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SYNAPTICS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements and Factors That May Affect Results You should read the following discussion and analysis in conjunction with our financial statements and related notes contained elsewhere in this report. This discussion contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including those set forth under Item 1A. Risk Factors. Overview We are a leading worldwide developer and supplier of custom-designed human interface solutions that enable people to interact more easily and intuitively with a wide variety of mobile computing, communications, entertainment, and other electronic devices. We believe our results to date reflect the combination of our customer focus, the strength of our intellectual property and our engineering know-how, which allow us to develop or engineer products that meet the demanding design specifications of OEMs. We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, delivery has occurred and title has transferred, the price is fixed or determinable, and collection is reasonably assured. Our net revenue increased from $514.9 million for fiscal 2010 to $947.5 million for fiscal 2014, representing a compound annual growth rate of approximately 17%. For fiscal 2010, we derived 59% of our net revenue from the personal computer market and 41% of our net revenue from the mobile product applications market. For fiscal 2014, revenue from the personal computer market accounted for 27% of our net revenue and revenue from the mobile product applications market accounted for 73% of our net revenue. Many of our customers have manufacturing operations in China, and many of our OEM customers have established design centers in Asia. With our expanding global presence, including offices in China, Finland, Hong Kong, India, Japan, Korea, Switzerland, Taiwan, and the United States, we are well positioned to provide local sales, operational, and engineering support services to our existing customers, as well as potential new customers, on a global basis. Our manufacturing operations are based on a variable cost model in which we outsource all of our production requirements and generally drop ship our products directly to our customers from our contract manufacturers' facilities, eliminating the need for significant capital expenditures and allowing us to minimize our investment in inventories. This approach requires us to work closely with our contract manufacturers and semiconductor fabricators to ensure adequate production capacity to meet our forecasted volume requirements. We provide our contract manufacturers with six-month rolling forecasts and issue purchase orders based on our anticipated requirements for the next 90 days. However, we do not have any long-term supply contracts with any of our contract manufacturers. We use two third-party wafer manufacturers to supply wafers and four third-party packaging manufacturers to package our proprietary ASICs. In certain cases, we rely on a single source or a limited number of suppliers to provide other key components of our products. Our cost of revenue includes all costs associated with the production of our products, including materials, logistics, manufacturing, assembly, and test costs paid to third-party manufacturers, and related overhead costs associated with our indirect manufacturing operations personnel. Additionally, we charge all warranty costs, yield losses, and any inventory provisions or write-downs to cost of revenue. Our gross margin generally reflects the combination of the added value we bring to our OEM customers' products in meeting their custom design requirements and the impact of our ongoing cost-improvement programs. These cost-improvement programs include reducing materials and component costs, and implementing design and process improvements. Our newly introduced products may have lower margins than our more mature products, which have realized greater benefits associated with our ongoing cost-improvement programs. As a result, new product introductions may initially negatively impact our gross margin. Our research and development expenses include costs for supplies and materials related to product development, as well as the engineering costs incurred to design human interface solutions for OEM customers prior to and after their commitment to incorporate those solutions into their products. These expenses have generally increased, reflecting our continuing commitment to the technological and design innovation required to maintain our position in our existing markets, and to adapt our existing technologies or develop new technologies for new markets. 31-------------------------------------------------------------------------------- Table of Contents Selling, general, and administrative expenses include expenses related to sales, marketing, and administrative personnel; internal sales and outside sales representatives' commissions; market and usability research; outside legal, accounting, and consulting costs; and other marketing and sales activities. These expenses have generally increased, primarily reflecting incremental staffing and related support costs associated with our increased business levels, growth in our existing markets, and penetration into new markets. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, cost of revenue, inventories, product warranty, share-based compensation costs, provision for income taxes, deferred income tax asset valuation allowances, uncertain tax positions, tax contingencies, goodwill, intangible assets, investments, and contingencies. We base our estimates on historical experience, applicable laws and regulations, and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The methods, estimates, interpretations, and judgments we use in applying our most critical accounting policies can have a significant impact on the results that we report in our consolidated financial statements. The SEC considers an entity's most critical accounting policies to be those policies that are both most important to the portrayal of the entity's financial condition and results of operations and those that require the entity's most difficult, subjective, or complex judgments, often as a result of the need to make assumptions and estimates about matters that are inherently uncertain. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, delivery has occurred and title has transferred, the price is fixed or determinable, and collection is reasonably assured, which is generally upon shipment of the product. We accrue for estimated sales returns, incentives and other allowances at the time we recognize revenue. Our products contain embedded firmware and software that allows for further differentiation and customer integration, which together with, or consisting of, our ASIC chip delivers the essential functionality of our products and, as such, software revenue recognition guidance is not applicable. Investments Accounting standards require us to record available-for-sale securities at fair value, with unrealized gains and losses being reported as a component of other comprehensive income. We follow the accounting standards to assess whether our investments with loss positions are other-than-temporarily impaired. We follow the hierarchal approach established under the accounting standards to determine fair value of our investments. The accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Our fair value estimates consider, among other factors, the collateral underlying the security investments, creditworthiness of the counterparty, timing of expected future cash flows, and, in the case of ARS investments, the probability of a successful auction in a future period. We follow the guidance provided to estimate fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability, and to determine circumstances that may indicate that a transaction is not orderly. Further, we use judgment in evaluating whether a decline in fair value is temporary or other-than-temporary and consider the following indicators: changes in credit ratings or asset quality; changes in the economic environment; length of time and extent to which fair value has been below cost basis; changes in market conditions; and changes in expected cash flows. We do not intend to sell the investments, and it is more likely than not that we will not be required to sell the investments before recovery of their amortized cost basis. Temporary declines in fair value are recorded as charges to accumulated other comprehensive income in the equity section of our balance sheet, while other-than-temporary declines in fair value are bifurcated between credit losses, which are charged to earnings, and noncredit losses which, depending on facts and circumstances may be charged to other comprehensive income or earnings. 32 -------------------------------------------------------------------------------- Table of Contents Inventory We state our inventories at the lower of cost or market. We base our assessment of the ultimate realization of inventories on our projections of future demand and market conditions. Sudden declines in demand, rapid product improvements, or technological changes, or any combination of these factors can cause us to have excess or obsolete inventories. On an ongoing basis, we review for estimated obsolete or unmarketable inventories and write down our inventories to their net realizable value based upon our forecasts of future demand and market conditions. If actual market conditions are less favorable than our forecasts, additional inventory write-downs may be required. The following factors influence our estimates: changes to or cancellations of customer orders, unexpected decline in demand, rapid product improvements and technological advances, and termination or changes by our OEM customers of any product offerings incorporating our product solutions. Periodically, we purchase inventory from our contract manufacturers when a customer delays its delivery schedule or cancels its order. In those circumstances in which our customer has cancelled its order and we purchase inventory from our contract manufacturers, we record a write-down, if necessary, to reduce the carrying value of the inventory purchased to its net realizable value. The effect of these write-downs is to establish a new cost basis in the related inventory, which we do not subsequently write up. We also record a liability and charge to cost of revenue for estimated losses on inventory we are obligated to purchase from our contract manufacturers when such losses become probable from customer delays or order cancellations. Goodwill Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets acquired. Goodwill is measured and tested for impairment annually during the last quarter of our fiscal year, or more frequently if we believe indicators of impairment exist. Events that could trigger a more frequent impairment review may include adverse industry or economic trends, restructuring actions, lower projections of profitability, or a sustained decline in our market capitalization. During our annual assessment of goodwill impairment, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying value before performing the two step quantitative impairment test. If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two step impairment test is not necessary. The first step requires comparing the fair value of our one reporting unit to its net book value, including goodwill. We have allocated our goodwill to a single company-wide reporting unit. If we subsequently determine that our goodwill should be allocated to a separate reportable unit within our company then determining the fair value of a reporting unit will be judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and forecasted operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable. Actual future results may differ from those estimates. Future competitive, market and economic conditions could negatively impact key assumptions including our market capitalization or the carrying value of our net assets, which could require us to realize an impairment of our goodwill and intangible assets. A potential impairment exists if the fair value of the reporting unit is less than its net book value. The second step of the process is only performed if a potential impairment exists, and it involves determining the difference between the fair value of the reporting unit's net assets, other than goodwill, to the fair value of the reporting unit. If the difference is less than the net book value of goodwill, an impairment exists and is recorded. No goodwill impairment was recognized in fiscal 2014, 2013, and 2012. Acquired Intangibles We review acquired intangible assets with finite lives for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Recoverability of these intangible assets is assessed based on the estimated undiscounted future cash flows expected to result from the use of the asset. If the undiscounted future cash flows are less than the carrying amount, the acquired intangible assets with finite lives are considered to be impaired. The amount of the impairment is measured as the difference between the carrying amount of these assets and the fair value. 33-------------------------------------------------------------------------------- Table of Contents Our business combinations have included the purchase of in-process research and development assets that are not amortizable until the underlying project is complete. We assess that our in-process research and development project is complete when all material research and development costs have been incurred and no significant risks remain. We review the carrying value of indefinite-lived intangible assets for impairment at least annually during the last quarter of our fiscal year, or more frequently if we believe indicators of impairment exist. Business Combinations We have applied significant estimates and judgments in order to determine the fair value of the identified assets acquired, liabilities assumed, goodwill recognized, and contingent consideration recorded in connection with our business combinations to ensure the value of the assets and liabilities acquired are recognized at fair value as of the acquisition date. In measuring the fair value, we utilize valuation techniques consistent with the market approach, income approach, or cost approach. The valuation of the identifiable assets and liabilities includes assumptions made in performing the valuation, such as projected revenue, weighted average cost of capital, discount rates, estimated useful lives, estimated probabilities of achieving contingent payment milestones, and other relevant assessments. These assessments can be significantly affected by our estimates, judgments, and assumptions. If actual results are not consistent with our estimates, judgments, or assumptions, or if additional or new information arises in the future that affects our fair value estimates, then adjustments to our initial fair value estimates may have a material impact to our purchase accounting or our results of operations. Share-Based Compensation Costs We account for employee share-based compensation costs in accordance with relevant accounting standards. We utilize the Black-Scholes option pricing model to estimate the grant date fair value of certain employee share-based compensatory awards, which requires the input of highly subjective assumptions, including expected volatility and expected life. Historical and implied volatilities were used in estimating the fair value of our share-based awards. The expected life for our options was previously estimated based on historical trends since our initial public offering. In fiscal 2011, we began to grant options with a contractual life of seven years rather than ten years, and we began using the simplified method of establishing the expected life as we do not have any history of options with seven-year lives. In fiscal 2013, we began to grant options that vest over a three-year period rather than a four-year period, and we continue to use the simplified method of establishing the expected life as we do not have any history of options that vest over a three-year period. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our share-based compensation. Estimated forfeitures for share-based awards that are not expected to vest are estimated based on historical trends since our initial public offering. We charge the estimated fair value less estimated forfeitures to earnings on a straight-line basis over the vesting period of the underlying awards, which is now generally three years for our stock options, DSUs, MSUs and up to two years for our employee stock purchase plan. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. As our stock option and our employee stock purchase plan awards have characteristics that differ significantly from traded options, and as changes in the assumptions can materially affect the estimated value, our estimate of fair value may not accurately represent the value assigned by a third party in an arms-length transaction. There currently is no market-based mechanism to verify the reliability and accuracy of the estimates derived from the Black-Scholes option pricing model or other allowable valuation models, nor is there a means to compare and adjust the estimates to actual values. While our estimate of fair value and the associated charge to earnings materially affects our results of operations, it has no impact on our cash position. We estimate the fair value of market-based MSUs at the date of grant using a Monte Carlo simulation model and amortize those fair values over the requisite service period, generally three years, adjusted for estimated forfeitures for each separately vesting tranche of the award. The Monte Carlo simulation model that we use to estimate the fair value of market-based MSUs at the date of grant incorporates into the valuation the possibility that the market condition may not be satisfied. Provided that the requisite service is rendered, the total fair value of the market-based MSUs at the date of grant must be recognized as compensation expense even if the market condition is not achieved. However, the number of shares that ultimately vest can vary significantly with the performance of the specified market criteria. 34-------------------------------------------------------------------------------- Table of Contents There are significant variations among allowable valuation models, and there is a possibility that we may adopt a different valuation model or refine the inputs and assumptions under our current valuation models in the future, resulting in a lack of consistency in future periods. Our current or future valuation model and the inputs and assumptions we make may also lack comparability to other companies that use different models, inputs, or assumptions, and the resulting differences in comparability could be material. Income Taxes We recognize federal, foreign, and state current tax liabilities or assets based on our estimate of taxes payable or refundable in the then current fiscal year for each tax jurisdiction. We also recognize federal, foreign, and state deferred tax liabilities or assets for our estimate of future tax effects attributable to temporary differences and carryforwards and record a valuation allowance to reduce any deferred tax assets by the amount of any tax benefits that, based on available evidence and our judgment, are not expected to be realized. If our assumptions, and consequently our estimates, change in the future, the valuation allowance we established for our deferred tax assets may change, which could impact income tax expense. We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement with a taxing authority. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of highly complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our consolidated financial position, result of operations, or cash flows. We believe we have adequately provided for reasonably foreseeable outcomes in connection with the resolution of income tax uncertainties. However, our results have in the past, and could in the future, include favorable and unfavorable adjustments to our estimated tax liabilities in the period a determination of such estimated tax liability is made or resolved, upon the filing of an amended return, upon a change in facts, circumstances, or interpretation, or upon the expiration of a statute of limitation. Accordingly, our effective tax rate could fluctuate materially from period to period. We consider the operating earnings of our foreign subsidiaries to be indefinitely invested outside the United States. Accordingly, no provision has been made for the U.S. federal, state, or foreign taxes that may result from future remittances of undistributed earnings of our foreign subsidiaries. We recognize a tax benefit upon expensing certain share-based awards associated with our share-based compensation plans, including nonqualified stock options, DSUs, and MSUs, but we cannot recognize tax benefit concurrent with the recognition of share-based compensation expenses associated with qualified stock options (incentive stock options and employee stock purchase plan shares). For qualified stock options, we recognize a tax benefit only in the period when disqualifying dispositions of the underlying stock occur, which historically has been up to several years after vesting and in a period when our stock price substantially increases. As a result, our future quarterly and annual effective tax rates will be subject to greater volatility and, consequently, our ability to estimate reasonably our future quarterly and annual effective tax rates is greatly diminished. Changes in contingent consideration can be significant from period to period and a portion of the change in contingent consideration is non-deductible. As a result, changes in contingent consideration can have a material impact on our effective tax rate from period to period. 35-------------------------------------------------------------------------------- Table of Contents Results of Operations The following sets forth certain of our consolidated statements of income data for fiscal 2014, 2013, and 2012, along with comparative information regarding the absolute and percentage changes in these amounts (in thousands, except percentages): 2014 (1) 2013 $ Change % Change 2013 2012 $ Change % ChangeMobile product applications $ 689,866 $ 424,076 $ 265,790 62.7 % $ 424,076 $ 270,106 $ 153,970 57.0 % PC product applications 257,673 239,512 18,161 7.6 % 239,512 278,122 (38,610 ) (13.9 %) Net revenue 947,539 663,588 283,951 42.8 % 663,588 548,228 115,360 21.0 % Gross margin 436,080 325,804 110,276 33.8 % 325,804 255,567 70,237 27.5 % Operating expenses: Research and development 192,681 144,699 47,982 33.2 % 144,699 117,954 26,745 22.7 % Selling, general, and administrative 100,005 79,620 20,385 25.6 % 79,620 70,045 9,575 13.7 % Acquired intangibles amortization 1,047 1,025 22 2.1 % 1,025 - 1,025 n/m (2) Change in contingent consideration 69,861 1,347 68,514 5086.4 % 1,347 - 1,347 n/m (2) Gain on sale of property and equipment - (1,578 ) 1,578 (100.0 %) (1,578 ) - (1,578 ) n/m (2) Operating income 72,486 100,691 (28,205 ) (28.0 %) 100,691 67,568 33,123 49.0 % Interest income, net 1,973 1,042 931 89.3 % 1,042 982 60 6.1 % Income before provision for income taxes 74,459 101,733 (27,274 ) (26.8 %) 101,733 68,550 33,183 48.4 % Provision for income taxes 27,770 2,800 24,970 891.8 % 2,800 14,406 (11,606 ) (80.6 %) Net income $ 46,689 $ 98,933 $ (52,244 ) (52.8 %) $ 98,933 $ 54,144 $ 44,789 82.7 % (1) Includes the results of operations from Validity, which was acquired on November 7, 2013 (see Note 5 to the consolidated financial statements) (2) not meaningful The following sets forth certain of our consolidated statements of income data as a percentage of net revenues for fiscal 2014, 2013, and 2012: Percentage Percentage Point Point Increase Increase 2014 (1) 2013 (Decrease) 2013 2012 (Decrease) Mobile product applications 72.8 % 63.9 % 8.9 % 63.9 % 49.3 % 14.6 % PC product applications 27.2 % 36.1 % (8.9 %) 36.1 % 50.7 % (14.6 %) Net revenue 100.0 % 100.0 % 100.0 % 100.0 % Gross margin 46.0 % 49.1 % (3.1 %) 49.1 % 46.6 % 2.5 % Operating expenses: Research and development 20.3 % 21.8 % (1.5 %) 21.8 % 21.5 % 0.3 % Selling, general, and administrative 10.6 % 12.0 % (1.4 %) 12.0 % 12.8 % (0.8 %) Acquired intangibles amortization 0.1 % 0.2 % (0.1 %) 0.2 % 0.0 % 0.2 % Change in contingent consideration 7.4 % 0.2 % 7.2 % 0.2 % 0.0 % 0.2 % Operating income 7.6 % 15.2 % (7.6 %) 15.2 % 12.3 % 2.9 % Income before provision for income taxes 7.9 % 15.3 % (7.4 %) 15.3 % 12.5 % 2.8 % Provision for income taxes 2.9 % 0.4 % 2.5 % 0.4 % 2.6 % (2.2 %) Net income 4.9 % 14.9 % (10.0 %) 14.9 % 9.9 % 5.0 % (1) Includes the results of operations from Validity, which was acquired on November 7, 2013 (see Note 5 to the consolidated financial statements) 36 -------------------------------------------------------------------------------- Table of Contents Fiscal 2014 Compared with Fiscal 2013 Net Revenue. Net revenue was $947.5 million for fiscal 2014 compared with $663.6 million for fiscal 2013, an increase of $283.9 million, or 42.8%. Of our fiscal 2014 net revenue, $689.8 million, or 72.8%, of net revenue was from the mobile product applications market and $257.7 million, or 27.2%, of net revenue was from the PC product applications market. The overall increase in net revenue for fiscal 2014 was attributable to a $265.8 million, or 62.7%, increase in net revenue from mobile product applications, and an increase of $18.1 million, or 7.6%, in net revenue from PC product applications. Specific reasons for the increase in net revenue include an increase in the units sold in the mobile product applications market, reflecting both the growing market and an increase in our market share, as well as sales related to our new biometrics products. Within the mobile product applications market, one customer accounted for 28% of fiscal 2014 net revenue. The increase in PC product applications was primarily a result of higher unit sales related to our new biometrics products. Fingerprint sensor product revenue, which contributed to both mobile and PC product applications revenue, was $105.4 million in fiscal 2014. Based on industry estimates of unit shipments from calendar 2013 to 2014, the smartphone market is anticipated to increase approximately 23%, the notebook market is anticipated to decrease approximately 4%, and the tablet market is anticipated to increase 12%. Gross Margin. Gross margin as a percentage of net revenue was 46.0%, or $436.1 million, for fiscal 2014 compared with 49.1%, or $325.8 million, for fiscal 2013. The 310 basis point decline in gross margin was primarily attributable to an unfavorable mix of lower margin revenue driven largely by the addition of fingerprint sensor module products, an increase in PC application module products, and further penetration into lower end mobile application products in China. We continuously introduce new product solutions, many of which have life cycles of less than a year. Further, as we sell our capacitive sensing technology in designs that are generally unique or specific to an OEM customer's application, gross margin varies on a product-by-product basis, making our cumulative gross margin a blend of our product specific designs. As a virtual manufacturer, our gross margin percentage is generally not impacted materially by our shipment volume. We charge losses on inventory purchase obligations and write-down to reduce the carrying value of obsolete, slow moving, and non-usable inventory to net realizable value (including warranty costs) to cost of revenue. Operating Expenses. Research and Development Expenses. Research and development expenses increased $48.0 million, to $192.7 million, for fiscal 2014 compared with fiscal 2013. The increase in research and development expenses primarily reflected (i) a $24.5 million increase in employee compensation and employment-related costs, resulting from a 38.2% increase in research and development headcount associated with the ongoing expansion of our product portfolio, including new employees related to the recent acquisition of Validity and annual compensation adjustments, (ii) a $7.2 million increase in infrastructure costs related to new facilities and information technology to support the additional staff, (iii) a $5.0 million increase in non-employee services, (iv) a $4.5 million increase in supplies and project related costs, and (v) a $2.3 million increase in software license fees. Selling, General, and Administrative Expenses. Selling, general, and administrative expenses increased $20.4 million, to $100.0 million, for fiscal 2014 compared with fiscal 2013. The increase in selling, general, and administrative expenses primarily reflected (i) a $10.2 million increase in employee compensation and employment-related costs resulting from a 30.8% increase in selling, general, and administrative headcount, including new employees related to the Validity acquisition, and annual compensation adjustments, (ii) a $5.2 million increase in professional fees, primarily associated with acquisition-related costs, (iii) a $4.1 million increase in temporary employee services, and (iv) a $2.6 million increase in travel and related expenses, partially offset by a $2.3 million decrease in share-based compensation. 37 -------------------------------------------------------------------------------- Table of Contents Acquired Intangibles Amortization. Acquired intangibles amortization reflects the amortization of intangibles acquired through recent acquisitions. See note 6 to the financial statements contained elsewhere in this report. Change in Contingent Consideration. Our contingent consideration increased $68.5 million for fiscal 2014 compared with fiscal 2013. The increase was primarily attributable to the increase in the estimated fair value of the contingent consideration liability related to the Validity acquisition, which resulted from a substantial increase in expected unit sales of products embodying the Validity fingerprint sensor technology over the remaining earn-out period. See note 5 to the financial statements contained elsewhere in this report. Gain on property and equipment. The gain on sale of property and equipment for fiscal 2013 resulted from the sale of our former headquarters building. Operating Income. We generated operating income of $72.5 million for fiscal 2014, a decline of $28.2 million compared with fiscal 2013. As discussed in the preceding paragraphs, the decrease in operating income was primarily the result of a significant increase in the change in contingent consideration, partially offset by increased operating leverage from the 42.8% increase in net revenue. Non-Operating Income. Interest income, net. Interest income, net was $2.0 million for fiscal 2014 compared with $1.0 million for fiscal 2013, resulting from increases in interest rates. Provision for Income Taxes. The provision for income taxes was $27.8 million and $2.8 million for fiscal 2014 and 2013, respectively. The income tax provision represented estimated U.S. federal, foreign, and state taxes for fiscal 2014 and 2013. The effective tax rate for fiscal 2014 was approximately 37.3% and diverged from the combined federal and state statutory rate, primarily as a result of overseas profits taxed in lower tax rate jurisdictions, and the benefit of research tax credits; partially offset by foreign withholding taxes, nondeductible contingent consideration, and net unrecognized tax benefits associated with qualified stock options. The effective tax rate for fiscal 2013 was approximately 2.8% and diverged from the combined federal and state statutory rate, primarily as a result of overseas profits taxed in lower tax rate jurisdictions, the resolution of an income tax audit, and the benefit of research tax credits; partially offset by foreign withholding taxes and net unrecognized tax benefits associated with qualified stock options. In May 2011, we were notified by the Internal Revenue Service, or the Service, that our fiscal 2003 through 2006 and fiscal 2008 through 2010 would be subject to examination. The early periods were being audited in connection with a mandatory review of tax refunds in excess of $2.0 million which resulted when we carried back our fiscal 2008 net operating loss. In March 2013, we received the Revenue Agent's Report resolving our examination with the Service and paid an assessment that had no material impact on our condensed consolidated financial statements. Our case is pending review by the Joint Committee on Taxation, which we anticipate will conclude in our fiscal 2015. Any prospective adjustments to our unrecognized tax benefits will be recorded as an increase or decrease to income tax expense and cause a corresponding change to our effective tax rate. Accordingly, our effective tax rate could fluctuate materially from period to period. On January 2, 2013, President Barack Obama signed into law The American Taxpayer Relief Act of 2013, or the Act. The Act extended the federal research credit for two years retroactively from January 1, 2012 through December 31, 2013. As such, we only recognized six months of tax benefit from the research tax credit for fiscal 2014. It is reasonably possible that the amount of liability for unrecognized tax benefits may change within the next 12 months and an estimate of the range of possible changes could result in an increase of up to $2.0 million. 38-------------------------------------------------------------------------------- Table of Contents Fiscal 2013 Compared with Fiscal 2012 Net Revenue. Net revenue was $663.6 million for fiscal 2013 compared with $548.2 million for fiscal 2012, an increase of $115.4 million, or 21.0%. Of our fiscal 2013 net revenue, $424.1 million, or 63.9%, of net revenue was from the mobile product applications market and $239.5 million, or 36.1%, of net revenue was from the PC product applications market. The overall increase in net revenue for fiscal 2013 was attributable to a $154.0 million, or 57.0%, increase in net revenue from mobile product applications, partially offset by a decrease of $38.6 million, or 13.9%, in net revenue from PC product applications. Specific reasons for the increase in net revenue were primarily attributable to an increase in the units sold in the mobile product applications market, reflecting both the growing market and an increase in our market share. Within the mobile product applications market, one customer accounted for 14% of fiscal 2013 net revenue. The decrease in revenue from PC product applications was primarily a result of lower unit sales reflecting the continued weakness in the worldwide PC product applications market. Gross Margin. Gross margin as a percentage of net revenue was 49.1%, or $325.8 million, for fiscal 2013 compared with 46.6%, or $255.6 million, for fiscal 2012. The 150 basis point improvement in gross margin was primarily attributable to a favorable mix of higher margin mobile product applications revenue driven largely by the continued shift in our overall revenue mix to mobile product applications revenue consisting predominately of higher margin chip solutions. Operating Expenses. Research and Development Expenses. Research and development expenses increased $26.7 million, to $144.7 million, for fiscal 2013 compared with fiscal 2012. The increase in research and development expenses primarily reflected a $16.0 million increase in employee compensation and employment-related costs, resulting from a 13.9% increase in research and development staffing and annual compensation adjustments, and a $5.8 million increase in infrastructure costs to support the additional staff. Selling, General, and Administrative Expenses. Selling, general, and administrative expenses increased $9.6 million, to $79.6 million, for fiscal 2013 compared with fiscal 2012. The increase in selling, general, and administrative expenses primarily reflected a $7.6 million increase in employee compensation and employment-related costs resulting from a 11.8% increase in selling, general, and administrative staffing and annual compensation adjustments. Acquired Intangibles Amortization. Acquired intangibles amortization reflects the amortization of intangibles acquired through recent acquisitions. See note 6 to the financial statements contained elsewhere in this report. Change in Contingent Consideration. Change in contingent consideration reflects the change in fair value of the contingent consideration liability related to our acquisition of Pacinian. Gain on property and equipment. The gain on sale of property and equipment resulted from the sale of our former headquarters building. Operating Income. We generated operating income of $100.7 million for fiscal 2013, an increase of $33.1 million compared with fiscal 2012. As discussed in the preceding paragraphs, the increase in operating income was primarily the result of increased operating leverage from the 21% increase in net revenue, the decline in operating expenses as a percentage of net revenue, and the higher gross margin percentage. 39 -------------------------------------------------------------------------------- Table of Contents Non-Operating Income. Interest Income, net. Interest income, net was $1.0 million for fiscal 2013 compared with $982,000 for fiscal 2012. Provision for Income Taxes. The provision for income taxes was $2.8 million and $14.4 million for fiscal 2013 and 2012, respectively. The income tax provision represented estimated U.S. federal, foreign, and state taxes for fiscal 2013 and 2012. The effective tax rate for fiscal 2013 was approximately 2.8% and diverged from the combined federal and state statutory rate, primarily as a result of overseas profits taxed in lower tax rate jurisdictions, the resolution of an income tax audit, and the benefit of research tax credits; partially offset by foreign withholding taxes and net unrecognized tax benefits associated with qualified stock options. The effective tax rate for fiscal 2012 was approximately 21.0% and diverged from the combined federal and state statutory rate, primarily as a result of overseas profits taxed in lower tax rate jurisdictions, the recognition of previously unrecognized tax benefits, and the benefit of research tax credits, partially offset by foreign withholding taxes and net unrecognized tax benefits associated with qualified stock options. As a result of the Revenue Agent's Report discussed above, we paid an assessment that had no material impact to our condensed consolidated financial statements, which at that time triggered the reevaluation of the measurement of prior year uncertain tax positions and resulted in the recognition of $15.8 million of previously unrecognized tax benefits for fiscal 2013. 40-------------------------------------------------------------------------------- Table of Contents Quarterly Results of Operations The following table sets forth our unaudited quarterly results of operations for the eight quarters in the two-year period ended June 30, 2014. The following table should be read in conjunction with the financial statements and related notes contained elsewhere in this report. We have prepared this unaudited information on the same basis as our audited financial statements. This table includes all adjustments, consisting only of normal recurring adjustments that we consider necessary for a fair presentation of our financial position and results of operations for the quarters presented. Past results of operations are not necessarily indicative of future operating performance; accordingly, you should not draw any conclusions about our future results from the results of operations for any quarter presented. Three Months Ended (in thousands, except per share amounts) June March December September June March December September (unaudited) 2014(1) 2014(1) 2013(1) 2013 2013 2013 2012 2012 Net revenue $ 314,898 $ 204,271 $205,763 $ 222,607 $ 230,183 $ 163,324 $ 143,040 $ 127,041 Cost of revenue 175,072 111,841 111,218 113,328 115,062 82,241 74,010 66,471 Gross margin 139,826 92,430 94,545 109,279 115,121 81,083 69,030 60,570 Operating expenses: Research and development 56,896 49,412 45,931 40,442 40,900 36,740 34,257 32,802 Selling, general, and administrative 30,180 25,856 22,845 21,124 21,521 20,183 19,008 18,908 Acquired intangibles amortization 262 262 261 262 262 262 261 240 Change in contingent consideration 13,130 53,043 3,430 258 247 237 576 287 Gain on sale of property and equipment - - - - (1,578 ) - - - Total operating expenses 100,468 128,573 72,467 62,086 61,352 57,422 54,102 52,237 Operating income/(loss) 39,358 (36,143 ) 22,078 47,193 53,769 23,661 14,928 8,333 Interest income, net 560 516 471 426 415 193 220 214 Income/(loss) before income taxes 39,918 (35,627 ) 22,549 47,619 54,184 23,854 15,148 8,547 Provision/(benefit) for income taxes 5,446 4,429 5,215 12,680 8,864 (12,592 ) 4,034 2,494 Net income/(loss) $ 34,472 $ (40,056 ) $ 17,334 $ 34,939 $ 45,320 $ 36,446 $ 11,114 $ 6,053 Net income/(loss) per share: Basic $ 0.95 $ (1.12 ) $ 0.51 $ 1.06 $ 1.37 $ 1.13 $ 0.34 $ 0.18 Diluted $ 0.89 $ (1.12 ) $ 0.48 $ 1.00 $ 1.29 $ 1.07 $ 0.33 $ 0.18 Shares used in computing net income/(loss) per share: Basic 36,411 35,685 33,990 32,958 32,979 32,234 32,478 32,941 Diluted 38,817 35,685 36,059 35,020 35,150 34,135 33,313 34,014 (1) Includes the results of operations from Validity, which was acquired on November 7, 2013 (see Note 5 to the condensed consolidated financial statements) Liquidity and Capital Resources Our cash and cash equivalents, which exclude ARS investments, were $447.2 million as of the end of fiscal 2014 compared with $355.3 million as of the end of fiscal 2013, an increase of $91.9 million. This increase primarily reflected $131.6 million provided from operating cash flows, $80.7 million from the issuance of shares under our employee equity compensation programs, $19.3 million for excess tax benefit from share-based compensation, partially offset by $70.3 million used to repurchase shares of our common stock, $38.7 million used for the purchase of property and equipment, which includes the renovation of our new headquarters campus and the purchase of two adjacent buildings for future expansion, $19.6 million used for a business acquisition, and $8.9 million used for payroll taxes for deferred stock units. We consider earnings of our foreign subsidiaries indefinitely invested overseas and have made no provision for income or withholding taxes that may result from a future repatriation of those earnings. As of June 30, 2014, $289.3 million of cash and cash equivalents was held by our foreign subsidiaries. If these funds are needed for our operations in the United States, we would be required to accrue and pay U.S. taxes to repatriate these funds. 41-------------------------------------------------------------------------------- Table of Contents Cash Flows from Operating Activities. For fiscal 2014, net cash provided by operating activities of $131.6 million was primarily attributable to net income of $46.7 million plus adjustments for non-cash charges, including accretion and re-measurement of the contingent consideration liability of $69.9 million, share-based compensation costs of $32.8 million, depreciation and amortization of $14.2 million, other non-cash adjustments of $18.6 million, and a net change in operating assets and liabilities of $50.8 million. The net change in operating assets and liabilities related primarily to the $42.8 million increase in accounts receivable, which resulted from the substantial increase in net revenue in the fourth quarter of fiscal 2014 compared with fiscal 2013. Our days sales outstanding improved from 58 to 56 days from fiscal 2013 to fiscal 2014. Our inventory turns decreased from nine to eight from fiscal 2013 to fiscal 2014. For fiscal 2013, net cash provided by operating activities of $102.2 million was primarily attributable to net income of $98.9 million plus adjustments for non-cash charges, including share-based compensation costs of $32.2 million, depreciation and amortization of $10.8 million, other non-cash adjustments of $1.0 million and a net change in operating assets and liabilities of $38.8 million. The net change in operating assets and liabilities related primarily to the $44.3 million increase in accounts receivable resulting from the substantial increase in net revenue in the fourth quarter of fiscal 2013 compared with fiscal 2012. Our days sales outstanding improved from 68 to 58 days from fiscal 2012 to fiscal 2013. Our inventory turns remained stable at nine for the same period. For fiscal 2012, net cash provided by operating activities of $101.4 million was primarily attributable to net income of $54.1 million plus adjustments for non-cash charges, including share-based compensation costs of $34.2 million, depreciation and deferred taxes aggregating $9.7 million, and a net change in operating assets and liabilities of $2.2 million. Our days sales outstanding increased from 59 to 68 days from fiscal 2011 to fiscal 2012 as our net revenue was more backend loaded in fiscal 2012 than it was in fiscal 2011. Our inventory turns decreased from 11 to nine for the same period. Cash Flows from Investing Activities. Net cash used in investing activities for fiscal 2014, 2013, and 2012 was $58.3 million, $37.5 million, and $14.9 million, respectively. Net cash used in investing activities for fiscal 2014 consisted of $38.7 million used for the purchase of capital assets and $19.6 million used for a business acquisition. Net cash used in investing activities for fiscal 2013 consisted of $48.5 million used for the purchase of capital assets and $5.0 million used for a business acquisition, partially offset by proceeds of $12.6 million for the sale of a building and land, as well as proceeds of $3.4 million from redemptions of ARS investments. Net cash used in investing activities for fiscal 2012 consisted of $14.6 million used for a business acquisition, $10.4 million used for the purchase of capital assets, partially offset by proceeds of $10.1 million from redemptions of ARS investments. Cash Flows from Financing Activities.Net cash provided by financing activities for fiscal 2014 was $18.6 million, and net cash used in financing for fiscal 2013 and 2012 was $14.3 million and $28.7 million, respectively. Our net cash provided by financing activities for fiscal 2014 was primarily attributable to $80.7 million of proceeds from common stock issued under our share-based compensation plans and $19.3 million of excess tax benefit from share-based compensation, partially offset by $70.3 million used to repurchase shares of our common stock in the open market, and $8.9 million used for the payment of payroll taxes for DSUs and MSUs. Our net cash used in financing activities for fiscal 2013 was primarily attributable to $46.3 million used to repurchase shares of our common stock in the open market, $4.7 million used for the payment of payroll taxes for DSUs, and $4.6 million used for the payment of contingent consideration, partially offset by $37.4 million of proceeds from common stock issued under our share-based compensation plans. Our net cash used in financing activities for fiscal 2012 was primarily attributable to $61.7 million used to repurchase shares of our common stock in the open market and $3.9 million used for the payment of payroll taxes for DSUs, partially offset by $34.9 million of proceeds from common stock issued under our share-based compensation plans. Common Stock Repurchase Program. In July 2014, our Board of Directors authorized the purchase of up to an additional $110.0 million of our common stock pursuant to our common stock repurchase program bringing the cumulative authorized total to $730.0 million, expiring in July 2016. The program authorizes us to purchase our common stock in the open market or in privately negotiated transactions, depending upon market conditions and other factors. The number of shares purchased and the timing of purchases is based on the level of our cash balances, general business and market conditions, and other factors, including alternative investment opportunities. Common stock purchased under this program is held as treasury stock. From April 2005 through the end of fiscal 2014, we repurchased 19,047,711 shares of our common stock in the open market for an aggregate cost of $530.4 million. Treasury shares purchased prior to August 28, 2008 were not subject to the stock split on that date if adjusted for the stock split, the average cost would be $22.48. As of July 2014, we had $199.6 million remaining under our common stock repurchase program. Bank Credit Facility. We currently maintain a $75.0 million working capital line of credit with Wells Fargo Bank. The Wells Fargo Bank revolving line of credit, which expires on September 1, 2014, provides for an interest rate equal to the prime lending rate or 150 basis points above LIBOR, depending on whether we choose a variable or fixed rate, respectively. We did not borrow any amounts under the line of credit during and subsequent to fiscal 2014. We are currently negotiating the replacement of this line of credit with a $300 million multi-bank five-year term loan and line of credit lead by Wells Fargo Bank. 42-------------------------------------------------------------------------------- Table of Contents $100 Million Shelf Registration. We have registered an aggregate of $100.0 million of common stock and preferred stock for issuance in connection with acquisitions, which shares generally will be freely tradeable after their issuance under Rule 145 of the Securities Act unless held by an affiliate of the acquired company, in which case such shares will be subject to the volume and manner of sale restrictions of Rule 144. Liquidity and Capital Resources. We believe our existing cash and cash equivalents and anticipated cash flows from operating activities will be sufficient to meet our working capital and other cash requirements of our existing business for at least the next 12 months, including our contingent consideration obligation associated with the acquisition of Validity. We are currently negotiating a $300 million aggregate multi-bank five-year term loan and line of credit lead by Wells Fargo Bank, to be used in part to finance our acquisition of RSP. Our future capital requirements will depend on many factors, including our revenue, the timing and extent of spending to support product development efforts, costs related to protecting our intellectual property, the expansion of sales and marketing activities, the timing of introductions of new products and enhancements to existing products, the costs to ensure access to adequate manufacturing capacity, the costs of maintaining sufficient space or renovating recently acquired building space for our expanding workforce, the continuing market acceptance of our product solutions, our common stock repurchase program, and the amount and timing of our investments in, or acquisitions of, other technologies or companies. Further equity or debt financing may not be available to us on acceptable terms or at all. If sufficient funds are not available or are not available on acceptable terms, our ability to take advantage of business opportunities or to respond to competitive pressures could be limited or severely constrained. Our non-current investments consist of ARS investments, which have failed to settle in auctions. These investments are not liquid, and in the event we need to access these funds, we will not be able to do so without a loss of principal, unless a future auction on these investments is successful. Based on our ability to access our cash and cash equivalents, our expected operating cash flows, and our other sources of cash, we do not anticipate that the lack of liquidity on these investments will affect our ability to operate our business as usual. Further, while we do not anticipate the need to remit undistributed earnings of our foreign subsidiaries to meet our working capital and other cash requirements, if we did remit such earnings we would be required to accrue and pay U.S. taxes to repatriate these funds, which would adversely impact our financial position and results of operations. Contractual Obligations and Commercial Commitments The following table sets forth a summary of our material contractual obligations and commercial commitments as of the end of fiscal 2014 (in millions): Payments due by period Less than 1-3 3-5 More than Contractual Obligations Total 1 year Years Years 5 Years Leases $ 13 $ 4 $ 5 $ 3 $ 1 Purchase obligations and other commitments (1) 108 58 50 - - Total $ 121 $ 62 $ 55 $ 3 $ 1 (1) Purchase obligations and other commitments include payments due under a building construction agreement, contingent consideration, long-term services agreement and inventory purchase obligations with contract manufacturers . In connection with the acquisition of Validity in November 2013, we entered into a contingent consideration arrangement. As of June 30, 2014, we may owe up to $146.2 million of additional cash consideration to the former Validity stockholders and option holders based on unit sales of products utilizing Validity technology through March 2016. The estimated fair value of the contingent consideration liability as of June 30, 2014 was $104.0 million. In connection with the acquisition of Pacinian in June 2012, we entered into a contingent consideration arrangement and subsequently paid $5.0 million of additional consideration to the former Pacinian stockholders upon customer acceptance of a ThinTouch product. As of June 30, 2014, we may owe up to $10.0 million of additional consideration to the former Pacinian stockholders based on unit sales of products utilizing ThinTouch technology through June 2016. The estimated fair value of the contingent consideration liability as of June 30, 2014 was $6.1 million. 43 -------------------------------------------------------------------------------- Table of Contents The amounts in the table above exclude unrecognized tax benefits of $10.2 million. As of June 30, 2014, we were unable to make a reasonably reliable estimate of when cash settlement with a taxing authority may occur in connection with our gross unrecognized tax benefit. Off-Balance Sheet Arrangements We do not have any transactions, arrangements, or other relationships with unconsolidated entities that are reasonably likely to materially affect our financial condition, revenues or expenses, results of operations, liquidity, or capital resources. We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support; engage in leasing, hedging, or research and development services; or have other relationships that expose us to liability that is not reflected in our financial statements. Recently Issued Accounting Pronouncements Not Yet Effective In July 2013, the Financial Accounting Standards Board, or the FASB, issued an accounting standards update on presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss carryforward, or a tax credit carryforward exists. The new standard requires that an unrecognized tax benefit should be presented as a reduction of deferred tax assets for a net operating loss carryforward, a similar tax loss carryforward, or a tax credit carryforward, if such carryforwards are required or expected to settle additional income taxes in the event the uncertain tax position is disallowed. The new standard also requires in situations carryforwards cannot be used or the deferred tax assets are not intended to be used for such purpose, that the unrecognized tax benefit should be recorded as a liability and should not be presented as a reduction of deferred tax assets. We are required to adopt this standard for our interim and annual periods in fiscal 2015. We are currently evaluating the impact of adopting this guidance, but do not expect it to have a material impact on our consolidated financial statements. In May 2014, the FASB issued an accounting standards update on Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new standard will replace most existing revenue recognition guidance in U.S. GAAP when the new standard becomes effective. The new standard is effective for us in our fiscal year 2018. Early application is not permitted. We are evaluating the effect the new standard will have on our consolidated financial statements and related disclosures. The new standard permits the use of either the retrospective or cumulative effect transition method. We have not yet selected a transition method or determined the effect of the standard on our ongoing financial reporting. 44-------------------------------------------------------------------------------- Table of Contents |