing activities in fiscal 2019 and 2018 includes $15.4 million and $17.9 million of cash used in investing activities of discontinued operations.
For fiscal 2021, we target approximately $400.0 million of net capital investment, which is primarily related to capacity and infrastructure projects to support our Wolfspeed segment longer-term growth and strategic priorities. This target is highly dependent on the timing and overall progress on the construction of our new silicon carbide fabrication facility in New York and is net of expected reimbursements from the State of New York Urban Development Corporation under a Grant Disbursement Agreement (GDA). For more details on the GDA, see Note 16, "Commitments and Contingencies," in our consolidated financial statements included in Item 8 of this Annual Report.
Cash Flows from Financing Activities
Net cash provided by financing activities in fiscal 2020 primarily consisted of proceeds of $575.0 million from the issuance of the 2026 Notes and net proceeds of $59.5 million from issuances of common stock pursuant to the exercise of employee stock options, partially offset by payments on long-term debt of $145.1 million, the payment of $13.6 million in debt issuance costs from the issuance of the 2026 Notes and incentive-related refundable escrow deposits of $11.5 million relating to the construction of our future silicon carbide fabrication facility in New York. The escrow deposits will be returned to us upon successful completion of defined objectives relating to New York state funded incentives.
Net cash provided by financing activities in fiscal 2019 primarily consisted of $575.0 million in proceeds from the issuance of the 2023 Notes and net proceeds of $136.4 million from issuances of common stock pursuant to the exercise of employee stock options, partially offset by the net repayment on our line of credit of $292.0 million and the payment of debt issuance costs of $12.9 million from the issuance of the 2023 Notes.
Net cash provided by financing activities in fiscal 2018 primarily consisted of a net draw on our line of credit of $147.0 million to help fund the Infineon RF Power acquisition, $86.4 million in net proceeds from issuance of common stock pursuant to the exercise of employee stock options and proceeds of $4.9 million from San'an's capital contribution to Cree Venture LED, slightly offset by payment of acquisition-related contingent consideration of $1.8 million in connection with our acquisition of Arkansas Power Electronics International, Inc., which was completed in fiscal 2016.
Financial and Market Risks
We are exposed to financial and market risks, including changes in interest rates, currency exchange rates and commodities risk. We have entered, and may in the future enter, into foreign currency derivative financial instruments in an effort to manage or hedge some of our foreign exchange rate risk. We may not be able to engage in hedging transactions in the future, and even if we do, foreign currency fluctuations may still have a material adverse effect on our results of operations and financial performance. All of the potential changes noted below are based on sensitivity analysis performed on our financial positions at June 28, 2020 and June 30, 2019. Actual results may differ materially.
Interest Rate Risk
We maintain an investment portfolio principally composed of money market funds, municipal bonds, corporate bonds, U.S. agency securities, U.S. treasury securities, commercial paper, certificates of deposit, and variable rate demand notes. In order to minimize risk, our cash management policy permits us to acquire investments rated “A” grade or better. As of June 28, 2020 and June 30, 2019, our cash equivalents and short-term investments had a fair value of $1,106.8 million and $789.0 million, respectively. If interest rates were to hypothetically increase by 100 basis points, the fair value of our short-term investments would decrease by $11.1 million at June 28, 2020 and $7.9 million at June 30, 2019.
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As of June 28, 2020, we maintain a secured revolving line of credit under which we can borrow, repay and reborrow loans from time to time prior to its scheduled maturity date of January 9, 2023. As of and during the fiscal years ending June 28, 2020 and June 30, 2019, no balances were outstanding under the line of credit.
Currency Rate and Price Risk
We operate internationally and have transactions denominated in foreign currencies and are exposed to currency exchange rate risks. As a result, fluctuations in exchange rates may adversely affect our expenses and results of operations as well as the value of our assets and liabilities. Our primary exposure relates to the exchange rate between the United States Dollar (USD) and the TWD as our Lextar investment is held in TWD. Additionally, our investment relates to owning shares that are publicly traded on the Taiwan Stock Exchange and subject to price risks from market trading. The value of our Lextar investment was $55.9 million and $39.5 million as of June 28, 2020 and June 30, 2019, respectively. A hypothetical 10% decrease in the value of the USD compared to the TWD or a hypothetical 10% decrease in quoted market values on our investment would each individually result in potential losses of approximately $5.6 million and $4.0 million for the years ended June 28, 2020 and June 30, 2019, respectively.
Commodities
We utilize significant amounts of precious metals, gases and other commodities in our manufacturing processes. General economic conditions, market specific changes or other factors outside of our control may affect the pricing of these commodities. We do not use financial instruments to hedge commodity prices.
Off-Balance Sheet Arrangements
We do not use off-balance sheet arrangements with unconsolidated entities or related parties, nor do we use any other forms of off-balance sheet arrangements. Accordingly, our liquidity and capital resources are not subject to off-balance sheet risks from unconsolidated entities. As of June 28, 2020, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with U.S. GAAP. In the application of U.S. GAAP, we are required to make estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities in our consolidated financial statements. Changes in the accounting estimates from period to period are reasonably likely to occur. Accordingly, actual results could differ significantly from the estimates made by management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations may be affected.
We evaluate our estimates on an ongoing basis, including those related to revenue recognition, valuation of inventories, tax related contingencies, valuation of stock-based compensation, valuation of long-lived and intangible assets, other contingencies and litigation, among others. We base our estimates on historical experience and on various other assumptions, including expected trends that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.
Our significant accounting policies are discussed in Note 2, “Basis of Presentation and Summary of Significant Accounting Policies,” to the consolidated financial statements included in Item 8 of this Annual Report. We believe that the following are our most critical accounting policies and estimates, each of which is critical to the portrayal of our financial condition and results of operations and requires our most difficult, subjective and complex judgments. Our management has reviewed our critical accounting policies and the related disclosures with the Audit Committee of our Board of Directors.
Revenue Recognition
Revenue is recognized when control of a good or service promised in a contract (i.e., performance obligation) is transferred to a customer. Control is obtained when a customer has the ability to direct the use of and obtain substantially all of the remaining benefits from that good or service. The majority of our revenues are recognized at a point-in-time as control is transferred at a distinct point in time per the terms of a contract. We adopted Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 606 "Revenue from Contracts with Customers" (ASC 606) on June 25, 2018 using the modified retrospective approach. Refer to Note 2, "Basis of Presentation and Summary of Significant Accounting Policies" and Note 4, "Revenue Recognition" for additional information related to the adoption of ASC 606.
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We provide our customers with limited rights of return for non-conforming shipments and product warranty claims. We estimate an allowance for anticipated sales returns based upon an analysis of historical sales returns and other relevant data. We recognize an allowance for non-conforming returns at the time of sale as a reduction of product revenue. We recognize a liability for product warranty claims at the time of sale as an increase to cost of revenue.
For the year ended June 28, 2020, 44% of our revenue was from sales to distributors. Distributors stock inventory and sell our products to their own customer base, which may include: value added resellers; manufacturers who incorporate our products into their own manufactured goods; or ultimate end users of our products. We recognize revenue upon shipment of our products to our distributors. This arrangement is often referred to as a “sell-in” or “point-of-purchase” model as opposed to a “sell-through” or “point-of-sale” model, where revenue is deferred and not recognized until the distributor sells the product through to their customer.
Our distributors may be provided limited rights that allow them to return a portion of inventory (product exchange rights or stock rotation rights) and receive credits for changes in selling prices (price protection rights) or customer pricing arrangements under our “ship and debit” program or other targeted sales incentives. When determining our net revenue, we make significant judgments and estimates corresponding with product shipments. We recognize a reserve for estimated future returns, changes in selling prices, and other targeted sales incentives when product ships. We also recognize an asset for the estimated value of product returns that we believe will be returned to inventory in the future and resold, and these estimates are based upon historical data, current economic trends, distributor inventory levels and other related factors. Our financial condition and operating results are dependent upon our ability to make reliable estimates. Actual results may vary and could have a significant impact on our operating results.
From time to time, we will issue a new price book for our products, and provide a credit to certain distributors for inventory quantities on hand if required by our agreement with the distributor. This practice is known as price protection. These credits are applied against the reserve that we establish upon initial shipment of product to the distributor.
Under the ship and debit program, products are sold to distributors at negotiated prices and the distributors are required to pay for the products purchased within our standard commercial terms. Subsequent to the initial product purchase, a distributor may request a price allowance for a particular part number(s) for certain target customers, prior to the distributor reselling that particular part to the customer. If we approve an allowance and the distributor resells the product to the target customer, we credit the distributor according to the allowance we approved. These credits are applied against a reserve we establish upon initial shipment of product to the distributor.
In addition, we run sales incentive programs with certain distributors, such as product rebates. We recognize these incentives at the time they are offered to customers and record a credit to their account with an offsetting expense as either a reduction to revenue, increase to cost of revenue, or marketing expense depending on the type of sales incentive.
We also have inventory consignment agreements in which revenue is recognized at a point in time, when the customer or distributor pulls product from consignment inventory that we store at designated locations. Delivery and transfer of control occur at that point, when title and risk of loss transfers and the customer or distributor becomes obligated to pay for the products pulled from inventory. Until the products are pulled for use or sale by the customer or distributor, we retain control over the products’ disposition, including the right to pull back or relocate the products.
From time to time, we may enter into licensing arrangements related to our intellectual property. Revenue from licensing arrangements is recognized when earned and estimable. The timing of revenue recognition is dependent on the terms of each license agreement. Generally, we will recognize non-refundable upfront licensing fees related to patent licenses immediately upon receipt of the funds if we have no significant future obligations to perform under the arrangement. However, we will defer recognition for licensing fees where we have significant future performance requirements, the fee is not fixed (such as royalties earned as a percentage of future revenue), or the fees are otherwise contingent.
Leases (new for fiscal 2020 due to ASC 842 Adoption)
At lease inception, we determine that an arrangement is a lease if the contract involves the use of a distinct identified asset, the lessor does not have substantive substitution rights and we obtain control of the asset throughout the period by obtaining substantially all of the economic benefit of the asset and the right to direct the use of the asset.
Right-of-use assets represent our right to use an underlying asset during the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Assets and liabilities are recognized based on the present value of lease payments over the lease term. Most leases include one or more options to renew, with renewal terms that can extend the lease term from one to five years or more. The exercise of the renewal option is at our sole discretion and we consider these options in determining the lease term used to establish our right-of-use assets and lease liabilities. We will remeasure our lease
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liability and adjust the related right-of-use asset upon the occurrence of the following: lease modifications not accounted for as a separate contract; a triggering event that changes the certainty of the lessee exercising an option to renew or terminate the lease, or purchase the underlying asset; a change to the amount probable of being owed by us under a residual value guarantee; or the resolution of a contingency upon which the variable lease payments are based such that those payments become fixed.
Because most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on information available at the lease commencement date in determining the present value of lease payments. We use the implicit rate when readily determinable. Operating lease expense is generally recognized on a straight-line basis over the lease term. Finance lease assets are amortized on a straight-line basis over the shorter of the useful life of the asset or the lease term. Interest expense on the finance lease liability is recognized using the effective interest rate method and is presented within interest expense on our consolidated statements of operations.
We have agreements with lease and non-lease components, which are accounted for as a single lease component. Leases with a lease term of 12 months or less are not recorded on the balance sheet. We recognize lease expense for these leases on a straight-line basis over the lease term. Variable lease payment amounts that cannot be determined at the commencement of the lease, such as increases in lease payments based on changes in index rates, are not included in the right-of-use assets or liabilities. These variable lease payments are expensed as incurred.
Inventories
Inventories are stated at the lower of cost or net realizable value. We write-down our inventories for estimated obsolescence equal to the difference between the cost of the inventory and its estimated market value based upon an aging analysis of the inventory on hand, specifically known inventory-related risks (such as technological obsolescence), and assumptions about future demand. We also analyze sales levels by product type, including historical and estimated future customer demand for those products to determine if any additional reserves are appropriate. For example, we adjust for items that are considered obsolete based upon changes in customer demand, manufacturing process changes or new product introductions that may eliminate demand for the product. Any adjustment to our inventories as a result of an estimated obsolescence or net realizable condition is reflected as a component of our cost of revenue. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and any subsequent improvements in facts and circumstances do not result in the restoration or increase in that newly established lower-cost basis.
In order to determine what costs can be included in the valuation of inventories, we determine normal capacity for our manufacturing facilities based on historical patterns. If our estimates regarding customer demand are inaccurate, or market conditions or technology change in ways that are less favorable than those projected by management, we may be required to take excess capacity charges in accordance with U.S. GAAP, which could have an adverse effect on our operating results.
Deferred Tax Asset Valuation Allowances
In accordance with FASB ASC 740, “Income Taxes” (ASC 740), we evaluate all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a deferred tax asset is more likely than not to be realized. In assessing the adequacy of a recognized valuation allowance, we consider all available positive and negative evidence to estimate if sufficient future taxable income will be generated to utilize the existing deferred tax assets by jurisdiction. This consideration includes a variety of factors such as historical and projected future taxable income and prudent and feasible tax planning strategies. When we establish or increase a valuation allowance, our income tax expense increases in the period such determination is made. If we decrease a valuation allowance, our income tax expense decreases in the period such a determination is made.
Tax Contingencies
We are subject to periodic audits of our income tax returns by federal, state, local and foreign agencies. These audits typically include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In accordance with ASC 740, we regularly evaluate the exposures associated with our various tax filing positions. ASC 740 states that a tax benefit should not be recognized for financial statement purposes for an uncertain tax filing position where it is not more likely than not (likelihood of greater than 50%) of being sustained by the taxing authorities based on the technical merits of the position.
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In accordance with the provisions of ASC 740, we establish unrecognized tax benefits (as a reduction to the deferred tax asset or as an increase to other liabilities) to reduce some or all of the tax benefit of any of our tax positions at such time that we determine the position has become uncertain based upon one of the following: the tax position is not “more likely than not” to be sustained; the tax position is “more likely than not” to be sustained, but for a lesser amount; or the tax position is “more likely than not” to be sustained, but not in the financial period in which the tax position was originally taken. For purposes of evaluating whether or not a tax position is uncertain, we presume the tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information; the technical merits of a tax position are derived from authorities such as legislation and statutes, legislative intent, regulations, rulings and case law and their applicability to the facts and circumstances of the tax position; and each tax position is evaluated without consideration of the possibility of offset or aggregation with other tax positions taken. We adjust these unrecognized tax benefits, including any impact on the related interest and penalties, in light of changing facts and circumstances, such as the progress of a tax audit.
A number of years may elapse before a particular matter for which we have established an unrecognized tax benefit is audited and fully resolved. To the extent we prevail in matters for which we have established an unrecognized benefit or are required to pay amounts in excess of what we have recognized, our effective tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement might require use of our cash and/or result in an increase in our effective tax rate in the year of resolution. A favorable tax settlement would be recognized as a reduction in our effective tax rate in the year of resolution.
Stock-Based Compensation
We account for awards of stock-based compensation under our employee stock-based compensation plans using the fair value method. Accordingly, we estimate the grant date fair value of our stock-based awards and amortize this fair value to compensation expense over the requisite service period or vesting term. We currently use the Black-Scholes option-pricing model to estimate the fair value of our stock option and Employee Stock Purchase Plan (ESPP) awards. The grant date fair value of performance stock units that vest upon meeting certain market conditions is estimated using the Monte Carlo valuation model. The determination of the fair value of stock-based awards on the date of grant using an option-pricing model is affected by our then current stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, the risk-free interest rate and expected dividends.
Due to the inherent limitations of option-valuation models, future events that are unpredictable and the estimation process utilized in determining the valuation of the stock-based awards, the ultimate value realized by award holders may vary significantly from the amounts expensed in our financial statements. For restricted stock and stock unit awards, grant date fair value is based upon the market price of our common stock on the date of the grant. This fair value is then amortized to compensation expense over the requisite service period or vesting term.
We estimate expected forfeitures at the time of grant and revise this estimate, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Our determination of an estimated forfeiture rate is primarily based upon a review of historical experience but may also include consideration of other facts and circumstances we believe are indicative of future activity. The assessment of an estimated forfeiture rate will not alter the total compensation expense to be recognized, only the timing of this recognition as compensation expense is adjusted to reflect instruments that actually vest.
If actual results are not consistent with our assumptions and judgments used in estimating key assumptions, we may be required to adjust compensation expense, which could be material to our results of operations.
Long-Lived Assets
We evaluate long-lived assets such as property, equipment and finite-lived intangible assets, such as patents, for impairment whenever events or circumstances indicate that the carrying value of the assets recognized in our financial statements may not be recoverable. Factors that we consider include whether there has been a significant decrease in the market value of an asset, a significant change in the way an asset is being used, or a significant change, delay or departure in our strategy for that asset. Our assessment of the recoverability of long-lived assets involves significant judgment and estimation. These assessments reflect our assumptions, which, we believe, are consistent with the assumptions hypothetical marketplace participants use. Factors that we must estimate when performing recoverability and impairment tests include, among others, the economic life of the asset, sales volumes, prices, cost of capital, tax rates, and capital spending. These factors are often interdependent and therefore do not change in isolation. If impairment is indicated, we first determine if the total estimated future cash flows on an undiscounted basis are less than the carrying amounts of the asset or assets. If so, an impairment loss is measured and recognized.
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After an impairment loss is recognized, a new, lower cost basis for that long-lived asset is established. Subsequent changes in facts and circumstances do not result in the reversal of a previously recognized impairment loss.
Our impairment loss calculations require that we apply judgment in estimating future cash flows and asset fair values, including estimating useful lives of the assets. To make these judgments, we may use internal discounted cash flow estimates, quoted market prices when available and independent appraisals as appropriate to determine fair value.
If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be required to recognize additional impairment losses which could be material to our results of operations.
Goodwill
We test goodwill for impairment at least annually as of the first day of the fiscal fourth quarter, or when indications of potential impairment exist. We monitor for the existence of potential impairment indicators throughout the fiscal year. We conduct impairment testing for goodwill at the reporting unit level. Reporting units, as defined by FASB ASC 350, “Intangibles - Goodwill and Other”, may be operating segments as a whole or an operation one level below an operating segment, referred to as a component. We have determined that our reporting units are our two operating and reportable seg ments.
We may initiate goodwill impairment testing by considering qualitative factors to determine whether it is more likely than not that a reporting unit’s carrying value is greater than its fair value. Such factors may include the following, among others: a significant decline in the reporting unit’s expected future cash flows; a sustained, significant decline in our stock price and market capitalization; a significant adverse change in legal factors or in the business climate, unanticipated competition; and slower growth rates; as well as changes in management, key personnel, strategy, and customers. If our qualitative assessment indicates that goodwill impairment is more likely than not, we determine the amount by which the reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill.
We compare the fair value of the reporting unit to its carrying value, including goodwill. We derive a reporting unit ’ s fair value through a combination of the market approach (a guideline transaction method) and the income approach (a discounted cash flow analysis). The income approach utilizes a discount rate from the capital asset pricing model. If all reporting units are analyzed during the goodwill impairment test, their respective fair values are reconciled back to our consolidated market capitalization.
If the fair value of a reporting unit exceeds its carrying value, then we conclude that no goodwill impairment has occurred. If the carrying value of the reporting unit exceeds the fair value, we recognize an impairment loss in an amount equal to the excess, not to exceed the carrying value of the reporting unit ’ s goodwill. Once an impairment loss is recognized, the adjusted carrying value of the goodwill becomes the new accounting basis of the goodwill for the reporting unit.
Contingent Liabilities
We provide for contingent liabilities in accordance with U.S. GAAP, under which a loss contingency is charged to income when (1) it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements, and (2) the amount of the loss can be reasonably estimated.
Periodically, we review the status of each significant matter to assess the potential financial exposure. If a potential loss is considered probable and the amount can be reasonably estimated, we reflect the estimated loss in our results of operations. Significant judgment is required to determine the probability that a liability has been incurred or an asset impaired and whether such loss is reasonably estimable. Because of uncertainties related to these matters, accruals are based on the best information available at the time. Further, estimates of this nature are highly subjective, and the final outcome of these matters could vary significantly from the amounts that may have been included in the accompanying consolidated financial statements. In determining the probability of an unfavorable outcome of a particular contingent liability and whether such liability is reasonably estimable, we consider the individual facts and circumstances related to the liability, opinions of legal counsel and recent legal rulings by the appropriate regulatory bodies, among other factors. As additional information becomes available, we reassess the potential liability related to our pending and threatened claims and litigation and may revise our estimates accordingly. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position. See also a discussion of specific contingencies in Note 16, “Commitments and Contingencies,” to our consolidated financial statements in Item 8 of this Annual Report.
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Recent Accounting Pronouncements
See Note 2, “Basis of Presentation and Summary of Significant Accounting Policies,” to our consolidated financial statements in Item 8 of this Annual Report for a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See the section entitled “Financial and Market Risks” included in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this Annual Report.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.