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 our continuing operations.
Industry Dynamics and Trends
There are a number of industry factors that affect our business which include, among others:
• COVID-19 Pandemic. While certain COVID-19 vaccines have been approved and are now generally available for use in the United States and certain other countries, we are unable to predict how widely utilized the vaccines will be, whether they will be effective in preventing the spread of COVID-19 (including its variant strains), and when or if normal economic activity and business operations will resume. In light of the increasing percentage of vaccinated individuals, many previously implemented restrictions have gradually been lifted. While the number of new cases is significantly below the levels witnessed at the height of the pandemic, there has been a recent uptick in the number of new cases. Despite the availability of vaccines, COVID-19 continues to spread globally and to impact the locations where we do business. The COVID-19 pandemic has negatively impacted the global economy, disrupted global supply chains and labor force participation and created significant volatility and disruption of financial markets. In order to combat the pandemic, significant business and travel restrictions and changes to behavior intended to reduce its spread were implemented. The COVID-19 pandemic caused us to modify our business practices (including employee travel, employee work locations and cancellation of physical participation in meetings, events and conferences). In light of the recent uptick in the number of new cases, the COVID-19 pandemic could continue to affect 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 on customers and their related demand and/or purchases, the impact on our suppliers' and contract manufacturers' ability to fulfill our orders, and the overall impact of the aforementioned items that could cause output challenges and increased costs. The potential continued spread of COVID-19 and any of its variants could result in a number of additional adverse effects, including additional laws and regulations affecting our business, restoration and/or expansion of restrictions, fluctuations in foreign currency markets and the credit risks of our customers. We continue to pay close attention to the evolving development of, and the disruption to business and economic activities caused by, the COVID-19 pandemic. However, given the dynamic nature of the COVID-19 pandemic, it is not practicable to provide a reasonable estimate of its impact on our financial position, cash flows and operating results at the present.
• Overall Demand for Products and Applications Using Our Wolfspeed Materials and Devices . 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 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, production equipment and production facilities. 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. 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 and RF markets we serve.
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• Technological Innovation and Advancement. Innovations and advancements in materials, power, and RF 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.
Fiscal 2021 Overview
The following is a summary of our financial results for the year ended June 27, 2021:
• Our year-over-year revenue increased by $54.9 million to $525.6 million.
• Gross margin decreased to 31.3% from 33.7%. Gross profit increased to $164.6 million from $158.5 million.
• Operating loss from continuing operations was $313.9 million in fiscal 2021 compared to $224.1 million in fiscal 2020. As discussed further below, operating loss from continuing operations for fiscal 2021 includes a $73.9 million expense related to the modification of our long-range plan regarding a building site in Durham, North Carolina.
• Diluted loss per share from continuing operations was $3.04 in fiscal 2021 compared to $1.83 in fiscal 2020.
• Combined cash, cash equivalents and short-term investments decreased to $1,154.6 million at June 27, 2021 from $1,239.7 million at June 28, 2020. Net cash used in operating activities of continuing operations was $112.5 million in fiscal 2021 compared to net cash used in operating activities of continuing operations of $91.6 million in fiscal 2020.
• Purchases of property and equipment, net of $10.7 million in reimbursements, was $559.8 million in fiscal 2021 compared to $229.9 million in fiscal 2020.
Business Outlook
We believe we are uniquely positioned as an innovator in the global semiconductor industry. The strength of our balance sheet provides us the ability to invest in our business, as indicated by our planned construction of a state-of-the-art, automated 200mm silicon carbide device fabrication facility and an expansion of our materials factory to expand our silicon carbide capacity, each of which was announced in May 2019. In September 2019, we announced our intention to build the new device 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 device fabrication facility commenced in the fourth quarter of fiscal 2020 and is expected to start production in fiscal 2022. In fiscal 2022, we expect to incur an estimated $80.0 million of start-up and pre-production costs as we ramp production at the facility.
The completion of the LED Business Divestiture on March 1, 2021 represents a key milestone in our transformation to be a global semiconductor powerhouse focused on disruptive technology solutions for high-growth applications. This transaction positions us with a sharpened strategic focus to lead the semiconductor industry transition from silicon to silicon carbide and further strengthens our financial position, which we target to support continued investments to capitalize on multi-decade growth opportunities across electrical vehicles (EVs), 5G and industrial applications.
We are focused on investing in our 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. We believe these efforts will support our goals of delivering higher revenue and shareholder returns over time.
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, particularly as we transition to our new device fabrication facility in Marcy, New York.
In regards to COVID-19, 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.
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 27, 2021, June 28, 2020 and June 30, 2019 is as follows:
Fiscal Years Ended
June 27, 2021 June 28, 2020 June 30, 2019
(in millions of U.S. Dollars, except share data) Amount % of Revenue Amount % of Revenue Amount % of Revenue
Revenue, net $525.6 100.0 % $470.7 100.0 % $538.2 100.0 %
Cost of revenue, net 361.0 68.7 % 312.2 66.3 % 294.5 54.7 %
Gross profit 164.6 31.3 % 158.5 33.7 % 243.7 45.3 %
Research and development 177.8 33.8 % 152.0 32.3 % 121.1 22.5 %
Sales, general and administrative 181.6 34.6 % 181.7 38.6 % 168.9 31.4 %
Amortization or impairment of acquisition-related intangibles 14.5 2.8 % 14.5 3.1 % 15.6 2.9 %
Abandonment of long-lived assets 73.9 14.1 % — 0.0 % — 0.0 %
Loss on disposal or impairment of other assets 1.6 0.3 % 1.5 0.3 % 5.0 0.9 %
Other operating expense 29.1 5.5 % 32.9 7.0 % 26.6 4.9 %
Operating loss (313.9) (59.7) % (224.1) (47.6) % (93.5) (17.4) %
Non-operating expense (income), net 26.3 5.0 % (18.5) (3.9) % 29.4 5.5 %
Loss before income taxes (340.2) (64.7) % (205.6) (43.7) % (122.9) (22.8) %
Income tax expense (benefit) 1.1 0.2 % (8.0) (1.7) % (4.4) (0.8) %
Net loss from continuing operations (341.3) (64.9) % (197.6) (42.0) % (118.5) (22.0) %
Net (loss) income from discontinued operations (181.2) (34.5) % 7.0 1.5 % (256.6) (47.7) %
Net loss (522.5) (99.4) % (190.6) (40.5) % (375.1) (69.7) %
Net income attributable to noncontrolling interest 1.4 0.3 % 1.1 0.2 % — — %
Net loss attributable to controlling interest ($523.9) (99.7) % ($191.7) (40.7) % ($375.1) (69.7) %
Basic and diluted loss per share
Continuing operations ($3.04) ($1.83) ($1.14)
Net loss attributable to controlling interest ($4.66) ($1.78) ($3.62)
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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 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Revenue $525.6 $470.7 $538.2 $54.9 12 % ($67.5) (13) %
The increase in revenue for fiscal 2021 compared to fiscal 2020 was primarily due to increases in demand for power and RF devices and increases in production capacity for our power devices.
The decrease in 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.
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 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Gross profit $164.6 $158.5 $243.7 $6.1 4 % ($85.2) (35) %
Gross margin 31 % 34 % 45 %
Gross Profit and Gross Margin
The increase in gross profit for fiscal 2021 compared to fiscal 2020 was primarily due to increased revenues in the current period.
The decrease in gross margin for fiscal 2021 compared to fiscal 2020 was primarily due to an unfavorable product mix shift and higher factory costs as we continue to bring on additional capacity.
The decrease in gross profit and gross margin for fiscal 2020 compared to fiscal 2019 was 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 Technologies Co., Ltd. in the second quarter of fiscal 2020. The decrease was further impacted by increased stock-based compensation and incremental manufacturing costs related to the COVID-19 pandemic.
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 costs also include developing supporting technologies for our planned expansion to a new silicon carbide device fabrication facility in Marcy, New York.
Research and development expenses were as follows:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Research and development $177.8 $152.0 $121.1 $25.8 17 % $30.9 26 %
Percent of revenue 34 % 32 % 23 %
The increases in research and development expenses 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 expansion of 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 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Sales, general and administrative $181.6 $181.7 $168.9 ($0.1) — % $12.8 8 %
Percent of revenue 35 % 39 % 31 %
Sales, general and administrative expenses stayed fairly steady in fiscal 2021 compared to fiscal 2020. Increased salaries and benefits, including incentive based stock-based compensation and commissions, were partially offset by decreased information technology costs and professional and legal fees. Additionally, further offsetting decreases related to a decrease of travel costs as a result of travel restrictions related to the COVID-19 pandemic and employee relocation expenses.
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.
Amortization or Impairment of Acquisition-Related Intangibles
As a result of our acquisitions, we recognize various amortizable intangible assets, including customer relationships, developed technology and non-compete agreements.
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 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Customer relationships $6.1 $6.1 $7.3 $— — % ($1.2) (16) %
Developed technology 5.4 5.4 5.4 — — % — — %
Non-compete agreements 3.0 3.0 2.9 — — % 0.1 3 %
Total $14.5 $14.5 $15.6 $— — % ($1.1) (7) %
Amortization of acquisition-related intangibles stayed fairly consistent throughout fiscal 2021, 2020 and 2019 due to the absence of acquisition-related intangible activity between the periods, as well as no impairments.
The slight decrease in fiscal 2020 compared to fiscal 2019 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 Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842, "Leases", due to the value representing a favorable lease.
Abandonment on Long-Lived Assets
In the fourth quarter of fiscal 2021, we modified our long-range plan regarding a portion of our Durham, North Carolina campus originally intended for expanding our LED production capacity that we had considered using to expand the manufacturing footprint for our silicon carbide materials product line. After we complete our current ongoing silicon carbide materials production capacity expansion in Durham, we now plan on further expansion of our silicon carbide materials production capacity outside of the Durham campus. As a result, we have decided we will no longer complete the construction of certain buildings on the Durham campus. Accordingly, an expense of $73.9 million was recorded upon an updated valuation of the property in connection with the preparation of our financial statements for the period ended June 27, 2021.
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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 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Loss on disposal or impairment of other assets $1.6 $1.5 $5.0 $0.1 7 % ($3.5) (70) %
Loss on disposal or impairment of other assets primarily relate to proceeds from asset sales offset by write-offs of fixed asset projects, as well as the write-offs of impaired or abandoned patents.
The loss in fiscal 2019 primarily relates to an impairment of other assets in conjunction with our disposal of the Lighting Products business unit.
Other Operating Expense
Other operating expense was comprised of the following:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Factory optimization restructuring $7.6 $8.5 $4.1 ($0.9) (11) % $4.4 107 %
Severance and other restructuring 3.4 0.6 2.8 2.8 467 % (2.2) (79) %
Total restructuring costs 11.0 9.1 6.9 1.9 21 % 2.2 32 %
Project, transformation and transaction costs 7.3 12.2 16.9 (4.9) (40) % (4.7) (28) %
Factory optimization start-up costs 8.0 9.5 1.5 (1.5) (16) % 8.0 533 %
Non-restructuring related executive severance 2.8 2.1 1.3 0.7 33 % 0.8 62 %
Other operating expense $29.1 $32.9 $26.6 ($3.8) (12) % $6.3 24 %
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 18, "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.
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.
The decrease in other operating expense in fiscal 2021 compared to fiscal 2020 was primarily due to decreased project, transformation and transaction costs, partially offset by a slight increase in total restructuring costs.
The increase in other operating expense in fiscal 2020 compared to fiscal 2019 was primarily due to a full year of factory optimization restructuring and start-up costs in fiscal 2020, offset by a decrease in project, transformation and transaction costs and severance and other restructuring.
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Non-Operating Expense (Income), net
Non-operating expense (income), net was comprised of the following:
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
(Gain) loss on sale of investments, net ($0.4) ($1.5) $0.1 $1.1 (73) % ($1.6) (1,600) %
(Gain) loss on equity investment (8.3) (14.2) 16.2 5.9 42 % (30.4) (188) %
Gain on partial debt extinguishment — (11.0) — 11.0 100 % (11.0) (100) %
Gain on arbitration proceedings — (7.9) — 7.9 100 % (7.9) (100) %
Interest income (10.1) (16.3) (13.9) 6.2 38 % (2.4) (17) %
Interest expense 45.4 34.9 26.0 10.5 30 % 8.9 34 %
Foreign currency (gain) loss, net (1.3) (2.0) 1.3 0.7 35 % (3.3) (254) %
Loss on Wafer Supply Agreement 0.8 — — 0.8 100 % — — %
Other, net 0.2 (0.5) (0.3) 0.7 140 % (0.2) (67) %
Non-operating expense (income), net $26.3 ($18.5) $29.4 $44.8 242 % ($47.9) (163) %
(Gain) loss on equity investment. The (gain) loss on equity investment relates to changes in fair value of our previously held ENNOSTAR Inc. (ENNOSTAR) investment.
Our previously held ENNOSTAR equity investment was originally a 16% common stock ownership interest in Lextar Electronics Corporation (Lextar). In June 2020, Lextar announced a plan to restructure under a holding company with EPISTAR Corporation via a share swap. Effective January 6, 2021, we received 0.275 shares of common stock of the holding company named ENNOSTAR for each of our shares of Lextar, representing in the aggregate an approximate 3.3% common stock ownership interest in ENNOSTAR.
In the fourth quarter of fiscal 2021, we liquidated our common stock ownership interest in ENNOSTAR. We no longer hold any equity interest in ENNOSTAR.
Gain on partial debt extinguishment . The gain on partial debt extinguishment relates to a gain recognized as a result of spending $144.3 million to repurchase $150.2 million of the principal amount held on our 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 decrease in interest income in fiscal 2021 compared to fiscal 2020 was primarily due to significant reductions in investment returns on our short-term investment securities. The increase in interest income in fiscal 2020 compared to fiscal 2019 was primarily due to higher balances on our short-term investments.
Interest expense . The increases in interest expense in both comparative periods was primarily due to the addition of our 2026 Notes, which were sold on April 21, 2020, partially offset by the partial repurchase of our 2023 Notes soon after the sale of the 2026 Notes.
Foreign currency (gain) loss, net. Foreign currency (gain) loss, net primarily consists of remeasurement adjustments resulting from our previously held ENNOSTAR investment and from our international subsidiaries.
Loss on Wafer Supply Agreement . In connection with the completed sale of the LED Products business unit to SMART in fiscal 2021, we entered into the Wafer Supply Agreement, pursuant to which we will supply CreeLED with certain silicon carbide materials and fabrication services for up to four years.
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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 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Income tax expense (benefit) $1.1 ($8.0) ($4.4) 9.1 114 % (3.6) (82) %
Effective tax rate — % 4 % 4 %
The change in the effective tax rate from 4% in fiscal 2020 to 0% in fiscal 2021 was primarily due to the increased tax benefit recorded in fiscal 2020 related to net operating loss provisions of the Coronavirus Aid, Relief, and Economic Security Act.
There was no change in the effective tax rate from fiscal 2019 to fiscal 2020.
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 differing tax rates than the U.S., and (iii) tax credits generated.
As a result of the LED Business Divestiture and the liquidation of our common stock ownership interest in ENNOSTAR, and as discussed further in Note 14, "Income Taxes," to our consolidated financial statements included in Item 8 of this Annual Report, we are reviewing our legal entity structure and performing the due diligence necessary to understand our ability and desire to restructure our Luxembourg holding company. If we decide to restructure our Luxembourg holding company, which could happen as soon as the first quarter of fiscal 2022, it is reasonably possible that this action could generate taxable income of the right character to utilize all or a portion of our existing $121.8 million of deferred tax assets in Luxembourg. This may result in the release of all or a portion of our valuation allowance on the Luxembourg holding company. The release of this valuation allowance could result in the recognition of $121.8 million of net operating loss deferred tax assets and a decrease to income tax expense in the period the release is recorded. There can be no assurance that we will make the decision to restructure our Luxembourg holding company or, if we do, that we will be able to recognize some or all of the net operating loss deferred tax assets in Luxembourg.
Net Loss from Discontinued Operations
Fiscal Years Ended Year-Over-Year Change
(in millions of U.S. Dollars) June 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Net loss from discontinued operations of the Lighting Products business unit $— $— ($317.2) $— — % $317.2 100 %
Net (loss) income from discontinued operations of the LED Products business (181.2) 7.0 60.6 (188.2) (1) (53.6) (88) %
Total ($181.2) $7.0 ($256.6) ($188.2) (1) $263.6 103 %
(1) Percentage not relevant for analysis.
As discussed above, we have classified the results of our former LED Products segment as discontinued operations in our consolidated statements of operations for all periods presented. Net loss from discontinued operations for fiscal 2021 includes $112.6 million of goodwill impairment, an impairment to assets held for sale associated with the LED Business Divestiture of $19.5 million and a loss on sale of $29.1 million. Additionally, total costs to sell of $27.4 million were recognized throughout fiscal 2021 and fiscal 2020 and are included in net loss from discontinued operations for those periods.
For fiscal 2019, net loss from discontinued operations also includes the operational results of our former Lighting Products business unit, and includes $90.3 million of goodwill impairment as well as a $66.2 million loss on the sale of the Lighting Products business unit.
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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 and availability under our line of credit. We have a $125 million line of credit as discussed in Note 10, “Long-term Debt,” to 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.
On April 21, 2020, we issued and sold a total of $575.0 million aggregate principal amount of our 2026 Notes, as discussed in Note 10, “Long-term Debt,” to 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.
Additionally, in the third quarter of fiscal 2021, we filed a shelf registration statement on Form S-3 to register for possible future sale shares of our common stock. We may offer an indeterminate amount of common stock in amounts, at prices and on terms to be determined by the board of directors if and when shares are issued. The registration statement became automatically effective upon filing with the SEC on February 11, 2021. Using this shelf registration statement, we implemented an at-the-market program (the ATM Program) as described in Note 11, “Shareholders’ Equity,” to our consolidated financial statements included in Item 8 of this Annual Report. The ATM Program was conducted pursuant to an equity distribution agreement (the Equity Distribution Agreement) with Wells Fargo Securities, LLC, BMO Capital Markets Corp., BofA Securities Inc., Canaccord Genuity LLC, Citigroup Global Markets Inc., Credit Suisse Securities (USA) LLC, Goldman Sachs & Co. LLC, Morgan Stanley & Co. LLC and Truist Securities, Inc. (the Managers). On February 19, 2021, we announced that we had sold approximately $500.0 million of common stock under the ATM Program. As such, the ATM Program automatically terminated in accordance with the terms of the Equity Distribution Agreement. In total, we sold and received payment for 4,222,511 shares of our common stock at a weighted average price of $118.41 per share for total gross proceeds of approximately $500.0 million and net proceeds of approximately $489.1 million, after $10.0 million in commissions to the Managers and $0.9 million in other offering costs. We expect to use the net proceeds for general corporate purposes.
In the fourth quarter of fiscal 2021, we liquidated our common stock ownership interest in ENNOSTAR and received net proceeds of $66.4 million.
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. For example, we recently completed the LED Business Divestiture, which provided us with (i) $50 million in upfront payments (ii) a $125 million unsecured promissory note due in August 2023, and (iii) the potential to receive an earn-out payment between $2.5 million and $125 million based on the revenue and gross profit performance of the LED Business in the first four full fiscal quarters following the closing, also payable in the form of an unsecured promissory note due March 2025. We may also access capital markets through the issuance of debt or additional shares of common stock, which we may use in connection with the acquisition of complementary businesses or other significant assets or for other strategic opportunities or general corporate purposes.
We are currently building a new silicon carbide device fabrication facility in Marcy, New York, to expand capacity for our silicon carbide device business. We expect to invest more than $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 in future fiscal years by the State of New York through a grant program administered by the State of New York Urban Development Corporation (doing business as Empire State Development). Given our current cash position, we believe we are positioned to adequately fund the construction of the facility.
The full extent to which the COVID-19 pandemic may impact our results of operations or liquidity is uncertain. 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 industry, and the economies in which we operate.
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To the extent the COVID-19 virus and its variants continue to spread, we believe our future results of operations, including the results for fiscal 2022, could be materially impacted by the COVID-19 pandemic, but at this time we do not expect the impact from the COVID-19 pandemic 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. The ultimate extent to which the COVID-19 pandemic will impact our business depends on future developments, which include the effectiveness and utilization of vaccines for COVID-19 and its variants. New information may emerge concerning the severity of COVID-19 and its variants, and additional actions may be taken in order to contain or limit their spread. 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 27, 2021, 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 12.0 4.5 5.5 1.8 0.2
Finance lease obligations 15.2 3.7 0.9 0.9 9.7
Purchase obligations 470.1 468.9 1.2 — —
Long-term debt (1)
999.8 — 424.8 575.0 —
Interest payments on long-term debt (2)
59.6 13.8 25.7 20.1 —
Other long-term liabilities (3)
4.6 — 4.6 — —
Total contractual obligations $1,561.3 $490.9 $462.7 $597.8 $9.9
(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 27, 2021 also includes customer deposits of $22.2 million, long-term tax contingencies and other tax liabilities of $3.3 million, and a Wafer Supply Agreement liability of $9.4 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 device fabrication facility in New York. The leases for our Wolfspeed manufacturing space in Malaysia expire in November 2026 and the 49-year ground lease in New York expires in April 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 27, 2021 June 28, 2020 Change
Cash and cash equivalents $379.0 $448.8 ($69.8)
Short-term investments 775.6 790.9 (15.3)
Total cash, cash equivalents and short-term investments $1,154.6 $1,239.7 ($85.1)
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 27, 2021 June 28, 2020 Change
Days of sales outstanding (a) 52 53 (1)
Days of supply in inventory (b) 147 117 30
Days in accounts payable (c) (92) (115) 23
Cash conversion cycle 107 55 52
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 (excluding inventory related to the Wafer Supply Agreement entered into in connection with the LED Business Divestiture) 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. Due to the significant amount of capital expenditures associated with our future silicon carbide device fabrication facility in New York, we exclude accounts payable related to capital expenditures in connection with the facility. DPO is calculated by dividing ending accounts payable and accrued expenses (less accrued salaries and wages and accounts payable balances related to our future silicon carbide device fabrication facility in New York) by the average cost of revenue, net per day for the respective 90-day period.
The increase in the cash conversion cycle was primarily driven by increased inventory balances as we expand production globally and build a raw materials buffer to ensure continuity of supply during the pandemic. Further contributing to the increase was a decrease in accounts payable (excluding amounts related to capital expenditures for our future silicon carbide device fabrication facility in Marcy, New York) while our cost of revenue for the quarter increased.
As of June 27, 2021, we had unrealized losses on our short-term investments of $0.4 million. All of our short-term investments had investment grade ratings, and any such investments that were in an unrealized loss position at June 27, 2021 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 pandemic. We evaluate our short-term investments for expected credit losses. We believe we are able to and we intend to hold each of the investments held with an unrealized loss as of June 27, 2021 until the investments fully recover in market value. No allowance for credit losses was recorded as of June 27, 2021.
Cash Flows
In summary, our cash flows were as follows (in millions of U.S. Dollars):
Fiscal Years Ended Year-Over-Year Change
June 27, 2021 June 28, 2020 June 30, 2019 2020 to 2021 2019 to 2020
Cash (used in) provided by operating activities ($125.5) ($29.0) $202.3 ($96.5) ($231.3)
Cash used in investing activities (448.6) (486.9) (227.1) 38.3 (259.8)
Cash provided by financing activities 504.1 464.3 406.5 39.8 57.8
Effect of foreign exchange changes 0.2 (0.1) (0.1) 0.3 —
Net (decrease) increase in cash and cash equivalents ($69.8) ($51.7) $381.6 ($18.1) ($433.3)
Cash Flows from Operating Activities
Net cash used in operating activities increased in fiscal 2021 compared to fiscal 2020 primarily due to an increase in net loss during the period and decreased cash provided by operating activities of discontinued operations, as well as slightly decreased working capital.
Net cash from 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.
Total cash flows from operating activities in fiscal 2021, 2020 and 2019 includes ($13.0) million, $62.6 million and $105.1 million of cash (used in) provided by operating activities of discontinued operations.
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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.
The decrease in net cash used in investing activities in fiscal 2021 compared to fiscal 2020 was primarily due to an increase in property and equipment purchases of $340.6 million partially offset by an increase in net proceeds from short-term investments of $247.8 million, net proceeds from the sale of the LED Business of $43.7 million, net proceeds from the liquidation of our ENNOSTAR equity investment of $66.4 million and $10.7 million of property related reimbursements from the State of New York Urban Development Corporation under a Grant Disbursement Agreement (GDA). For more details on the GDA, see Note 15, "Commitments and Contingencies," in our consolidated financial statements included in Item 8 of this Annual Report.
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 property and equipment purchases of $105.2 million offset by a decrease in net purchases of short term investments of $50.6 million.
Total cash used in investing activities in fiscal 2021, 2020 and 2019 includes $0.3 million, $12.4 million and $25.0 million of cash used in investing activities of discontinued operations.
For fiscal 2022, we target approximately $475.0 million of net capital investment, which is primarily related to capacity and infrastructure projects to support 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 approximately $300.0 million of expected reimbursements from the State of New York Urban Development Corporation under the GDA.
Cash Flows from Financing Activities
Net cash provided by financing activities in fiscal 2021 primarily consisted of net proceeds of $503.5 million from issuances of common stock pursuant to the exercise of employee stock options and issuances of common stock in connection with the ATM Program.
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.
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 27, 2021 and June 28, 2020. 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 27, 2021 and June 28, 2020, our cash equivalents and short-term investments had a fair value of $979.8 million and $1,094.8 million, respectively. If interest rates were to hypothetically increase by 100 basis points, the fair value of our short-term investments would decrease by $9.8 million at June 27, 2021 and $10.9 million at June 28, 2020.
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Additionally, as part of the completed LED Business Divestiture, we hold a $125 million unsecured promissory note due in August 2023. The promissory note bears interest at the London Interbank Offered Rate (LIBOR) plus 3%. Due to relatively low LIBOR rates as of June 27, 2021, combined with the 3% minimum interest rate of the note, a hypothetical decrease in interest rates would result in an immaterial impact to interest income as of June 27, 2021.
As of June 27, 2021, 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 June 27, 2021 and June 28, 2020, 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.
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 27, 2021, 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 our 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.
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We provide our customers with limited rights of return for non-conforming shipments. 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 adopted FASB 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.
For the year ended June 27, 2021, 26% 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.
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.
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.
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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. In addition, our international sales and purchases are subject to numerous United States and foreign laws and regulations which may limit or restrict our sales and shipments to foreign customers. 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.
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.
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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 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. As of June 27, 2021, we have $73.4 million of unrecognized compensation cost related to nonvested awards, which is expected to be recognized over a weighted average period of 1.88 years.
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.
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. 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. For example, we recognized an impairment to assets held for sale associated with the LED Business Divestiture of $19.5 million during the second fiscal quarter of 2021.
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.
Government Grant Disbursements
Government grant disbursements are recognized when there is reasonable assurance that: (1) we will comply with the relevant conditions and (2) the grant disbursement will be received. We receive grant disbursements from the State of New York Development Corporation relating to property, plant and equipment purchases in connection with our construction of a new silicon carbide device fabrication facility in Marcy, New York. Grant disbursements are recorded as a reduction to the related asset(s), which then reduces depreciation expense over the expected useful life of the asset on a straight-line basis.
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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 we operate as one operating and reportable seg ment.
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 market and income approaches require significant judgment, including estimation of future revenues, gross margins, and operating expenses, which are dependent on internal forecasts, current and anticipated economic conditions and trends, selection of market multiples through assessment of the reporting unit’s performance relative to peer competitors, the estimation of the long-term revenue growth rate and discount rate from the capital asset pricing model and the determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the fair value of the goodwill reporting unit, potentially resulting in a non-cash impairment charge. The 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 15, “Commitments and Contingencies,” to our consolidated financial statements in Item 8 of this Annual Report.
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.
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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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