INTEVAC, INC. Management's Discussion and Analysis (MD&A) is intended to facilitate an understanding ofIntevac's business and results of operations. This MD&A should be read in conjunction withIntevac's Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10- K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A includes the following sections:
• Overview: a summary of
• Results of Operations: a discussion of operating results.
• Liquidity and Capital Resources: an analysis of cash flows, sources and
uses of cash, and financial position.
• Critical Accounting Policies: a discussion of critical accounting
policies that require the exercise of judgments and estimates.
Overview
Intevac is a provider of vacuum deposition equipment for a wide variety of
thin-film applications, and a leading provider of digital night-vision
technologies and products to the defense industry. The Company leverages its
core capabilities in high-volume manufacturing of small substrates to provide
process manufacturing equipment solutions to the HDD, DCP, and solar cell
industries. Intevac also provides sensors, cameras and systems for government
applications such as night vision and long-range target identification.
Intevac's customers include manufacturers of hard disk media, DCPs and solar
cells as well as the U.S. government and its agencies, allies and contractors.
Intevac reports two segments: TFE and Photonics.
Product development and manufacturing activities occur in North America and
Asia . Intevac has field offices in Asia to support its TFE customers. Intevac's
products are highly technical and are sold primarily through Intevac's direct
sales force. Intevac also sells its products through distributors in Japan and
China .
Intevac's results are driven by a number of factors including success in its
equipment growth initiatives in the DCP and solar markets and by worldwide
demand for HDDs. Demand for HDDs depends on the growth in digital data creation
and storage, the rate of areal density improvements, the end-user demand for
PCs, enterprise data storage, nearline "cloud" applications, video players and
video game consoles that include such drives. Intevac continues to execute its
strategy of equipment diversification into new markets by introducing new
products, such as for a thin-film PVD application for protective coating for DCP
manufacturing and a thin-film PVD application for PV solar cell manufacturing.
Intevac believes that expansion into these markets will result in incremental
equipment revenues for Intevac and decrease Intevac's dependence on the HDD
industry. Intevac's equipment business is subject to cyclical industry
conditions, as demand for manufacturing equipment and services can change
depending on supply and demand for HDDs, cell phones, and PV cells as well as
other factors such as global economic conditions and technological advances in
fabrication processes.
Change
Fiscal Year 2019 2018 2019 vs. 2018
(in thousands, except percentages and per share amounts)
Net revenues $ 108,885 $ 95,114 $ 13,771
Gross profit $ 40,868 $ 32,694 $ 8,174
Gross margin percent 37.5 % 34.4 % 3.1 points
Operating income (loss) $ 3,925 $ (4,217 ) $ 8,142
Net income $ 1,148 $ 3,581 * $ (2,433 )
Net income per diluted share $ 0.05 $ 0.16 * $ (0.11 )
* The Company's results for fiscal 2018 included the reversal of the valuation
allowance recorded against the deferred tax assets in
reversal resulted in the recognition of a non-cash income tax benefit in the
fourth quarter of 2018 of
Fiscal 2018 financial results reflected a challenging environment. In 2018,Intevac recognized revenue on four 200 Lean HDD systems as our HDD customer upgraded the technology level of their manufacturing capacity. In 2018,Intevac recognized revenue on the three solar implantENERGi systems shipped in the previous year. Photonics continued to deliver production shipments of the night-vision camera modules for the F35 Joint Strike Fighter program in fiscal 2018. With the completion of 21
-------------------------------------------------------------------------------- the Apache program in 2017, the Photonics revenue profile moved from a product-driven one to a funded R&D revenue profile. Photonics margins and operating results were negatively impacted by a higher-mix of lower margin technology development contracts versus product sales. Fiscal 2018 net income reflected recognition of an income tax benefit and lower operating expenses due to cost containment activities put in place in the first quarter of fiscal 2018, offset in part by lower net revenues and lower gross margins. During fiscal 2018, the Company reversed the valuation allowance recorded against the deferred tax assets related to itsSingapore operations. This reversal resulted in the recognition of a non-cash income tax benefit of$7.9 million . During fiscal 2018, the Company did not recognize an income tax benefit on itsU.S. net operating loss. Fiscal 2019 financial results reflected an improved environment as the Company resumed its growth trajectory. Fiscal 2019 HDD equipment sales were slightly lower than 2018.Intevac recognized revenue on four 200 Lean HDD systems with an additional two in backlog at the end of the year. In 2019,Intevac recognized revenue on nine solar implantENERGi systems. We also made significant progress in our TFE growth initiatives, placing evaluation tools with leading manufacturers in both the display cover glass market and the advanced semiconductor packaging market. In fiscal 2019, Photonics business levels were higher compared to the prior year due primarily to the$31.6 million U.S. Army IVAS contract award. Photonics continued to deliver production shipments of the night-vision camera modules for the F35 Joint Strike Fighter program in fiscal 2019 and resumed shipments of the Apache camera in the second half of 2019. Fiscal 2019 net income was the result of higher net revenues and higher gross margins. During 2019, the Company received an unfavorable decision on its appeal to a tax audit inSingapore and although management has decided to appeal this decision, management determined that the Company could no longer support a more likely than not position. Accordingly, the Company recorded a charge of$732,000 which is included in the provision for income taxes. During fiscal 2019, the Company did not recognize an income tax benefit on itsU.S. net operating loss. We believe that we will continue to be profitable in fiscal 2020.Intevac expects that HDD equipment sales will be down from 2019 levels as a HDD manufacturer takes delivery of the two 200 Lean HDD systems in backlog. In 2020,Intevac expects higher sales of new TFE products as we expect to: (i) convert at least one of the two systems under evaluation at customer factories to revenue and (ii) obtain follow on production orders for our VERTEX coating system for DCPs and our solar implantENERGi system. The second evaluation system at a customer factory is expected to convert to revenue in 2021. In 2020, we expect Increased product revenue in Photonics as we continue to deliver product shipments of the Apache camera and the night-vision camera modules for the F35 Joint Strike Fighter program. In 2020, we expect increased contract R&D revenue as development work continues on the multi-year IVAS contract award for the development and production of digital night-vision cameras to support theU.S. Army's IVAS program. For fiscal 2020,Intevac expects that Photonics profits will be higher than fiscal 2019 as Photonics results will reflect higher revenue levels. Results of Operations Net revenues Change 2019 2018 2019 vs. 2018 (in thousands) TFE$ 73,678 $ 69,348 $ 4,330 Photonics Products 15,550 15,972 (422 ) Contract R&D 19,657 9,794 9,863 35,207 25,766 9,441 Total net revenues$ 108,885 $ 95,114 $ 13,771 Net revenues consist primarily of sales of equipment used to manufacture thin-film disks, PV cells, DCPs and related equipment and system components; sales of low-light imaging products; and revenue from contract R&D related to the development of electro-optical sensors, cameras and systems. The increase in TFE revenues in fiscal 2019 versus fiscal 2018 was due primarily to higher systems sales as TFE recognized revenue on four 200 Lean HDD systems and nine solar implantENERGi systems, offset in part by decreases in revenue recognized on technology upgrades, service and spare parts. In fiscal 2018, TFE revenue recognized four 200 Lean HDD systems and three solar implantENERGi systems as well as technology upgrades, service and spare parts. 22 -------------------------------------------------------------------------------- Photonics revenues increased by 36.6% to$35.2 million in fiscal 2019 versus fiscal 2018. Photonics product revenue reflected the resumption of the Apache camera shipments and higher unit shipments for the F35 Joint Strike Fighter program night-vision camera. Contract R&D revenue in fiscal 2019 increased as a result of development on the IVAS program. Backlog December 28, 2019 December 29, 2018 (in thousands) TFE $ 21,391 $ 64,803 Photonics 71,015 43,711 Total backlog $ 92,406 $ 108,514 TFE backlog atDecember 28, 2019 included two 200 Lean HDD systems. TFE backlog atDecember 29, 2018 included six 200 Lean HDD systems and nineENERGi solar ion implant systems. Significant portions ofIntevac's revenues in any particular period have been attributable to sales to a limited number of customers. The following customers accounted for at least 10 percent ofIntevac's consolidated net revenues in fiscal 2019 and 2018. 2019 2018 Seagate Technology 49 % 52 % U.S. Government 20 % * Jolywood (Hongkong) Industrial Holdings Co., Limited 14 % * HGST * 13 % * Less than 10% Revenue by geographic region 2019 2018 (in thousands) TFE Photonics Total TFE Photonics Total United States$ 1,306 $ 34,664 $ 35,970 $ 4,050 $ 23,862 $ 27,912 Asia 72,372 - 72,372 65,298 31 65,329 Europe - 543 543 - 1,648 1,648 Rest of World - - - - 225 225 Total net revenues$ 73,678 $ 35,207 $ 108,885 $ 69,348 $ 25,766 $ 95,114
International sales include products shipped to overseas operations of
The increase in sales to theAsia region in 2019 versus 2018 reflected higher system sales, offset in part by lower technology upgrade, service and spare parts sales. Sales to theAsia region in 2019 included four 200 Lean HDD systems and nine solar implantENERGi systems. Sales to theAsia region in 2018 included four 200 Lean HDD systems and three solar implantENERGi systems.
Sales to the
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Gross margin
Fiscal Year Change
2019 2018 2019 vs. 2018
(in thousands, except percentages)
TFE gross profit $ 27,377 $ 25,328 $ 2,049
% of TFE net revenues 37.2 % 36.5 %
Photonics gross profit $ 13,491 $ 7,366 $ 6,125
% of Photonics net revenues 38.3 % 28.6 %
Total gross profit $ 40,868 $ 32,694 $ 8,174
% of net revenues 37.5 % 34.4 %
Cost of net revenues consists primarily of purchased materials and costs attributable to contract R&D, and also includes assembly, test and installation labor and overhead, customer-specific engineering costs, warranty costs, royalties, provisions for inventory reserves and scrap.
TFE gross margin was 37.2% in fiscal 2019 compared to 36.5% in fiscal 2018. Fiscal 2019 gross margins improved over fiscal 2018 as higher margins on upgrades were offset in part by lower margins on the sale of nine solar implantENERGi systems. Gross margins in the TFE business vary depending on a number of factors, including product mix, product cost, system configuration and pricing, factory utilization, and provisions for excess and obsolete inventory.
Photonics gross margin was 38.3% in fiscal 2019 compared to 28.6% in fiscal 2018. The improvement in gross margin for fiscal 2019 over fiscal 2018 is due primarily to higher revenue levels and improved margins on contract R&D work. Manufacturing costs for digital night-vision products decreased in fiscal 2019 and 2018 as a result of cost reductions and yield improvements.
Research and development
Fiscal Year Change
2019 2018 2019 vs. 2018
(in thousands)
Research and development expense
Research and development expense consists primarily of salaries and related costs of employees engaged in and prototype materials used in ongoing research, design and development activities for PV cell manufacturing equipment, DCP manufacturing equipment, HDD disk sputtering equipment, semiconductor Fan-out equipment and Photonics products.
TFE research and development spending in fiscal 2019 decreased compared to fiscal 2018 due to lower spending on semiconductor Fan-out development.
Research and development spending for Photonics increased during 2019 as compared to fiscal 2018 primarily related to the development of the next generation of our low light level CMOS camera. Research and development expenses do not include costs of$12.3 million and$9.1 million in 2019 and 2018, respectively, which are related to customer-funded contract R&D programs and therefore included in cost of net revenues.
Selling, general and administrative
Fiscal Year Change
2019 2018 2019 vs. 2018
(in thousands)
Selling, general and administrative expense
2,439
Selling, general and administrative expense consists primarily of selling, marketing, customer support, financial and management costs. All domestic sales and the majority of international sales of HDD disk sputtering products inAsia are made throughIntevac's direct sales force.Intevac also sells its TFE products through distributors inJapan andChina .Intevac has offices inSingapore ,Malaysia andChina to supportIntevac's TFE customers inAsia . 24 -------------------------------------------------------------------------------- Selling, general and administrative expenses increased in 2019 over the amount spent in 2018 due to higher variable compensation costs, increased spending to support a customer evaluation of a next generation product and the lapse of the 2018 cost containment initiatives which included temporary salary reductions for executive management.
Acquisition-related (benefit), net
Fiscal Year Change
2019 2018 2019 vs. 2018
(in thousands)
Acquisition-related (benefit), net $ 7 $ (139 ) $ 146
Acquisition-related (benefit), net, represents the change in the fair value of a
contingent consideration earnout arrangement related to the SIT acquisition. The
earnout period terminated on June 30, 2019 .
Cost reduction plan
During the first quarter of fiscal 2018,Intevac substantially completed implementation of the 2018 cost reduction plan (the "2018 Plan"), which reduced expenses and reduced its workforce by 6 percent. The total cost of implementing the 2018 Plan was$95,000 of which$61,000 was reported under cost of net revenues and$34,000 was reported under operating expenses. Substantially all cash outlays in connection with the 2018 Plan were completed in fiscal 2018. Implementation of the 2018 Plan reduced salary, wages and other employee-related expenses by approximately$1.8 million on an annual basis.
Interest income and other income (expense), net
Fiscal Year Change
2019 2018 2019 vs. 2018
(in thousands)
Interest income and other income (expense), net
(40 )
Interest income and other income (expense), net in fiscal 2019 included$574,000 of interest income on investments and$20,000 earnout income from a divestiture, offset in part by$85,000 of foreign currency losses. Interest income and other, net in fiscal 2018 included$516,000 of interest income on investments and$135,000 earnout income from a divestiture, offset in part by$80,000 of foreign currency losses. The increase in interest income in 2019 over 2018 reflected higher interest rates onIntevac's investments and higher invested balances.
Provision for (benefit from) income taxes
Fiscal Year Change
2019 2018 2019 vs. 2018
(in thousands)
Provision for (benefit from) income taxes $ 3,359 $ (7,176 ) $ 10,535 During fiscal 2018 the Company reversed the valuation allowance recorded against
the deferred tax assets related to its
During 2019 the Company received an unfavorable decision on its appeal to a tax audit inSingapore and although management plans to pursue an appeal to theSingapore High Court , management determined that the Company could no longer support a more likely than not position. Accordingly, the Company recorded a charge of$732,000 in provision for income taxes.Intevac's effective income tax rate was 74.5% for fiscal 2019 and 199.6% for fiscal 2018. Our effective income tax rate in 2018, excluding the impact of the reduction in our deferred income tax asset valuation allowance was (20.4%).Intevac's tax rate differs from the applicable statutory rates due primarily to establishment and reversal of a valuation allowance, the utilization of deferred and current credits and the effect of permanent differences, adjustments of prior permanent differences and changes in estimates of uncertain tax positions.Intevac's future effective income tax rate depends on various factors including, the level of 25
--------------------------------------------------------------------------------Intevac's projected earnings, the geographic composition of worldwide earnings, tax regulations governing each region, net operating loss carry forwards, availability of tax credits and the effectiveness ofIntevac's tax planning strategies. Management carefully monitors these factors and timely adjusts the effective income tax rate accordingly. In fiscal 2014, a valuation allowance of$9.4 million was established on a portion of theSingapore deferred tax asset. The Company concluded that, as ofDecember 29, 2018 , it is more likely than not that the Company will generate sufficient taxable income inSingapore to realize its deferred tax assets and reversed the valuation allowance during the fourth quarter of 2018. This reversal resulted in the recognition of a non-cash income tax benefit of$7.9 million for fiscal 2018. The Company has considered all positive and negative evidence regarding the ability to fully realize the deferred tax asset, including past operating results and the forecast of future taxable income. This conclusion, and the resulting reversal of the deferred tax asset valuation allowance, is based upon consideration of a number of factors, including the Company's completion of 7 consecutive quarters of profitability and its forecast of future profitability under multiple scenarios that support the utilization of net operating loss carryforwards. After recognizing the reversal, the Company does not have a remaining valuation allowance against the deferred tax assets inSingapore atDecember 28, 2019 . In fiscal 2012, a valuation allowance of$23.4 million was established to record the portion of theU.S. federal deferred tax asset that more likely than not will not be realized. For fiscal 2019 a valuation allowance decrease of$689,000 and for fiscal 2018 a valuation allowance increase of$930,000 , respectively, were recorded for theU.S. federal deferred tax asset. A valuation allowance is recorded against the entire state deferred tax asset which consists of state income tax temporary differences and deferred research and other tax credits that are not realizable in the foreseeable future. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period are reduced or increased, or if objective negative evidence in the form of cumulative losses is no longer present and additional weight may be given to subjective evidence such as our projections for growth.
Liquidity and Capital Resources
AtDecember 28, 2019 ,Intevac had$42.8 million in cash, cash equivalents, restricted cash and investments compared to$40.3 million atDecember 29, 2018 . During fiscal 2019, cash, cash equivalents, restricted cash and investments increased by$2.5 million due primarily to cash generated by operating activities and cash received from the sale ofIntevac common stock toIntevac's employees throughIntevac's employee benefit plans, offset in part by cash used for repurchases of common stock, purchases of fixed assets and tax payments related to the net share settlement of restricted stock units. Cash, cash equivalents, restricted cash and investments consist of the following: December 28, 2019 December 29, 2018 (in thousands) Cash and cash equivalents $ 19,767 $ 18,715 Restricted cash 787 1,169 Short-term investments 16,720 16,076 Long-term investments 5,537 4,372 Total cash, cash-equivalents, restricted cash and investments $ 42,811 $ 40,332 Cash generated by operating activities totaled$4.9 million in 2019. Cash used in operating activities totaled$1.7 million in 2018. Improved operating cash flow in 2019 was a result of net income and improved working capital. Accounts receivable totaled$28.6 million atDecember 28, 2019 compared to$27.7 million atDecember 29, 2018 . Customer advances for products that had not been shipped to customers and included in accounts receivable were$201,000 atDecember 28, 2019 compared to$3.7 million atDecember 29, 2018 . The number of days outstanding for Intevac's accounts receivable was 72 atDecember 28, 2019 compared to 78 atDecember 29, 2018 . Net inventories totaled$24.9 million atDecember 28, 2019 compared to$30.6 million atDecember 29, 2018 . Net inventories atDecember 28, 2019 included one VERTEX SPECTRA system for DCP under evaluation in a customer's factory and one MATRIX PVD system for advance semiconductor packaging under evaluation in a customer's factory. Net inventories atDecember 29, 2018 included threeENERGi implant systems in finished goods and oneENERGi implant system in work in process that were virtually complete and shipped to the customer inJanuary 2019 . Inventory turns were 2.5 in fiscal 2019 and were 2.2 in fiscal 2018. Accounts payable decreased to$4.2 million atDecember 28, 2019 compared to$6.1 million atDecember 29, 2018 due to lower 26 -------------------------------------------------------------------------------- manufacturing activities at the end of the year. Other accrued liabilities decreased to$3.6 million atDecember 28, 2019 compared to$5.0 million atDecember 29, 2018 primarily due to lower deferred revenue balances. Other accrued liabilities atDecember 29, 2018 included$1.1 million in deferred revenue related to the recognition of the ASC 606 transition adjustment. Accrued payroll and related liabilities increased to$6.5 million atDecember 28, 2019 compared to$4.7 million atDecember 29, 2018 as a result of higher variable compensation accruals. Customer advances decreased from$14.3 million atDecember 29, 2018 to$4.0 million atDecember 28, 2019 as a result of recognition of revenue. Investing activities used cash of$5.8 million in 2019 and$1.0 million in 2018. Purchases of investments net of proceeds from sales and maturities of investments, totaled$1.7 million in 2019. Proceeds from sales and maturities of investments net of purchases of investments, totaled$2.2 million in 2018. Capital expenditures were$4.1 million in 2019 and$3.2 million in 2018. Financing activities generated cash of$1.5 million in 2019 and$1.8 million in 2018. The sale ofIntevac common stock toIntevac's employees throughIntevac's employee benefit plans provided$2.3 million in 2019 and$3.2 million in 2018. Tax payments related to the net share settlement of restricted stock units were$404,000 in 2019 and$831,000 in 2018. InNovember 2013 ,Intevac's Board of Directors approved a stock repurchase program authorizing up to$30 million in repurchases. OnAugust 15, 2018 ,Intevac's Board of Directors approved a$10.0 million increase to the original stock repurchase program authorizing up to$40.0 million in repurchases. Cash used to repurchase common stock totaled$111,000 in 2019 and$558,000 in 2018. In connection with the acquisition of SIT,Intevac agreed to pay to the selling shareholders in cash a revenue earnout onIntevac's net revenue from commercial sales of certain solar implant products over a specified period up to an aggregate of$9.0 million . The earnout period terminated onJune 30, 2019 . Payments made associated with the revenue earnout obligation were$230,000 in 2019.Intevac's investment portfolio consists principally of investment grade money market mutual funds,U.S. treasury and agency securities, certificates of deposit, commercial paper, municipal bonds and corporate bonds.Intevac regularly monitors the credit risk in its investment portfolio and takes measures, which may include the sale of certain securities, to manage such risks in accordance with its investment policies. As ofDecember 28, 2019 , approximately$11.6 million of cash and cash equivalents and$3.4 million of short term investments were domiciled in foreign tax jurisdictions.Intevac expects a significant portion of these funds to remain off shore in the short term. If the Company chose to repatriate these funds tothe United States , it would be required to accrue and pay additional taxes on any portion of the repatriation subject to foreign withholding taxes.Intevac believes that its existing cash, cash equivalents and investments will be sufficient to meetIntevac's cash requirements for the next 12 months.Intevac intends to undertake approximately$6.0 million in capital expenditures during the next 12 months.
Off-Balance Sheet Arrangements
Off-balance sheet firm commitments relating to outstanding letters of credit amounted to approximately$787,000 as ofDecember 28, 2019 . These letters of credit and bank guarantees are collateralized by$787,000 of restricted cash. We do not maintain any other off-balance sheet arrangements, transactions, obligations, or other relationships that would be expected to have a material current or future effect on the consolidated financial statements.
Critical Accounting Policies
The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted inthe United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies.
A critical accounting policy is defined as one that is both material to the
presentation of
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required to make assumptions about matters that are highly uncertain at the time
of the estimate; and (2) different estimates Intevac could reasonably have used,
or changes in the estimate that are reasonably likely to occur, would have a
material effect on Intevac's financial condition or results of operations.
Estimates and assumptions about future events and their effects cannot be
determined with certainty. Intevac bases its estimates on historical experience
and on various other assumptions believed to be applicable and reasonable under
the circumstances. These estimates may change as new events occur, as additional
information is obtained and as Intevac's operating environment changes. These
changes have historically been minor and have been included in the consolidated
financial statements as soon as they became known. In addition, management is
periodically faced with uncertainties, the outcomes of which are not within its
control and will not be known for prolonged periods of time. These uncertainties
are discussed in the section above entitled "Risk Factors." Based on a critical
assessment of its accounting policies and the underlying judgments and
uncertainties affecting the application of those policies, management believes
that Intevac's consolidated financial statements are fairly stated in accordance
with accounting principles generally accepted in the United States of America ,
and provide a meaningful presentation of Intevac's financial condition and
results of operations.
Management believes that the following are critical accounting policies:
Revenue Recognition
In our TFE segment, a majority of our equipment sales revenue continues to be
recognized when products are shipped from our manufacturing facilities. Revenue
recognition for our equipment sales arrangements, which includes systems,
technology upgrades, service and spare parts, remains materially consistent with
our historical practice.
In our TFE segment, we recognize revenue for equipment sales at a point in time
following the transfer of control of such products to the customer, which
typically occurs upon shipment or delivery depending on the terms of the
underlying contracts. Our contracts with customers may include multiple
performance obligations. For such arrangements, under the new revenue standard
we allocate revenue to each performance obligation based on its relative
standalone selling price. We generally determine standalone selling prices based
on the prices charged to customers or by using expected cost plus margin. Under
the new revenue standard, the expected costs associated with our base warranties
continue to be recognized as expense when the equipment is sold.
In our Photonics segment, we recognize revenue for cost plus fixed fee ("CPFF")
and firm fixed price ("FFP") government contracts over time under the
cost-to-cost method for the majority of our government contracts, which is
consistent with our historical revenue recognition model. Revenue on the
majority of our government contracts will continue to be recognized over time
because of the continuous transfer of control to the customer. For U.S.
government contracts, this continuous transfer of control to the customer is
supported by clauses in the contract that allow the customer to unilaterally
terminate the contract for convenience, pay us for costs incurred plus a
reasonable profit and take control of any work in process. Similarly, for
non-U.S. government contracts, the customer typically controls the work in
process as evidenced either by contractual termination clauses or by our rights
to payment for work performed to date to deliver products or services that do
not have an alternative use to the Company. Under the new standard, the
cost-to-cost measure of progress continues to best depict the transfer of
control of assets to the customer, which occurs as we incur costs.
The majority of our contracts in our Photonics segment have a single performance
obligation as the promise to transfer the individual goods or services is not
separately identifiable from other promises in the contracts and, therefore, not
distinct. Some of our contracts have multiple performance obligations, most
commonly due to the contract covering multiple phases of the product lifecycle
(development and production). For contracts with multiple performance
obligations, we allocate the contract's transaction price to each performance
obligation using our best estimate of the standalone selling price of each
distinct good or service in the contract. The primary method used to estimate
standalone selling price is the expected cost plus a margin approach, under
which we forecast our expected costs of satisfying a performance obligation and
then add an appropriate margin for that distinct good or service.
In our Photonics segment, we recognize revenue for homogenous manufactured
military products sold to the U.S. government and its contractors over time
under the units-of-delivery method because of the continuous transfer of control
to the customer. Intevac believes that the units-of-delivery method is an
appropriate measure for measuring progress for the manufactured units as an
equal amount of value is individually transferred to the customer upon delivery.
The Company previously recognized revenue for substantially all manufactured
military products sold to the U.S. government and its contractors when the
customers took delivery of the products, which was generally upon shipment.
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The nature of our contracts in our Photonics segment gives rise to several types
of variable consideration including tiered pricing. Allocation of contract
revenues among Photonics military products, and the timing of the recognition of
those revenues, is impacted by agreements with tiered pricing or variable rate
structures. We include variable consideration in the estimated transaction price
when there is a basis to reasonably estimate the amount of the consideration.
These estimates are based on historical experience, anticipated performance and
our best judgment at the time. Because of our certainty in estimating these
amounts, they are included in the transaction price of our contracts and the
associated remaining performance obligations.
Accounting for CPFF and FFP contracts and programs involves the use of various
techniques to estimate total contract revenue and costs. For these contracts, we
estimate the profit on a contract as the difference between the total estimated
revenue and expected costs to complete a contract and recognize that profit over
the life of the contract. Contract estimates are based on various assumptions to
project the outcome of future events. These assumptions include the complexity
of the work to be performed; the cost and availability of materials; the
performance of subcontractors; and the availability and timing of funding from
the customer.
As a significant change in one or more of these estimates could affect the
profitability of our contracts, we review and update our contract-related
estimates regularly. We recognize adjustments in estimated profit on contracts
under the cumulative catch-up method. Under this method, the impact of the
adjustment on profit recorded to date on a contract is recognized in the period
the adjustment is identified. Revenue and profit in future periods of contract
performance are recognized using the adjusted estimate. If at any time the
estimate of contract profitability indicates an anticipated loss on the
contract, we recognize the total loss in the quarter it is identified.
Inventories
Inventories are valued using average actual costs and are stated at the lower of cost or net realizable value. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the net realizable value based upon assumptions about future demand.Intevac evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material adverse effect onIntevac's business, financial condition and results of operations.
Warranty
Intevac estimates the costs that may be incurred under the warranty it provides and records a liability in the amount of such costs at the time the related revenue is recognized. Estimated warranty costs are determined by analyzing specific product and historical configuration statistics and regional warranty support costs.Intevac's warranty obligation is affected by product failure rates, material usage, and labor costs incurred in correcting product failures during the warranty period. AsIntevac's customer service engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required.
Income Taxes
Intevac accounts for income taxes by recognizing deferred tax assets and
liabilities using enacted tax rates for the effect of temporary differences
between the book and tax bases of recorded assets and liabilities, net operating
losses and tax credit carryforwards. Deferred tax assets are also reduced by a
valuation allowance if it is more likely than not that a portion of the deferred
tax asset will not be realized. Management has determined that it is more likely
than not that its future taxable income will not be sufficient to realize its
entire deferred tax assets.
In determining whether to establish or maintain a valuation allowance against a
deferred tax asset, the Company reviews available evidence to determine whether
it is more likely than not that all or a portion of the Company's net deferred
tax assets will be realized in future periods. Consideration is given to various
positive and negative factors that could affect the realization of the net
deferred tax assets. In making such a determination, the Company considers,
among other things, future reversals of existing taxable temporary differences,
projected future taxable income, tax-planning strategies, historical financial
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-------------------------------------------------------------------------------- performance, the length of statutory carry forward periods, experience with operating loss and tax credit carry forwards not expiring unused. If the Company determines that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, the Company would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. The effective tax rate is highly dependent upon the geographic composition of worldwide earnings, tax regulations governing each region, non-tax deductible expenses and availability of tax credits. Management carefully monitors the changes in many factors and adjusts the effective income tax rate as required. If actual results differ from these estimates,Intevac could be required to record additional valuation allowances on deferred tax assets or adjust its effective income tax rate, which could have a material adverse effect onIntevac's business, financial condition and results of operations. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent withIntevac's expectations could have a material impact onIntevac's results of operations and financial condition.
Valuation of Acquisition-Related Contingent Consideration
Contingent consideration related to a business combination is recorded at the acquisition date at the estimated fair value of the contingent payments. The acquisition date fair value is measured based on the consideration expected to be transferred (probability-weighted), discounted back to present value. The discount rate used is determined at the time of the acquisition in accordance with accepted valuation methods. The fair value of the acquisition-related contingent consideration is remeasured at the estimated fair value at each reporting period with the change in fair value recognized as income or expense in the consolidated statements of income.
Equity-Based Compensation
Intevac records compensation expense for equity-based awards using the Black-Scholes option pricing model. This model requiresIntevac to estimate the expected volatility of the price ofIntevac's common stock and the expected life of the equity-based awards. Estimating volatility and expected life requires significant judgment and an analysis of historical data. Intevac accounts for forfeitures as they occur rather than estimating expected forfeitures.Intevac may have to increase or decrease compensation expense for equity-based awards if actual results differ significantly fromIntevac's estimates.
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