SMART GLOBAL HOLDINGS, INC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and accompanying notes for the year endedAugust 27, 2021 . This discussion contains forward looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed below and elsewhere in this report. See also "Cautionary Note Regarding Forward-Looking Statements." Our fiscal year is the 52 or 53-week period ending on the last Friday in August. Fiscal 2021, 2020 and 2019 each contained 52 weeks. All period references are to our fiscal periods unless otherwise indicated. All financial information for our subsidiaries inBrazil is included in our consolidated financial statements on a one-month lag because their fiscal years end onJuly 31 of each year. All tabular dollar amounts are in millions, except per share amounts. Overview For an overview of our business, including a discussion of our acquisition of our LED Solutions business from Cree and effects on us of COVID-19, see "PART I - Item 1. Business - Overview." As a result of our recent acquisitions and heightened focus on operational excellence over the past several years, we grew our net sales by 34% to$1.5 billion in 2021 compared to$1.1 billion in 2020. Over the same period, our total segment operating income grew by 90.9% to$160.8 million , or 10.7% operating margin, in 2021, compared to$84.2 million , or 7.5% operating margin, in 2020. See table below in "Segment Operating Income" for further details. Our operating expenses have grown in recent periods as we drive innovation, expand our products and services portfolio and invest in greater operational capabilities to support our growth. Our total operating expenses grew in 2021, primarily as a result of the addition of the LED Solutions business. We expect to continue to see increased operating expenses in 2022 as we record a full year of operating expenses for the LED Solutions business, continue to increase our investment in new products and services for the IPS business and experience the phase-out of certainBrazil financial tax credits, which result in an increase in operating expense in Memory Solutions.
Factors Affecting Our Operating Performance
Macro-Economic Demand Factors. Our business segments each have their own unique set of demand factors. Demand in our Memory Solutions group is driven by end-market demand from OEMs for customer-specific solutions in vertical markets such as industrial, government, networking, high-performance compute and enterprise storage, as well as from OEMs for memory modules used in desktop and notebook computers, smartphones, IoT and SSD products inBrazil . In addition, macro-economic factors specific to theBrazil economy affect this segment, given our sales and operations in that market. Our IPS business is driven by demand for high compute solutions across AI and machine learning initiatives, as well as traditional workload optimization and efficiency applications. Finally, demand for our LED products is derived from targeted end-market applications, such as general high-power and mid-power lighting and specialty lighting, such as video and horticulture applications. We believe our diversified business segments may provide a natural hedge against downturns in any particular industry although broader macro-economic trends, such as the COVID-19 pandemic, can adversely affect all three segments concurrently. Shifts in the Mix of Our Revenue. Shifts in the mix of revenue from our operating segments, which can vary significantly from period to period, can impact our business and operating results, including gross and operating margins. For example, our Memory Solutions group, while not party to long-term fixed purchasing commitments, has nonetheless historically seen relatively stable demand and margins. By contrast, our IPS group has shown solid growth, but is subject to greater variability in its sales and margin profile from period to period, as recognition of revenue is tied to customer decisions as to the completion of delivery and system go-live events, and margin is driven by the extent to which higher margin software and managed services comprise IPS sales. In addition, while we have experienced favorable demand and overall margin uplift compared to the rest of our businesses from our LED Solutions group to date, this group is the newest segment of our business, and we may be subject to unforeseen changes in its business and operating results. Our resource commitments and planning for each segment are relatively fixed in the short term, and as such, variability in expected revenue mix will have direct implications for our operating income and margins. 48 [[Image Removed]]
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Our Ability to Identify, Complete and Successfully Integrate Acquisitions. A
substantial portion of our growth over the last several years has been driven by
acquisitions, and we intend to continue to use corporate development as an
engine for growth. Within our existing segments, we plan to pursue acquisitions
to expand features and functionality, expand into adjacent businesses and grow
our customer base and geographic footprint. From time to time, we may seek to
expand our addressable market by entering new business segments where, as we did
with our LED business, we identify a business opportunity at scale with a path
to being accretive to our overall operations in the near term. If we are unable
to identify and complete attractive acquisitions, we may not be successful in
growing our revenue and/or expanding our margins. Any acquisitions we do
complete may require us to raise debt or equity financing or may subject us to
unforeseen liabilities or operational challenges that in turn impede our ability
to realize the expected returns on our investment.
Disruptions in Our Supply Chain May Adversely Affect Our Businesses. We depend
on third-party suppliers for key components of our products, such as commodity
DRAM components from offshore foundries that we use in our specialty memory
products and third-party wafers that we use in our memory and LED businesses. We
have adopted this "Fab-Light" business model to reduce our capital expenditures
and operating expenses, while affording greater flexibility in adapting to
shifts in demand and other market trends. In recent periods, our Fab-Light
business model has contributed significantly to margin expansion in our overall
business. However, our reliance on third-party manufacturers exposes us to risk
of supply chain disruption and lost business. For example, the current global
semiconductor shortage has adversely affected our operating results. If such
disruptions worsen or are prolonged, or if there is meaningful disruption in our
supply arrangement with any of our third-party suppliers, our operating results
and financial condition could be adversely affected.
Results of Operations
August 27, % of net August 28, % of net August 30, % of net
Year ended 2021 sales (1) 2020 sales (1) 2019 sales (1)
Net sales:
Memory Solutions $ 931,818 62.1 % $ 857,237 76.4 % $ 995,441 82.1 %
Intelligent Platform
Solutions 344,757 23.0 % 265,140 23.6 % 216,558 17.9 %
LED Solutions 224,567 15.0 % - - - -
Total net sales 1,501,142 100.0 % 1,122,377 100.0 % 1,211,999 100.0 %
Cost of sales 1,192,762 79.5 % 905,981 80.7 % 974,472 80.4 %
Gross profit 308,380 20.5 % 216,396 19.3 % 237,527 19.6 %
Operating expenses:
Research and development 49,274 3.3 % 52,056 4.6 % 47,920 4.0 %
Selling, general and
administrative 169,455 11.3 % 119,523 10.6 % 103,226 8.5 %
Change in fair value of
contingent consideration 32,400 2.2 % - - (2,700 ) (0.2 )%
Other operating (income)
expense 2,054 0.1 % 3,487 0.3 % - -
Total operating expenses 253,183 16.9 % 175,066 15.6 % 148,446 12.2 %
Operating income 55,197 3.7 % 41,330 3.7 % 89,081 7.3 %
Non-operating (income)
expense:
Interest expense, net 17,600 1.2 % 15,000 1.3 % 20,716 1.7 %
Other non-operating (income)
expense (375 ) (0.0 )% 16,970 1.5 % 2,161 0.2 %
Total non-operating expense 17,225 1.1 % 31,970 2.8 % 22,877 1.9 %
Income before taxes 37,972 2.5 % 9,360 0.8 % 66,204 5.5 %
Income tax provision 15,466 1.0 % 10,503 0.9 % 14,872 1.2 %
Net income (loss) 22,506 1.5 % (1,143 ) (0.1 %) 51,332 4.2 %
Net income attributable to
noncontrolling interest 1,196 0.1 % - - - -
Net income (loss)
attributable to SGH $ 21,310 1.4 % $ (1,143 ) (0.1 %) $ 51,332 4.2 %
(1) Summations of percentages may not compute precisely due to rounding.
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Net sales increased by$378.8 million , or 33.7%, in 2021 compared to the prior year, due to$224.6 million of revenue from our recent acquisition of the LED Business inMarch 2021 and to strong performance in our IPS and Memory Solutions businesses. IPS net sales increased by$79.6 million , or 30.0%, primarily due to higher volumes of sales in our Penguin Computing business. Memory Solutions sales increased by$74.6 million , or 8.7%, primarily due to a 24.7% higher volume of DRAM products and a 39.1% increase in average selling prices for mobile memory. Net sales decreased by$89.6 million , or 7.4%, in 2020 compared to the prior year, primarily due to$138.2 million lower Memory Solutions revenue, partially offset by$48.6 million higher IPS revenue. The decrease in Memory Solutions sales was mainly due to lower DRAM and mobile memory product sales, primarily resulting from 32.8% and 36.5% lower average selling prices, respectively, partially offset by higher OEM Flash memory sales resulting from 74.8% higher average selling prices and product mix. IPS sales increased by 22.4% over the prior year, primarily as the result of our two acquisitions inJuly 2019 , which contributed to sales for the full year in 2020, partially offset by lower Penguin revenue due to lower federal spending as a result of COVID-19. Cost of sales increased by$286.8 million , or 31.7%, in 2021 compared to the prior year, primarily due to higher cost of materials and production costs, due to a higher level of sales for our Memory Solutions and IPS segments, and from our acquisition of the LED Business. Cost of sales decreased by$68.5 million , or 7.0%, in 2020 compared to the prior year, primarily due to lower cost of materials and production resulting from the lower level of overall sales, which was partially offset by higher materials and production costs related to the growth in the IPS segment resulting from acquisitions in 2019, for which there was a full year reflected for the first time in 2020. Included in the cost of sales changes was a favorable foreign exchange impact of$5.9 million and$4.5 million due to locally sourced cost of sales inBrazil in 2021 and 2020, respectively. Gross margin increased to 20.5% in 2021 compared to 19.6% in 2020 primarily due to inclusion of higher margin LED Solutions products in the second half of the year, as well as process and efficiency improvement in the Memory Solutions and IPS segments compared to the prior year. Gross margin remained relatively flat at 19.3% in 2020, compared to 19.6% in 2019. Segment Operating Income Year ended August 27, 2021 August 28, 2020 August 30, 2019 Segment operating income: (1) Memory Solutions$ 91,737 9.8 %$ 71,867 8.4 %$ 109,314 11.0 % Intelligent Platform Solutions 32,931 9.6 % 12,362 4.7 % 3,579 1.7 % LED Solutions 36,126 16.1 % - - - - Total segment operating income 160,794 10.7 % 84,229 7.5 % 112,893 9.3 % Unallocated: Share-based compensation (33,877 ) (18,716 ) (18,199 ) Change in fair value of contingent consideration (32,400 ) - 2,700 Amortization of intangible assets (20,255 ) (13,654 ) (5,614 ) Flow through of inventory step up (7,090 ) - - Restructure and integration expense (2,054 ) (3,487 ) - Other (9,921 ) (7,042 ) (2,699 ) (105,597 ) (42,899 ) (23,812 ) Consolidated operating income$ 55,197 $ 41,330 $ 89,081
(1) Percentages represent segment operating income as a percentage of segment
net sales.
In the fourth quarter of 2021, we reorganized SGH into three business units:
Memory Solutions, Intelligent Platforms Solutions and LED Solutions. Two of our
previous segments, specialty memory products and Brazil products, have been
combined to become Memory Solutions. Intelligent Platform Solutions was formerly
referred to as specialty compute and storage solutions. All prior year
information in the table above has been revised to reflect the change to our
three reportable segments.
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-------------------------------------------------------------------------------- Memory Solutions operating income increased by$19.8 million , or 27.6%, in 2021 compared to the prior year primarily due to higher sales, as well as a decrease of$10.8 million in operating expenses mainly driven by lower research and development expense due toBrazil financial credits. Memory Solutions operating income decreased by$37.4 million , or 34.3%, in 2020 compared to the prior year primarily due to lower sales, partially offset by a decrease of$11.3 million in operating expenses mainly driven by lower research and development expense due toBrazil financial credits and lower research & development spend, travel and personnel-related expenses, as well as favorable currency exchange rates. IPS operating income increased by$20.6 million , or 166.4%, in 2021 compared to the prior year primarily due to higher sales, partially offset by$4.4 million higher operating expenses mainly driven by personnel-related expenses due to increased headcount to support the revenue growth. IPS operating income increased by$8.8 million , or 245.4%, in 2020 compared to the prior year primarily due to higher sales, partially offset by$23.5 million higher operating expenses due to the full year inclusion of the operations of companies acquired in 2019.
LED Solutions operating income of
Operating and Non-operating (Income) Expense
Research and Development Research and development expense decreased by$2.8 million , or 5.3%, in 2021 compared to the prior year, primarily due to an increase of$23.6 million in theBrazil financial credits that are reflected as a reduction of research and development expenses. The credits result from amendments to the IT law implemented inApril 2020 . The increase in credits is partially offset by$16.0 million additional costs from the acquisition of the LED Business, as well as higher personnel-related expenses and depreciation. In addition, research and development expense was favorably affected in 2021 by$2.7 million from the impact of currency exchange rates. We expect research and development expense to increase in absolute dollars in 2022 as we include the full year of operations for our LED Solutions segment and the effect of the end of theBrazil financial credits, currently scheduled to occur inJanuary 2022 . Research and development expense increased by$4.1 million , or 8.6%, in 2020 compared to the prior year primarily due to$12.4 million higher costs from the addition of our IPS acquisitions in 2019, partially offset by$6.4 million ofBrazil financial credits. In addition, research and development expense was unfavorably affected in 2020 by$2.2 million from the impact of currency exchange rates.
Selling, General and Administrative
Selling, general and administrative expense increased by$49.9 million , or 41.8%, in 2021 compared to the prior year, primarily due to$21.5 million of additional costs from the acquisition of the LED Business (including$1.0 million in intangible amortization expense) as well as$14.1 million of higher share-based compensation expense, personnel-related expenses, professional services and acquisition expenses associated with the acquisition. Included in the selling, general and administrative expense increase was a favorable foreign exchange impact of$1.2 million . We expect selling, general and administrative expense to increase in absolute dollars in 2022 as we include the full year of operations for our LED Solutions segment. Selling, general and administrative expense increased by$16.3 million , or 15.8%, in 2020 compared to the prior year, primarily due to$16.8 million of higher costs from the addition of our IPS acquisitions in 2019 (including intangible amortization expense) as well as integration expenses associated with the acquisitions. In addition, selling, general and administrative expense was favorably affected in 2020 by$1.5 million from the impact of currency exchange rates.
Change in Fair Value of Contingent Consideration
Our acquisition of the LED Business included contingent consideration, which we estimated the fair value as of the date of acquisition to be$28.1 million . During the second half of 2021, we recorded charges of$32.4 million to adjust the value as of the date of acquisition to the fair value as of the end of 2021. The change in fair value reflected new information about the probability and timing of meeting the conditions of the revenue and gross profit targets of the LED Business. See further information in "Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Business Acquisitions - LED Business." 51 [[Image Removed]]
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Other Operating and Non-operating (Income) Expense
Other operating (income) expense in 2021 and 2020 primarily reflected restructuring activities in our IPS and Memory Solutions segments. Other non-operating (income) and expense primarily reflected gains and losses from changes in currency exchange rates, a loss in 2020 from the remeasurement of our Capped Calls and losses in 2020 from the extinguishment of debt. See "Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Other Operating (Income) Expense" and "- Other Non-operating (Income) Expense." Income Tax Provision
Our provision for income taxes increased by
EffectiveFebruary 1, 2011 , SMART Brazil began to participate in PADIS. This program is specifically designed to promote the development of the local semiconductor industry. The Brazilian government has approved multiple applications for different products by SMART Brazil for certain beneficial tax treatment under the PADIS incentive. This beneficial tax treatment includes a reduction in theBrazil statutory income tax rate from 34% to 9% on taxable income for the Brazilian semiconductor operations of SMART Brazil. We have operations inMalaysia , where we have tax incentive arrangements for our pioneer status activities and our global supply chain business. The statutory tax rate forMalaysia is 24%. TheseMalaysia arrangements are scheduled to expire inAugust 2028 and are subject to certain conditions, for which we have complied in 2021, 2020 and 2019. In general, these future tax holidays will have tax rates greater than our prior approved tax holidays, and therefore we expect that our effective income tax rate in the future may be higher depending on a combination of our overall and jurisdictional profitability. For additional information, see "Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Income Taxes."
Liquidity and Capital Resources
AtAugust 27, 2021 , we had cash and cash equivalents of$223.0 million , of which$191.8 million was held outside ofthe United States . Our principal uses of cash and capital resources have been acquisitions, debt service requirements as described below, capital expenditures, research and development expenditures and working capital requirements. We expect that future capital expenditures will focus on expanding capacity of our operations, expanding our research and development activities, manufacturing equipment upgrades, acquisitions and IT infrastructure and software upgrades. Cash and cash equivalents consist of funds held in demand deposit accounts and money market funds. We do not enter into investments for trading or speculative purposes. We expect that our existing cash and cash equivalents, borrowings available under our credit facilities and cash generated by operating activities will be sufficient to fund our operations for at least the next twelve months. We may from time to time seek additional equity or debt financing. Any future equity financing may be dilutive to our existing investors, and any future debt financing may include debt service requirements and financial and other restrictive covenants that may constrain our operations and growth strategies. In the event that we seek additional financing, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations and invest in continued product innovation, we may not be able to compete successfully, which would harm our business, operations and financial condition. For information regarding our debt obligations, see "Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Debt." For our operating lease obligations, see "Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Leases." For our purchase obligations, see "Item 8. Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Commitments and Contingencies." 52 [[Image Removed]]
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Cash Flows
August 27, August 28, August 30,
Year ended 2021 2020 2019
Net cash provided by operating activities
(84,178 ) (32,041 ) (109,440 )
Net cash provided by financing activities 2,849 12,594 100
Effect of changes in currency exchange rates 154 (15,086 ) 588
Net increase in cash and cash equivalents
Operating Activities: Cash flows from operating activities reflects net income adjusted for certain non-cash items, including depreciation and amortization expense, share-based compensation, adjustments for changes in the fair value of contingent consideration, gains and losses from investing or financing activities and from the effects of changes in operating assets and liabilities. Net cash provided by operating activities in 2021 was$153.4 million , comprised primarily of net income of$22.5 million , adjusted for non-cash items of$132.6 million . Operating cash flows were also affected by a$1.7 million increase in our net operating assets and liabilities, consisting primarily of increases of$137.9 million in inventories,$51.4 million in accounts receivable and$17.5 million in other current assets, offset by the effects of an increase of$215.0 million in accounts payable and accrued expenses. The increase in both inventories and accounts payable and accrued expenses was primarily due to higher inventory along all business areas, and the increase in accounts receivable was primarily due to higher gross sales primarily in our Memory Solutions and IPS segments. Net cash provided by operating activities in 2020 was$87.2 million , resulting primarily from a net loss of$1.1 million , adjusted for non-cash items of$83.1 million . Operating cash flows also benefitted from a$5.3 million change in our net operating assets and liabilities, consisting primarily of an increase of$70.6 million in accounts payable and accrued expenses, partially offset by an increase of$51.8 million in inventories and an increase of$12.3 million in accounts receivable. The increases in accounts payable and accrued expenses and in inventories were primarily due to the transition of manufacturing from contract manufacturers to the company as well as higher purchases for certain programs. The increase in accounts receivable was primarily due to timing of sales. Net cash provided by operating activities in 2019 was$169.7 million , comprised of net income of$51.3 million , adjusted for non-cash items of$47.5 million . Operating cash flows also benefitted from a$70.8 million change in our operating assets and liabilities, consisting primarily of decreases of$102.1 million in inventories and$35.2 million in accounts receivable, partially offset by an increase of$64.2 million in accounts payable and accrued expenses. The decreases in inventories and accounts payable were primarily due to the reduction of inventory among all business areas as product lead times were reduced. The decrease in accounts receivable was primarily due to lower gross sales. Investing Activities: Net cash used in investing activities in 2021 was$84.2 million , consisting primarily of$47.6 million used for purchases of property and equipment and$35.7 million net cash used for the acquisition of the LED Business. Net cash used in investing activities in 2020 consisted primarily of purchases of property and equipment. Net cash used in investing activities in 2019 consisted primarily of$76.1 million net cash used for acquisitions and$33.4 million used for purchases of property and equipment. Financing Activities: Net cash provided by financing activities in 2021 was$2.8 million , consisting primarily of$25.0 million in net proceeds from borrowing under our line of credit,$14.9 million in proceeds from the issuance of ordinary shares and$11.4 million proceeds from issuance of debt, partially offset by$48.5 million used to repurchase our ordinary shares. Net cash provided by financing activities in 2020 consisted primarily of$243.1 million proceeds from the issuance of our convertible notes and$5.5 million in proceeds from the issuance of ordinary shares, partially offset by$204.9 million in payments for the extinguishment of debt,$21.8 million for the purchase of our Capped Calls and payment of$8.5 million for debt. Net cash provided by financing activities in 2019 was negligible. 53 [[Image Removed]]
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Critical Accounting Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted inthe United States of America requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Estimates and judgments are based on historical experience, forecasted events and various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and judgments on an ongoing basis. Our management believes the accounting policies below are critical in the portrayal of our financial condition and results of operations and require management's most difficult, subjective or complex judgments. Business Acquisitions: Accounting for acquisitions requires us to estimate the fair value of consideration paid and the individual assets and liabilities acquired, which involves a number of judgments, assumptions and estimates that could materially affect the amount and timing of costs recognized in subsequent periods. We typically obtain independent third-party valuation studies to assist in determining fair values, including assistance in determining future cash flows, discount rates and comparable market values. Items involving significant assumptions, estimates and judgments include the following:
• Fair value of consideration paid or transferred (including contingent
consideration);
• Inventory, including estimated future selling prices, timing of product
sales and completion costs for work in process;
• Property, plant and equipment, including determination of values in a
continued-use model;
• Debt and other liabilities, including discount rate and timing of payments;
• Intangible assets, including valuation methodology, estimates of future
revenues and costs, profit allocation rates attributable to the acquired
technology and discount rates; and
• Deferred taxes, including projections of future taxable income and tax rates.
The valuation of contingent consideration in connection with an acquisition may be inherently challenging due to the dependence on the occurrence of future events and complex payment provisions. Estimating the fair value of contingent consideration at an acquisition date and in subsequent periods involves significant judgments, including projecting future average selling prices, future sales volumes, manufacturing costs and gross margins. To project average selling prices and sales volumes, we review recent sales volumes, existing customer orders, current prices and other factors such as industry analyses of supply and demand, seasonal factors, general economic trends and other information. To project manufacturing costs, we must estimate future production levels and costs of production, including labor, materials and other overhead costs. Actual selling prices and sales volumes, as well as levels and costs of production, can often vary significantly from projected amounts. Income Taxes: We are required to estimate our provision for income taxes and amounts ultimately payable or recoverable in numerous tax jurisdictions around the world. These estimates involve significant judgment and interpretations of regulations and are inherently complex. Resolution of income tax treatments in individual jurisdictions may not be known for many years after completion of the applicable year. We are also required to evaluate the realizability of our deferred tax assets on an ongoing basis in accordance withU.S. GAAP, which requires the assessment of our performance and other relevant factors. Realization of deferred tax assets is dependent on our ability to generate future taxable income. Our income tax provision or benefit is dependent, in part, on our ability to forecast future taxable income in these and other jurisdictions. Such forecasts are inherently difficult and involve significant judgments including, among others, projecting future average selling prices and sales volumes, manufacturing and overhead costs and other factors that significantly impact our analyses of the amount of net deferred tax assets that are more likely than not to be realized. Inventories: Inventories are stated at the lower of cost or net realizable value. In our LED segment, cost is determined on a first-in, first-out method or average cost method. For all other segments, inventory value is determined on a specific identification basis for material and an allocation of labor and manufacturing overhead. At each balance sheet date, we evaluate ending inventories for excess quantities and obsolescence, including analyses of sales levels by product family, historical demand and forecasted demand in relation to inventory on hand, competitiveness of product offerings, market conditions and product life cycles. From time to time, our customers may request that we purchase and maintain significant inventory of raw materials for specific programs. Such inventory purchases are evaluated for excess quantities and potential obsolescence and could result in a provision at the time of purchase or subsequent to purchase. Inventory levels may fluctuate based on inventory held under service arrangements. Our provision for excess and obsolete inventory are also impacted by our arrangements with our customers and/or suppliers, including our ability or inability to resell such inventory to them. 54 [[Image Removed]]
--------------------------------------------------------------------------------Goodwill and Intangible Assets: We test goodwill for impairment in our fourth quarter each year, or more frequently if indicators of an impairment exist, to determine whether it is more likely than not that the fair value of the reporting unit with goodwill is less than its carrying value. For reporting units for which we conclude that it is more likely than not that the fair value is more than its carrying value, goodwill is considered not impaired and we are not required to perform the goodwill impairment test. Qualitative factors considered in this assessment include industry and market considerations, overall financial performance and other relevant events and factors affecting the fair value of the reporting unit. For reporting units for which this assessment concludes that it is more likely than not that the fair value is below the carrying value, goodwill is tested for impairment by determining the fair value of the reporting unit and comparing it to the carrying value of the net assets assigned to the reporting unit. If the fair value of the reporting unit exceeds its carrying value, goodwill is considered not impaired. If the carrying value of the reporting unit exceeds its fair value, we would record an impairment loss up to the difference between the carrying value and implied fair value. Determining when to test for impairment, the reporting units, the assets and liabilities of the reporting unit and the fair value of the reporting unit requires significant judgment and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates, forecasted manufacturing costs, budgets and other expenses developed as part of our long-range planning process. We test the reasonableness of the output of our long-range planning process by calculating an implied value per share and comparing that to current share prices, analysts' consensus pricing and management's expectations. These estimates and assumptions are used to calculate projected future cash flows for the reporting unit, which are discounted using a risk-adjusted rate to estimate a fair value. We base fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. We test other identified intangible assets with definite useful lives when events and circumstances indicate the carrying value may not be recoverable by comparing the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. Estimating fair values involves significant assumptions, including future sales prices, sales volumes, costs and discount rates. Property and Equipment: We review the carrying value of property and equipment for impairment when events and circumstances indicate that the carrying value of an asset or group of assets may not be recoverable from the estimated future cash flows expected to result from its use and/or disposition. In cases where undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized equal to the amount by which the carrying value exceeds the estimated fair value of the assets. The estimate of future cash flows involves numerous assumptions which require significant judgment by us, including, but not limited to, future use of the asset(s) for our operations versus sale or disposal of the asset(s), future selling prices for our products and future production and sales volumes. In addition, significant judgment is required in determining the groups of assets for which impairment tests are separately performed. Revenue Recognition: We recognize revenue based on the transfer of control of goods and services and apply the following five-step approach: (1) identification of a contract with a customer, (2) identification of the performance obligations in the contract, (3) determination of the transaction price, (4) allocation of the transaction price to the performance obligations in the contract and (5) recognition of revenue as performance obligations are satisfied.
Applying the five step approach in determining whether to recognize revenue at a point in time or over time requires significant judgement. A portion of our revenue is from sales of customized product which, in some cases, are non-cancellable and/or non-refundable. Significant judgement is required to determine when control passes to the customer and whether and when our performance obligations have been satisfied. This determination can significantly affect the timing of recognizing revenue.
Product revenue: Product revenue is generally recognized at a point in time when control of the promised goods is transferred to customers. Contracts with customers are generally short-term in duration at fixed, negotiated prices with payment generally due shortly after delivery. We estimate a liability for returns using the expected value method based on historical rates of return. In addition, we generally offer price protection to our distributors, which is a form of variable consideration that decreases the transaction price. We use the expected value method, based on historical price adjustments and current pricing trends, to estimate the amount of revenue recognized from sales to distributors. Differences between the estimated and actual amounts are recognized as adjustments to revenue. Non-cancellable, nonrefundable customized product sales are recognized over time on a cost incurred basis. In connection with these arrangements, customers obtain control and benefit from the services as they are performed. The terms for these arrangements provide us with a legally enforceable right to receive payment, including a reasonable profit margin upon customer cancellation, for performance completed to date. Accordingly, we recognize revenue over time as we complete the manufacture of these products. 55 [[Image Removed]]
-------------------------------------------------------------------------------- A portion of our revenue is derived from the sale of customized products. In certain cases, we recognize revenue when control of the underlying assets pass to the customer when the customer is able to direct the use of, and obtain substantially all of the remaining benefit from, the assets; the customer has the significant risks and rewards associated with ownership of the assets; and we have a present right to payment. Under the terms of these arrangements, we cannot repurpose products without the customer's consent and accordingly, we recognize revenue at the point in time when products are completed and made available to the customer. Service revenue: Our service revenue is derived from supply chain services as well as professional services. Supply chain services includes procurement, logistics, inventory management, temporary warehousing, kitting and packaging. Professional services include solution design, system installation, software automation and managed support services related to HPC and storage systems. A portion of our product sales include extended warranty and on-site services, subscriptions to our HPC environment, professional services, software and related support. Agent Services: We provide certain supply chain services on an agent basis, whereby we procure materials on behalf of our customers and then resell such materials to our customers. Gross amounts invoiced to customers in connection with these agent services include amounts related to the services performed by us in addition to the cost of the materials procured. However, only the amount related to the agent component is recognized as revenue in our results of operations. We generally recognize revenue for these procurement, logistics and inventory management services upon the completion of such services, which typically occurs at the time of shipment of product to the customer. Amounts we invoice to customers for cost of materials related to services performed, which remain unpaid as of the end of a reporting period, are included in accounts receivable. Additionally, cost of materials procured for customers under these agent services, but which remain on hand as of the end of a reporting period, are included in inventories. Amounts in accounts receivable and inventories impact the determination of net cash provided by (or used in) operations. Determining whether we are the principal or agent in these transactions requires significant judgement. This determination affects the amount of revenue we recognize; a principal recognizes revenues at the gross amount received for the goods and services, while an agent recognizes revenue at the net amount. The impact of this determination significantly impact the amount of revenue and cost of sales we recognize. Transaction Price: The transaction price is determined based on the consideration to which we will be entitled in exchange for transferring goods or services to the customer. We allocate the transaction price to each distinct product and service based on its relative standalone selling price. The standalone selling price for products primarily involves the cost to produce the deliverable plus the anticipated margin and for services is estimated based on our approved list price. A portion of our service revenue is from professional consulting services, including installation and other services and hardware and software related support. Each contract may contain multiple performance obligations, which requires the transaction price to be allocated to each performance obligation. We allocate the consideration to each performance obligation based on the relative selling price, determined as the best estimate of the price at which we would transact if it sold the deliverable regularly on a stand-alone basis. Contract Costs: As a practical expedient, we recognize the incremental costs of obtaining a contract, specifically commission expenses that have an amortization period of less than twelve months, as an expense when incurred. Additionally, we account for as an expense when incurred. Additionally, we account for shipping and handling costs, if any, that occur after control transfers to the customer as a fulfillment activity. We record shipping and handling costs related to revenue transactions within cost of sales as a period cost. Share-Based Compensation: Share-based compensation is estimated at the grant date based on the fair value of the award and is recognized as expense using the straight-line amortization method over the requisite service period. For performance-based share awards, the expense recognized is dependent on our assessment of the likelihood of the performance measure being achieved. We utilize forecasts of future performance to assess these probabilities and this assessment requires significant judgment. Determining the appropriate fair-value model and calculating the fair value of share-based awards at the grant date requires significant judgment, including estimating share price volatility and expected option life. We develop these estimates based on historical data and market information which can change significantly over time. A small change in the estimates used can result in a relatively large change in the estimated valuation. We use the Black-Scholes option valuation model to value employee options and awards granted under our employee share purchase plan. We estimate share price volatility based on an average of historical volatility and the implied volatility derived from traded options on our shares. 56 [[Image Removed]]
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