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SILICON LABORATORIES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and related notes thereto included elsewhere in this report. This discussion contains forward-looking statements. Please see the "Cautionary Statement" above and "Risk Factors" below for discussions of the uncertainties, risks and assumptions associated with these statements. Our fiscal year-end financial reporting periods are a 52- or 53- week year ending on the Saturday closest to December 31st. Fiscal 2014 will have 53 weeks with the extra week occurring in the fourth quarter of the year. Fiscal 2013 had 52 weeks. Our second quarter of fiscal 2014 ended June 28, 2014. Our second quarter of fiscal 2013 ended June 29, 2013. Overview We design and develop proprietary, analog-intensive, mixed-signal integrated circuits (ICs) for a broad range of applications. Mixed-signal ICs are electronic components that convert real-world analog signals, such as sound and radio waves, into digital signals that electronic products can process. Therefore, mixed-signal ICs are critical components in products addressing a variety of markets, including communications, consumer, industrial and automotive. Our major customers include Alcatel, Cisco, Harman Becker, Huawei, LG Electronics, Panasonic, Samsung, Technicolor, Varian Medical Systems and ZTE. As a fabless semiconductor company, we rely on third-party semiconductor fabricators in Asia, and to a lesser extent the United States and Europe, to manufacture the silicon wafers that reflect our IC designs. Each wafer contains numerous die, which are cut from the wafer to create a chip for an IC. We rely on third parties in Asia to assemble, package, and, in most cases, test these devices and ship these units to our customers. Testing performed by such third parties facilitates faster delivery of products to our customers (particularly those located in Asia), shorter production cycle times, lower inventory requirements, lower costs and increased flexibility of test capacity. Our expertise in analog-intensive, high-performance, mixed-signal ICs enables us to develop highly differentiated solutions that address multiple markets. We group our products into the following categories: † Broad-based products, which include our microcontroller (MCU) and wireless products, timing products (clocks and oscillators), power and isolation devices, and sensors; † Broadcast products, which include our broadcast audio and video products; and † Access products, which include our Voice over IP (VoIP) products, embedded modems and our Power over Ethernet (PoE) devices. Through acquisitions and internal development efforts, we have continued to diversify our product portfolio and introduce next-generation ICs with added functionality and further integration. On February 28, 2014, we purchased the full product portfolio and intellectual property of Touchstone Semiconductor, including op-amps, current sense amplifiers, low-power analog-to-digital converters (ADCs), comparators, power management ICs, timers, and voltage detectors and references. In the first six months of fiscal 2014, we introduced digital isolators offering high channel count, performance, reliability and data rates for cost-sensitive consumer electronics applications; energy-efficient capacitive sensing MCUs for human-machine interfaces (HMI); a comprehensive software solution designed to simplify the development of wirelessly connected smart meters for electricity, gas, water and heat resources; a 32-bit hardware and firmware development kit designed to accelerate the design of Made for iPod®/iPhone®/iPad® (MFi) accessories; a new version of the Simplicity Studio™ development ecosystem that provides unified support for our energy-friendly 32-bit EFM32™ Gecko MCUs and 8-bit MCUs; the expansion of our ARM®-based Ember® ZigBee® system-on-chip (SoC) family providing larger memory options for advanced smart energy and home automation applications; and single-chip digital ultraviolet (UV) index sensors designed to track UV exposure, ambient light and biometrics for smartphone and wearable computing products. We plan to continue to introduce products that increase the content we provide for existing applications, thereby enabling us to serve markets we do not currently address and expanding our total available market opportunity. 23 -------------------------------------------------------------------------------- Table of Contents During the six months ended June 28, 2014, we had one customer, Samsung, whose purchases across a variety of product areas represented more than 10% of our revenues. In addition to direct sales to customers, some of our end customers purchase products indirectly from us through distributors and contract manufacturers. An end customer purchasing through a contract manufacturer typically instructs such contract manufacturer to obtain our products and incorporate such products with other components for sale by such contract manufacturer to the end customer. Although we actually sell the products to, and are paid by, the distributors and contract manufacturers, we refer to such end customer as our customer. Two of our distributors, Edom Technology and Avnet, represented more than 10% of our revenues during the six months ended June 28, 2014. There were no other distributors or contract manufacturers that accounted for more than 10% of our revenues during the six months ended June 28, 2014. The percentage of our revenues derived from outside of the United States was 85% during the six months ended June 28, 2014. All of our revenues to date have been denominated in U.S. dollars. We believe that a majority of our revenues will continue to be derived from customers outside of the United States. The sales cycle for our ICs can be as long as 12 months or more. An additional three to six months or more are usually required before a customer ships a significant volume of devices that incorporate our ICs. Due to this lengthy sales cycle, we typically experience a significant delay between incurring research and development and selling, general and administrative expenses, and the corresponding sales. Consequently, if sales in any quarter do not occur when expected, expenses and inventory levels could be disproportionately high, and our operating results for that quarter and, potentially, future quarters would be adversely affected. Moreover, the amount of time between initial research and development and commercialization of a product, if ever, can be substantially longer than the sales cycle for the product. Accordingly, if we incur substantial research and development costs without developing a commercially successful product, our operating results, as well as our growth prospects, could be adversely affected. Because many of our ICs are designed for use in consumer products such as televisions, set-top boxes, radios and mobile handsets, we expect that the demand for our products will be typically subject to some degree of seasonal demand. However, rapid changes in our markets and across our product areas make it difficult for us to accurately estimate the impact of seasonal factors on our business. Results of Operations The following describes the line items set forth in our Condensed Consolidated Statements of Income: Revenues. Revenues are generated predominately by sales of our ICs. We recognize revenue on sales when all of the following criteria are met: 1) there is persuasive evidence that an arrangement exists, 2) delivery of goods has occurred, 3) the sales price is fixed or determinable, and 4) collectibility is reasonably assured. Generally, we recognize revenue from product sales to direct customers and contract manufacturers upon shipment. Certain of our sales are made to distributors under agreements allowing certain rights of return and price protection on products unsold by distributors. Accordingly, we defer the revenue and cost of revenue on such sales until the distributors sell the product to the end customer. A small portion of our revenues is derived from the sale of patents. The above revenue recognition criteria for patent sales are generally met upon the execution of the patent sale agreement. Our products typically carry a one-year replacement warranty. Replacements have been insignificant to date. 24 -------------------------------------------------------------------------------- Table of Contents Our revenues are subject to variation from period to period due to the volume of shipments made within a period, the mix of products we sell and the prices we charge for our products. The vast majority of our revenues were negotiated at prices that reflect a discount from the list prices for our products. These discounts are made for a variety of reasons, including: 1) to establish a relationship with a new customer, 2) as an incentive for customers to purchase products in larger volumes, 3) to provide profit margin to our distributors who resell our products or 4) in response to competition. In addition, as a product matures, we expect that the average selling price for such product will decline due to the greater availability of competing products. Our ability to increase revenues in the future is dependent on increased demand for our established products and our ability to ship larger volumes of those products in response to such demand, as well as our ability to develop or acquire new products and subsequently achieve customer acceptance of newly introduced products. Cost of Revenues. Cost of revenues includes the cost of purchasing finished silicon wafers processed by independent foundries; costs associated with assembly, test and shipping of those products; costs of personnel and equipment associated with manufacturing support, logistics and quality assurance; costs of software royalties, other intellectual property license costs and certain acquired intangible assets; and an allocated portion of our occupancy costs. Research and Development. Research and development expense consists primarily of personnel-related expenses, including stock-based compensation, as well as new product masks, external consulting and services costs, equipment tooling, equipment depreciation, amortization of intangible assets, and an allocated portion of our occupancy costs. Research and development activities include the design of new products, refinement of existing products and design of test methodologies to ensure compliance with required specifications. Selling, General and Administrative. Selling, general and administrative expense consists primarily of personnel-related expenses, including stock-based compensation, as well as an allocated portion of our occupancy costs, sales commissions to independent sales representatives, applications engineering support, professional fees, legal fees and promotional and marketing expenses. Interest Income. Interest income reflects interest earned on our cash, cash equivalents and investment balances. Interest Expense. Interest expense consists of interest on our short and long-term obligations, including our Credit Facilities. Other Income (Expense), Net. Other income (expense), net consists primarily of foreign currency remeasurement adjustments as well as other non-operating income and expenses. Provision for Income Taxes. Provision for income taxes includes both domestic and foreign income taxes at the applicable statutory rates adjusted for non-deductible expenses, research and development tax credits and other permanent differences. 25 -------------------------------------------------------------------------------- Table of Contents The following table sets forth our Condensed Consolidated Statements of Income data as a percentage of revenues for the periods indicated: Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, 2014 2013 2014 2013 Revenues 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenues 36.3 37.3 38.2 38.6 Gross margin 63.7 62.7 61.8 61.4 Operating expenses: Research and development 27.0 26.4 28.1 26.1 Selling, general and administrative 23.3 22.9 23.5 21.5 Operating expenses 50.3 49.3 51.6 47.6 Operating income 13.4 13.4 10.2 13.8 Other income (expense): Interest income 0.1 0.1 0.2 0.2 Interest expense (0.5 ) (0.6 ) (0.5 ) (0.5 ) Other income (expense), net 0.0 0.1 0.0 0.0 Income before income taxes 13.0 13.0 9.9 13.5 Provision for income taxes 3.8 4.1 2.5 2.1 Net income 9.2 % 8.9 % 7.4 % 11.4 % Revenues Three Months Ended Six Months Ended June 28, June 29, % June 28, June 29, % (in millions) 2014 2013 Change Change 2014 2013 Change Change Broad-based $ 79.7 $ 68.8 $ 10.9 15.8 % $ 152.0 $ 136.1 $ 15.9 11.7 % Broadcast 50.5 48.3 2.2 4.5 % 101.2 99.5 1.7 1.7 % Access 24.7 24.4 0.3 1.2 % 47.4 51.3 (3.9 ) (7.5 )% $ 154.9 $ 141.5 $ 13.4 9.4 % $ 300.6 $ 286.9 $ 13.7 4.8 % The change in revenues in the recent three month period was due primarily to: † Increased revenues of $10.9 million for our Broad-based ICs, due primarily to market share gains for our MCU and wireless products and the addition of revenues from the acquisition of Energy Micro in July 2013. † Increased revenues of $2.2 million for Broadcast, due primarily to the sale of patents of $5.0 million. The increase in Broadcast revenues was offset by decreased revenues for our audio ICs due to declines in market share. † Increased revenues of $0.3 million for our Access ICs. The change in revenues in the recent six month period was due primarily to: † Increased revenues of $15.9 million for our Broad-based ICs, due primarily to market share gains for our MCU and wireless products and the addition of revenues from the acquisition of Energy Micro. Broad-based revenue growth was offset in part by a decline in revenue for our touch controller ICs due to our exit from this market. † Increased revenues of $1.7 million for Broadcast, due primarily to market share gains for our video ICs and the sale of patents of $5.0 million. The increase in Broadcast revenues was offset by decreased revenues for our audio ICs due to declines in market share. † Decreased revenues of $3.9 million for our Access ICs, due primarily to declines in the market for embedded modem ICs. 26 -------------------------------------------------------------------------------- Table of Contents Unit volumes of our products increased by 9.4% and average selling prices decreased by 3.0% compared to the three months ended June 29, 2013. Unit volumes of our products decreased by 0.6% and average selling prices increased by 3.9% compared to the six months ended June 29, 2013. The average selling prices of our products may fluctuate significantly from period to period. In general, as our products become more mature, we expect to experience decreases in average selling prices. We anticipate that newly announced, higher priced, next generation products and product derivatives will offset some of these decreases. Gross Margin Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, (in millions) 2014 2013 Change 2014 2013 Change Gross margin $ 98.7 $ 88.8 $ 9.9 $ 185.8 $ 176.1 $ 9.7 Percent of revenue 63.7 % 62.7 % 1.0 % 61.8 % 61.4 % 0.4 % The increased dollar amount of gross margin in the recent three month period was due to increases in gross margin of $7.1 million for our Broad-based products, $2.5 million for our Broadcast products and $0.3 million for our Access products. The increased dollar amount of gross margin in the recent six month period was due to increases in gross margin of $10.6 million for our Broad-based products and $1.2 million for our Broadcast products, offset by a decrease in gross margin of $2.1 million for our Access products. The recent three and six month periods include gross margin from the sale of patents of $5.0 million, which had no associated cost of revenues. We may experience declines in the average selling prices of certain of our products. This creates downward pressure on gross margin as a percentage of revenues and may be offset to the extent we are able to: 1) introduce higher margin new products and gain market share with our ICs; 2) reduce costs of existing products through improved design; 3) achieve lower production costs from our wafer suppliers and third-party assembly and test subcontractors; 4) achieve lower production costs per unit as a result of improved yields throughout the manufacturing process; or 5) reduce logistics costs. Research and Development Three Months Ended Six Months Ended June 28, June 29, % June 28, June 29, %(in millions) 2014 2013 Change Change 2014 2013 Change Change Research and development $ 41.8 $ 37.4 $ 4.4 11.9 % $ 84.3 $ 75.0 $ 9.3 12.5 % Percent of revenue 27.0 % 26.4 % 28.1 % 26.1 % The increase in research and development expense in the recent three and six month periods was principally due to increases of (a) $2.6 million and $4.8 million, respectively, for personnel-related expenses, including personnel costs associated with (i) increased headcount, and (ii) the acquisition of Energy Micro, (b) $1.3 million and $2.7 million, respectively, for the amortization of intangible assets primarily related to our acquisition of Energy Micro, and (c) $0.4 million and $1.6 million, respectively, for new product introduction costs. We expect that research and development expense will increase in absolute dollars in the third quarter of 2014. 27 -------------------------------------------------------------------------------- Table of Contents Recent development projects include digital isolators offering high channel count, performance, reliability and data rates for cost-sensitive consumer electronics applications; energy-efficient capacitive sensing MCUs for HMI; a comprehensive software solution designed to simplify the development of wirelessly connected smart meters for electricity, gas, water and heat resources; a 32-bit hardware and firmware development kit designed to accelerate the design of MFi accessories; a new version of the Simplicity Studio development ecosystem that provides unified support for our energy-friendly 32-bit EFM32 Gecko MCUs and 8-bit MCUs; the expansion of our ARM-based Ember ZigBee SoC family providing larger memory options for advanced smart energy and home automation applications; single-chip digital UV index sensors designed to track UV exposure, ambient light and biometrics for smartphone and wearable computing products; a new family of sub-GHz wireless MCUs optimized for power-sensitive, battery-powered systems with RF connectivity; a high-performance bridge controller for USB connectivity applications; relative humidity (RH) and temperature sensors that simplify RH sensing designs while providing power efficiency and ease of use; the EFM32 Zero Gecko MCU family designed to achieve low system energy consumption for a wide range of battery-powered applications; a family of universal DVB demodulators that support the latest worldwide DVB standards for cable, terrestrial and satellite reception; a low-jitter, low-power and frequency-flexible timing solution for high-speed networking equipment based on the SyncE standard; a new family of silicon TV tuners offering high performance, integration and low system cost while supporting all worldwide terrestrial and cable TV standards; and highly integrated, feature-rich 8-bit MCUs optimized for cost-sensitive motor control applications. Selling, General and Administrative Three Months Ended Six Months Ended June 28, June 29, % June 28, June 29, % (in millions) 2014 2013 Change Change 2014 2013 Change Change Selling, general and administrative $ 36.0 $ 32.4 $ 3.6 11.3 % $ 70.6 $ 61.5 $ 9.1 14.8 % Percent of revenue 23.3 % 22.9 % 23.5 % 21.5 % The increase in selling, general and administrative expense in the recent three month period was principally due to increases of (a) $2.6 million for personnel-related expenses, primarily associated with (i) increased headcount, and (ii) the acquisition of Energy Micro, and (b) $1.4 million for legal fees, primarily related to litigation. The increase in selling, general and administrative expense in the recent six month period was principally due to increases of (a) $4.4 million for personnel-related expenses, (b) $2.7 million for adjustments to the fair value of acquisition-related contingent consideration, and (c) $1.3 million for legal fees. We expect that selling, general and administrative expense will increase in absolute dollars in the third quarter of 2014. Interest Income Interest income for the three and six months ended June 28, 2014 and June 29, 2013 was $0.2 million and $0.5 million, respectively. Interest Expense Interest expense for the three and six months ended June 28, 2014 was $0.8 million and $1.6 million, respectively, compared to $0.8 million and $1.7 million for the three and six months ended June 29, 2013, respectively. Other Income (Expense), Net Other income (expense), net for the three and six months ended June 28, 2014 was $(6) thousand and $61 thousand, respectively, compared to $0.1 million for the three and six months ended June 29, 2013. 28 -------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, (in millions) 2014 2013 Change 2014 2013 Change Provision for income taxes $ 5.9 $ 5.9 $ - $ 7.4 $ 5.9 $ 1.5 Effective tax rate 29.4 % 31.7 % 24.9 % 15.3 % The effective tax rate for the three months ended June 28, 2014 decreased from the prior period, primarily due to the recording of a valuation allowance in the prior period related to deferred tax assets for state net operating losses and research and development tax credits. This decrease was partially offset by the non-renewal of the 2014 federal research and development tax credit in the current period. The effective tax rate for the six months ended June 28, 2014 increased from the prior period, primarily due to the prior period recognition of the 2012 federal research and development tax credit due to the enactment of the American Taxpayer Relief Act of 2012 on January 2, 2013, as well as the non-renewal of the 2014 federal research and development tax credit in the current period. This increase was partially offset by the release in the current period of prior year unrecognized tax benefits due to the lapse of the statute of limitations applicable to a tax deduction claimed on a prior year foreign tax return. The effective tax rates for each of the periods presented differ from the federal statutory rate of 35% due to the amount of income earned in foreign jurisdictions where the tax rate may be lower than the federal statutory rate, research and development tax credits and other permanent items including changes to the liability for unrecognized tax benefits. Business Outlook We expect revenues in the third quarter of fiscal 2014 to be in the range of $153 to $157 million. Furthermore, we expect our diluted earnings per share to be in the range of $0.18 to $0.24. Liquidity and Capital Resources Our principal sources of liquidity as of June 28, 2014 consisted of $328.9 million in cash, cash equivalents and short-term investments, of which approximately $233.7 million was held by our U.S. entities. The remaining balance was held by our foreign subsidiaries. Our cash equivalents and short-term investments consisted of municipal bonds, corporate bonds, variable-rate demand notes, commercial paper, money market funds, certificates of deposit, asset-backed securities, international government bonds, U.S. government bonds and U.S. government agency. Our long-term investments consisted of auction-rate securities. In fiscal 2008, auctions for many of our auction-rate securities failed because sell orders exceeded buy orders. As of June 28, 2014, we held $12.4 million par value auction-rate securities, all of which have experienced failed auctions. These securities have contractual maturity dates ranging from 2033 to 2046. We are receiving the underlying cash flows on all of our auction-rate securities. The principal amounts associated with failed auctions are not expected to be accessible until a successful auction occurs, the issuer redeems the security, a buyer is found outside of the auction process or the underlying securities mature. We are unable to predict if these funds will become available before their maturity dates. We do not expect to need access to the capital represented by any of our auction-rate securities prior to their maturities. Net cash provided by operating activities was $63.4 million during the six months ended June 28, 2014, compared to net cash provided of $66.1 million during the six months ended June 29, 2013. Operating cash flows during the six months ended June 28, 2014 reflect our net income of $22.4 million, adjustments of $38.3 million for depreciation, amortization, stock-based compensation and deferred income taxes, and a net cash inflow of $2.7 million due to changes in our operating assets and liabilities. Accounts receivable decreased to $69.0 million at June 28, 2014 from $72.1 million at December 28, 2013. The decrease in accounts receivable resulted primarily from normal variations in the timing of collections and billings. Our average days sales outstanding (DSO) was 40 days at June 28, 2014 and 44 days at December 28, 2013. 29 -------------------------------------------------------------------------------- Table of Contents Inventory increased to $45.6 million at June 28, 2014 from $45.3 million at December 28, 2013. Our inventory level is primarily impacted by our need to make purchase commitments to support forecasted demand and variations between forecasted and actual demand. Our average days of inventory (DOI) was 73 days at June 28, 2014 and 71 days at December 28, 2013. Net cash used in investing activities was $62.0 million during the six months ended June 28, 2014, compared to net cash provided of $15.9 million during the six months ended June 29, 2013. The decrease in cash inflows was principally due to a decrease of $80.8 million of net proceeds from sales and maturities of marketable securities. We anticipate capital expenditures of approximately $10 to $14 million for fiscal 2014. Additionally, as part of our growth strategy, we expect to evaluate opportunities to invest in or acquire other businesses, intellectual property or technologies that would complement or expand our current offerings, expand the breadth of our markets or enhance our technical capabilities. Net cash used in financing activities was $3.9 million during the six months ended June 28, 2014, compared to net cash provided of $6.0 million during the six months ended June 29, 2013. The increase in cash outflows was principally due to an increase of $11.0 million for repurchases of our common stock. In January 2014, our Board of Directors authorized a program to repurchase up to $100 million of our common stock through January 2015. Debt On July 31, 2012, we entered into a $230 million five-year Credit Agreement (the "Agreement"). The Agreement consists of a $100 million Term Loan Facility and a $130 million Revolving Credit Facility. The Term Loan Facility provides for quarterly principal amortization (equal to 5% of the principal in each of the first two years and 10% of the principal in each of the next three years) with the remaining balance payable upon the maturity date. The Revolving Credit Facility includes a $25 million letter of credit sublimit and a $10 million swingline loan sublimit. We have an option to increase the size of the Revolving Credit Facility by up to an aggregate of $50 million in additional commitments, subject to certain conditions. On September 27, 2012, we borrowed $100 million under the Term Loan Facility. To date, we have not borrowed under the Revolving Credit Facility. The Term Loan Facility and Revolving Credit Facility, other than swingline loans, will bear interest at LIBOR plus an applicable margin or, at our option, a base rate (defined as the highest of the Bank of America prime rate, the Federal Funds rate plus 0.50% and a daily rate equal to one-month LIBOR plus 1.00%) plus an applicable margin. Swingline loans accrue interest at the base rate plus the applicable margin for base rate loans. The applicable margins for the LIBOR rate loans range from 1.50% to 2.50% and for base rate loans range from 0.50% to 1.50%, depending in each case, on the leverage ratio as defined in the Agreement. We also pay a commitment fee on the unused amount of the Revolving Credit Facility. In connection with the closing of the Credit Agreement, we entered into a security and pledge agreement. Under the security and pledge agreement, we pledged equity securities of certain of our subsidiaries, subject to exceptions and limitations. The Credit Facilities contain various conditions, covenants and representations with which we must be in compliance in order to borrow funds and to avoid an event of default, including financial covenants that we must maintain a leverage ratio (funded debt/EBITDA) of no more than 2.5 to 1 and a minimum fixed charge coverage ratio (EBITDA/debt payments, income taxes and capital expenditures) of no less than 1.50 to 1. As of June 28, 2014, the Company was in compliance with all covenants of the Credit Facilities. See Note 7, Debt, to the Condensed Consolidated Financial Statements for additional information. We have entered into an interest rate swap agreement as a hedge against the LIBOR portion of the variable interest payments under the Term Loan Facility and effectively converted the LIBOR portion of the interest on the Term Loan Facility to a fixed interest rate through the maturity date. See Note 4, Derivative Financial Instruments, to the Condensed Consolidated Financial Statements for additional information. 30 -------------------------------------------------------------------------------- Table of Contents Our future capital requirements will depend on many factors, including the rate of sales growth, market acceptance of our products, the timing and extent of research and development projects, potential acquisitions of companies or technologies and the expansion of our sales and marketing activities. We believe our existing cash, cash equivalents, investments and credit under our Credit Facilities are sufficient to meet our capital requirements through at least the next 12 months, although we could be required, or could elect, to seek additional funding prior to that time. We may enter into acquisitions or strategic arrangements in the future which also could require us to seek additional equity or debt financing. Critical Accounting Policies and Estimates The preparation of financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles requires that we make estimates and assumptions that affect the amounts reported. Changes in facts and circumstances could have a significant impact on the resulting estimated amounts included in the financial statements. We believe the following critical accounting policies affect our more complex judgments and estimates. We also have other policies that we consider to be key accounting policies, such as our policies for revenue recognition, including the deferral of revenues and cost of revenues on sales to distributors; however, these policies do not meet the definition of critical accounting estimates because they do not generally require us to make estimates or judgments that are difficult or subjective. Inventory valuation - We assess the recoverability of inventories through the application of a set of methods, assumptions and estimates. In determining net realizable value, we write down inventory that may be slow moving or have some form of obsolescence, including inventory that has aged more than 12 months. We also adjust the valuation of inventory when its manufacturing cost exceeds the estimated market value less selling costs. We assess the potential for any unusual customer returns based on known quality or business issues and write-off inventory losses for scrap or non-saleable material. Inventory not otherwise identified to be written down is compared to an assessment of our 12-month forecasted demand. The result of this methodology is compared against the product life cycle and competitive situations in the marketplace to determine the appropriateness of the resulting inventory levels. Demand for our products may fluctuate significantly over time, and actual demand and market conditions may be more or less favorable than those that we project. In the event that actual demand is lower or market conditions are worse than originally projected, additional inventory write-downs may be required. Stock-based compensation - We recognize the fair-value of stock-based compensation transactions in the Consolidated Statements of Income. The fair value of our full-value stock awards (with the exception of market-based performance awards) equals the fair market value of our stock on the date of grant. The fair value of our market-based performance award grants is estimated at the date of grant using a Monte-Carlo simulation. The fair value of our stock option and employee stock purchase plan grants is estimated at the date of grant using the Black-Scholes option pricing model. In addition, we are required to estimate the expected forfeiture rate of our stock grants and only recognize the expense for those shares expected to vest. If our actual experience differs significantly from the assumptions used to compute our stock-based compensation cost, or if different assumptions had been used, we may have recorded too much or too little stock-based compensation cost. See Note 9, Stock-Based Compensation, to the Condensed Consolidated Financial Statements for additional information. 31 -------------------------------------------------------------------------------- Table of Contents Investments in auction-rate securities - We determine the fair value of our investments in auction-rate securities using a discounted cash flow model. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, amount of cash flows, expected holding periods of the securities and a discount to reflect our inability to liquidate the securities. For available-for-sale auction-rate securities, if the calculated value is below the carrying amount of the securities, we then determine if the decline in value is other-than-temporary. We consider various factors in determining whether an impairment is other-than-temporary, including the severity and duration of the impairment, changes in underlying credit ratings, forecasted recovery, our intent to sell or the likelihood that we would be required to sell the investment before its anticipated recovery in market value and the probability that the scheduled cash payments will continue to be made. When we conclude that an other-than-temporary impairment has occurred, we assess whether we intend to sell the security or if it is more likely than not that we will be required to sell the security before recovery. If either of these two conditions is met, we recognize a charge in earnings equal to the entire difference between the security's amortized cost basis and its fair value. If we do not intend to sell a security and it is not more likely than not that we will be required to sell the security before recovery, the unrealized loss is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recorded in accumulated other comprehensive loss. Acquired intangible assets - When we acquire a business, a portion of the purchase price is typically allocated to identifiable intangible assets, such as acquired technology and customer relationships. Fair value of these assets is determined primarily using the income approach, which requires us to project future cash flows and apply an appropriate discount rate. We amortize intangible assets with finite lives over their expected useful lives. Our estimates are based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur. Incorrect estimates could result in future impairment charges, and those charges could be material to our results of operations. Impairment of goodwill and other long-lived assets - We review long-lived assets which are held and used, including fixed assets and purchased intangible assets, for impairment whenever changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Such evaluations compare the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset over its expected useful life and are significantly impacted by estimates of future prices and volumes for our products, capital needs, economic trends and other factors which are inherently difficult to forecast. If the asset is considered to be impaired, we record an impairment charge equal to the amount by which the carrying value of the asset exceeds its fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. We test our goodwill for impairment annually as of the first day of our fourth fiscal quarter and in interim periods if certain events occur indicating that the carrying value of goodwill may be impaired. The goodwill impairment test is a two-step process. The first step of the impairment analysis compares our fair value to our net book value. In determining fair value, the accounting guidance allows for the use of several valuation methodologies, although it states quoted market prices are the best evidence of fair value. If the fair value is less than the net book value, the second step of the analysis compares the implied fair value of our goodwill to its carrying amount. If the carrying amount of goodwill exceeds its implied fair value, we recognize an impairment loss equal to that excess amount. Income taxes - We are required to calculate income taxes in each of the jurisdictions in which we operate. This process involves calculating the actual current tax liability together with assessing temporary differences in recognition of income (loss) for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheet. We record a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. In assessing the need for a valuation allowance, we are required to estimate the amount of expected future taxable income. Judgment is inherent in this process and differences between the estimated and actual taxable income could result in a material impact on our Consolidated Financial Statements. 32 -------------------------------------------------------------------------------- Table of Contents We recognize liabilities for uncertain tax positions based on a two-step process. The first step requires us to determine if the weight of available evidence indicates that the tax position has met the threshold for recognition; therefore, we must evaluate whether it is more likely than not that the position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step requires us to measure the tax benefit of the tax position taken, or expected to be taken, in an income tax return as the largest amount that is more than 50% likely of being realized upon ultimate settlement. This measurement step is inherently complex and requires subjective estimations of such amounts to determine the probability of various possible outcomes. We re-evaluate the uncertain tax positions each quarter based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, expirations of statutes of limitation, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period. Although we believe the measurement of our liabilities for uncertain tax positions is reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals. If additional taxes are assessed as a result of an audit or litigation, it could have a material effect on our income tax provision and net income in the period or periods for which that determination is made. We operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues which may require an extended period of time to resolve and could result in additional assessments of income tax. We believe adequate provisions for income taxes have been made for all periods. Recent Accounting Pronouncements In June 2014, the Financial Accounting Standards Board (FASB) issued FASB Accounting Standards Update (ASU) No. 2014-12, Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. The amendments in this update require that a performance target that affects vesting and that could be achieved after the requisite service period should be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718 as it relates to awards with performance conditions that affect vesting to account for such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. We are currently evaluating the effect that the adoption of this ASU will have on our financial statements. In May 2014, the FASB issued FASB ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in ASC 605, Revenue Recognition. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides a five-step process to achieve that core principle. ASU 2014-09 requires disclosures enabling users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, using one of two retrospective application methods. Early application is not permitted. We are currently evaluating the effect that the adoption of this ASU will have on our financial statements. 33 -------------------------------------------------------------------------------- Table of Contents In April 2014, the FASB issued FASB ASU No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this update require a disposal of a component of an entity or a group of components of an entity to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results. ASU 2014-08 expands disclosure requirements about discontinued operations and adds new disclosures for individually significant dispositions that do not qualify as discontinued operations. ASU 2014-08 is effective prospectively for annual periods beginning on or after December 15, 2014, and interim periods within annual periods beginning on or after December 15, 2015. Early adoption is permitted, but only for disposals that have not been reported in financial statements previously issued. The adoption of this ASU is not expected to have a material impact on our financial statements. |