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PERICOM SEMICONDUCTOR CORP - 10-Q - : Management's Discussion and Analysis(Edgar Glimpses Via Acquire Media NewsEdge) of Financial Condition and Results of Operations Pericom Semiconductor CorporationThe following information should be read in conjunction with the unaudited financial statements and notes thereto included in Part 1 - Item 1 of this Quarterly Report and the audited financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended June 28, 2014 (the "Form 10-K"). Factors That May Affect Operating Results This Quarterly Report on Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. All statements other than statements of historical fact are "forward-looking statements" for purposes of these provisions, including any statements regarding our sales to Taiwan and China, the continuation of a high level of turns orders, higher or lower levels of inventory, future gross profit and gross margin; the plans and objectives of management for future operations; our tax rate; currency fluctuations; the adequacy of allowances for returns, price protection and other concessions; the sufficiency of cash generated from operations and cash balances; our exposure to interest rate risk; expectations regarding our research and development and selling, general and administrative expenses; and our possible future acquisitions and assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as "may," "will," "expects," "plans," "anticipates," "estimates," "potential," or "continue," or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to risks and uncertainties, including but not limited to the factors set forth (i) in Item 1A, Risk Factors, of Part II of this Form 10-Q, and (ii) in Note 1 to the Notes to Condensed Consolidated Financial Statements. All forward-looking statements and reasons why results may differ included in this Quarterly Report are made as of the date hereof, and we assume no obligation to update any such forward-looking statement or reason why actual results may differ. Executive Overview We design, develop and market high-performance integrated circuits and frequency control products used in many of today's advanced electronic systems. A few years ago, we embarked on a strategy to transform our business, as sales of our products used in personal computers and laptops declined with the transition to mobile devices such as tablets and smart phones where we had lower market shares. Our strategy was to increase sales from those market segments offering higher gross margins and growth potential, such as the ultramobility and embedded markets, including automotive. During the three months ended September 27, 2014, net sales increased 2% as compared with the three months ended September 28, 2013, with gains in the embedded, PC/notebook and server end market segments, partially offset by declines in the networking, telecom and ultramobility market segments. We increased gross profit for the three months ended September 27, 2014 to $14.1 million for an increase of $1.3 million from $12.8 million for the three months ended September 28, 2013, primarily due to improved product mix in both IC and FCP products. The resulting gross margin for the three months ended September 27, 2014 was 42.3%, a 300 basis point improvement, as compared to 39.3% for the three months ended September 28, 2013. Operating income was $2.2 million for the three months ended September 27, 2014, as compared with operating income of $76,000 for the three months ended September 28, 2013. Net income for the three months ended September 27, 2014 was $2.5 million, or $0.11 per diluted share as compared to a net income of $374,000 or $0.02 per share for the three months ended September 28, 2013. 20 -------------------------------------------------------------------------------- In summary, our progress in the execution of our market segment transition and gross margin expansion activities are evident in our financial results for the first quarter of fiscal 2015. Results of Operations The following table sets forth certain statement of operations data as a percentage of net revenues for the periods indicated. Three Months Ended September 27, September 28, 2014 2013 Net revenues 100.0 % 100.0 % Cost of revenues 57.7 % 60.7 % Gross profit 42.3 % 39.3 % Operating expenses: Research and development 13.8 % 15.5 % Selling, general and administrative 21.9 % 23.6 % Total 35.7 % 39.1 % Income from operations 6.6 % 0.2 % Interest and other income, net 3.8 % 1.5 % Income before income taxes 10.4 % 1.7 % Income tax expense 3.1 % 0.7 % Net income from consolidated companies 7.3 % 1.0 % Equity in net income of unconsolidated affiliates 0.1 % 0.1 % Net income 7.4 % 1.1 % Net Revenues The following table sets forth our revenues and the customer concentrations with respect to such revenues for the periods indicated. Three Months Ended (in thousands) September 27, September 28, % 2014 2013 Change Net revenues $ 33,259 $ 32,608 2.0 % % of net sales accounted for by top 5 direct customers (1) 52.0 % 47.0 % Number of direct customers that each account for more than 10% of net sales 2 2 % of net sales accounted for by top 5 end customers (2) 29.9 % 29.8 % Number of end customers that each account for more than 10% of net sales - 1 (1) Direct customers purchase products directly from us and include distributors, contract manufacturers and original equipment manufacturers ("OEMs"). (2) End customers are OEMs and their products are manufactured using our products. End customers may purchase directly from us or from distributors or contract manufacturers. For end customer data, we rely on information provided by our direct distribution and contract manufacturing customers. 21 -------------------------------------------------------------------------------- We design, develop and market high-performance integrated circuits ("ICs" or IC products) and frequency control products ("FCPs" or FCP products) used in many of today's advanced electronic systems. Our IC products include products that support the connectivity, timing and signal conditioning of high-speed parallel and serial protocols that transfer data among a system's microprocessor, memory and various peripherals, such as displays and monitors, and between interconnected systems. Our FCPs are electronic components that provide frequency references such as crystals, oscillators, and hybrid timing generation products for computer, communication and consumer electronic products. Our analog, digital and mixed-signal ICs, together with our FCP products enable higher system bandwidth and signal quality, resulting in better operating reliability, signal integrity, and lower overall system cost in applications such as notebook computers, servers, network switches and routers, storage area networks, digital TVs, cell phones, GPS and digital media players. Net revenues consist of product sales, which we generally recognize upon shipment, less an estimate for returns and allowances. Net revenues increased $651,000 or 2.0% in the first three months of fiscal 2015 versus the first three months of fiscal 2014. Net revenue for IC and FCP products in the first three months of fiscal 2015 versus the first three months of fiscal 2014 reflected: · an increase of $531,000 or 2.7% in sales of IC products to $20.2 million, and · an increase of $120,000 or 0.9% in sales of our FCP products to $13.1 million. The increase in sales of IC products was primarily driven by increased sales in the embedded, PC/notebook and server end market segments. The following table sets forth net revenues by country as a percentage of total net revenues for the three months ended September 27, 2014 and September 28, 2013: Three Months Ended September 27, September 28, 2014 2013 China (including Hong Kong) 49 % 46 % Taiwan 32 % 30 % United States 4 % 6 % Other (less than 10% each) 15 % 18 % Total 100 % 100 % Over the past several years, sales to China and Taiwan have constituted the majority of our sales. We expect this trend will continue in the future. Our net revenue levels have been highly dependent on the number of new orders that are received for products to be delivered to the customer within the same quarter, also called "turns" orders. Because of our lack of visibility into demand when turns orders are high, it is difficult to predict which products to build to match future demand. We believe the current high level of turns orders will continue indefinitely. The sustainability of customer demand is uncertain and our markets are highly dependent on worldwide economic conditions. The high level of turns orders together with the uncertainty of product mix and pricing makes it difficult to predict future levels of sales and may require us to carry higher levels of inventory. 22 --------------------------------------------------------------------------------Gross Profit The following table sets forth our gross profit for the periods indicated: Three Months Ended September 27, September 28, % (in thousands) 2014 2013 Change Net revenues $ 33,259 $ 32,608 2.0 % Gross profit 14,080 12,808 9.9 % Gross profit as a percentage of net revenues (gross margin) 42.3 % 39.3 % The increase in gross profit in the first three months of fiscal 2015 as compared to the first three months of fiscal 2014 of $1.3 million is the result of: · a 2.0% increase in sales, which led to $276,000 of increased gross profit, and · a gross margin increase from 39.3% to 42.3%, resulting in a $996,000 improvement in gross profit. The sales increase was discussed above. The gross margin increase resulted primarily from our initiative to focus on higher-margin opportunities in server, storage, networking, telecom and embedded market segments, as well as increased sales mix of crystal oscillator products. Future gross profit and gross margin are highly dependent on the level and product mix of net revenues. This includes the mix of sales between lower margin FCP products and our higher margin IC products. Although we have been successful at favorably improving our integrated circuit product mix and penetrating new end markets, there can be no assurance that this will continue. Accordingly, we are not able to predict future gross profit levels or gross margins with certainty. During the three months ended September 27, 2014 and September 28, 2013, gross profit and gross margin benefited as a result of the sale of inventory of $88,000 and $108,000 respectively, that we had previously identified as excess and written down to zero value. Research and Development ("R&D") Three Months Ended September 27, September 28, % (in thousands) 2014 2013 Change Net revenues $ 33,259 $ 32,608 2.0 % Research and development 4,588 5,045 -9.1 % R&D as a percentage of net revenues 13.8 % 15.5 % Research and development expenses consist primarily of costs related to personnel and overhead, non-recurring engineering charges, and other costs associated with the design, prototyping, testing, manufacturing process design support, and technical customer applications support of our products. The expense decrease of $457,000 for the three month period ended September 27, 2014 as compared to the same period of the prior year included decreases of $337,000 in total compensation expenses including stock-based compensation and $116,000 in depreciation expenses. We believe that continued spending on research and development to develop new products and improve manufacturing processes is critical to our long-term success, and as a result we expect to continue to invest in research and development projects. In the short term, we intend to continue to focus on cost control as business conditions improve. If business conditions deteriorate or the rate of improvement does not meet our expectations, we may implement further cost-cutting actions. 23 --------------------------------------------------------------------------------Selling, General and Administrative ("SG&A") Three Months Ended September 27, September 28, % (in thousands) 2014 2013 Change Net revenues $ 33,259 $ 32,608 2.0 % Selling, general and administrative 7,300 7,687 -5.0 % SG&A as a percentage of net revenues 21.9 % 23.6 % Selling, general and administrative expenses consist primarily of personnel and related overhead costs for sales, marketing, finance, administration, human resources and general management. The expense decrease of approximately $387,000 for the three month period ended September 27, 2014 as compared to the same period of the prior year is attributable primarily to the incurrence in the prior year quarter of $558,000 in lease restructuring and moving costs related to the relocation of corporate headquarters and $215,000 in reduced rent and utilities expenditures in the three months ended September 27, 2014, partially offset by increased expenditures of $205,000 for sales commissions and $181,000 for increases in legal and payroll services. We anticipate that selling, general and administrative expenses will increase in future periods over the long term due to increased staffing levels, particularly in sales and marketing, as well as increased commission expense to the extent we achieve higher sales levels. We intend to continue our focus on controlling costs. If business conditions deteriorate or the rate of improvement does not meet our expectations, we may implement further cost-cutting actions. Interest and Other Income, Net Three Months Ended September 27, September 28, % (in thousands) 2014 2013 Change Interest income $ 647 $ 635 1.9 % Other income (expense) 44 47 -6.4 % Foreign exchange transaction gain (loss) 583 (196 ) NM Interest and other income, net $ 1,274 $ 486 162.1 % NM = not meaningful Interest and other income for the three month period ended September 27, 2014 increased $788,000 as compared with the same period of the prior year due primarily to a swing from foreign exchange transaction losses last year to foreign exchange transaction gains in the current quarter with the principal impact coming from the strengthening U.S. dollar against the New Taiwan Dollar. Income Tax Expense Three Months Ended September 27, September 28, % (in thousands) 2014 2013 Change Pre-tax income $ 3,466 $ 562 516.7 % Income tax expense 1,010 231 337.2 % Effective tax rate 29.1 % 41.1 % 24 -------------------------------------------------------------------------------- The difference in the effective tax rate for the three months ended September 27, 2014 as compared with the same period of the prior year is due primarily to the allocation of earnings between different tax jurisdictions and the inability to utilize losses in certain non-includable entities. Our effective tax rate differs from the federal statutory rate primarily due to state income taxes, the effect of foreign income tax and foreign losses, stock-based compensation from equity grants, and the utilization of research and development tax credits. Equity in Net Income of Unconsolidated Affiliate Equity in net income of unconsolidated affiliate consists of our allocated portion of the net income of Jiyuan Crystal Photoelectric Frequency Technology Ltd. ("JCP"), an FCP manufacturing company located in Science Park of Jiyuan City, Henan Province, China. JCP is a key manufacturing partner of PSE-TW, and PSE-TW has acquired a 49% equity interest in JCP. For the three month periods ended September 27, 2014 and September 28, 2013, the Company's allocated portion of JCP's results was income of $39,000 and $43,000, respectively. Liquidity and Capital Resources As of September 27, 2014, our principal sources of liquidity included cash, cash equivalents and short-term investments of approximately $123.8 million as compared with $119.1 million on June 28, 2014. Our investment in debt securities includes government securities, corporate debt securities and mortgage-backed and asset-backed securities. Government securities include US treasury securities, US federal agency securities, foreign government and agency securities, and US state and municipal bond obligations. Many of the municipal bonds are insured; those that are not are nearly all AAA/Aaa rated. The corporate debt securities are all investment grade and nearly all are single A-rated or better. The asset-backed securities are AAA/Aaa rated and are backed by auto loans, student loans, credit card balances and residential or commercial mortgages. Most of our mortgage-backed securities are collateralized by prime residential mortgages issued by government agencies including FNMA, FHLMC and FHLB. Those issued by banks are AAA-rated. At September 27, 2014, unrealized gains on marketable securities net of taxes were $73,000. When assessing marketable securities for other than temporary declines in value, we consider a number of factors. Our analyses of the severity and duration of price declines, portfolio manager reports, economic forecasts and the specific circumstances of issuers indicate that it is reasonable to expect marketable securities with unrealized losses at September 27, 2014 to recover in fair value up to our cost bases within a reasonable period of time. We have the ability and intent to hold investments with unrealized losses until maturity, when the obligors are required to redeem them at full face value or par, and we believe the obligors have the financial resources to redeem the debt securities. Accordingly, we do not consider our investments to be other than temporarily impaired at September 27, 2014. As of September 27, 2014, $27.6 million was classified as cash and cash equivalents compared with $33.0 million as of June 28, 2014. The maturities of our short term investments are staggered throughout the year so that cash requirements are met. Because we are a fabless semiconductor manufacturer, we have lower capital equipment requirements than other semiconductor manufacturers who own wafer fabrication facilities. For the three month period ended September 27, 2014, we spent approximately $1.1 million on property and equipment, compared to $1.2 million for the three month period ended September 28, 2013. We generated approximately $647,000 of interest income for the three month period ended September 27, 2014, as compared with $635,000 of interest income for the three month period ended September 28, 2013. In the longer term we may generate less interest income if our total invested balance decreases and these decreases are not offset by rising interest rates or increased cash generated from operations or other sources. Our net cash provided by operating activities of $7.1 million for the three months ended September 27, 2014 was primarily the result of $2.5 million of net income and the addition of non-cash expenses of $2.3 million in depreciation and amortization, $709,000 of share-based compensation expense, $301,000 from write off of equipment and $293,000 of tax benefit from share-based transactions, partially offset by deductions of $29,000 of excess tax benefit from share-based transactions and $39,000 of equity in net income of unconsolidated affiliate. An additional contribution to cash included reductions of $370,000 in inventories and $1.4 million in prepaid expenses and other current assets, and an increase of $371,000 in accounts payable. Such contributions were partially offset by increases of $1.0 million in accounts receivable. Our net cash provided by operating activities was $47,000 in the three months ended September 28, 2013. 25 --------------------------------------------------------------------------------Our cash used in investing activities of $11.6 million for the three months ended September 27, 2014 was the result of purchases of available for sale investments exceeding sales and maturities of available for sale investments by approximately $10.4 million, and additions to property and equipment of approximately $1.1 million. Our cash used in investing activities was $5.3 million for the three months ended September 28, 2013. Our cash used in financing activities for the three months ended September 27, 2014 of $775,000 was the result of expenditures of $2.3 million for the repurchase of our common stock, partially offset by $1.5 million of proceeds from common stock issuance under stock plans. Our cash used in financing activities was $765,000 for the three months ended September 28, 2013. A portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we may evaluate potential acquisitions of such businesses, products or technologies. Our long-term future capital requirements will depend on many factors, including our level of revenues, the timing and extent of spending to support our product development efforts, the expansion of sales and marketing efforts, the timing of our introductions of new products, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products. We could be required, or could elect, to seek additional funding through public or private equity or debt financing and additional funds may not be available on terms acceptable to us or at all. We believe our current cash balances and cash flows generated by operations will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures. Contractual Obligations and Commitments Our contractual obligations and commitments at September 27, 2014 are as follows: Payments Due by Period Less than (in thousands) Total 1 Year 1 - 3 Years Thereafter Operating lease payments $ 491 $ 423 $ 68 $ - Capital equipment purchase obligations 216 216 - - Facility modifications 303 238 65 - Total obligations $ 1,010 $ 877 $ 133 $ - The operating lease commitments are primarily facility leases at our various Asian subsidiaries. The facility modification commitments have been made by our Shandong, China manufacturing operation for a general contractor and architecture firm to develop feasibility studies, plans and cost estimates for potential additional development of our plant site. We have no other purchase obligations beyond routine purchase orders as of September 27, 2014. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements, defined by Regulation S-K Item 303(a)(4). 26 --------------------------------------------------------------------------------Critical Accounting Policies Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of such statements requires us to make estimates and assumptions that affect the reported amounts of revenues and expenses during the reporting period and the reported amounts of assets and liabilities as of the date of the financial statements. Our estimates are based on historical experience and other assumptions that we consider to be reasonable given the circumstances. Actual results may vary from our estimates. The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. The Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results of operations, and require us to make our most difficult and subjective accounting judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, our most critical accounting policies include revenue recognition and accounts receivable allowances, which impact the recording of revenues; valuation of inventories, which impacts costs of goods sold and gross margins; accounting for income taxes, which impacts the income tax provision and net income; impairment of intangible assets and investments, which impacts the intangible asset and investment accounts; and stock-based compensation, which impacts costs of goods sold and operating expenses. These policies and the estimates and judgments involved are discussed further below. REVENUE RECOGNITION. We recognize revenue from the sale of our products upon shipment, provided title and risk of loss has passed to the customer, the price is fixed or determinable and collection of the revenue is reasonably assured. A provision for estimated future returns and other charges against revenue is recorded at the time of shipment. For the three months ended September 27, 2014, the majority of our revenues were from sales to distributors. We sell products to large, domestic distributors at the price listed in our price book for that distributor. We recognize revenue at the time of shipment. At the time of sale we record a sales reserve for ship from stock and debits ("SSD"s), stock rotations, return material authorizations ("RMA"s), authorized price protection programs, and any special programs approved by management. The sales reserve is offset against revenues, which then leads to the net revenue amount reported. The market price for our products can be significantly different from the book price at which the product was sold to the distributor. When the market price, as compared with the book price, of a particular sales opportunity from the distributor to their customer would result in low or negative margins to the distributor, a ship from stock and debit is negotiated with the distributor. SSD history is analyzed and used to develop SSD rates that form the basis of the SSD sales reserve recorded each period. We capture these historical SSD rates from our historical records to estimate the ultimate net sales price to the distributor. Our distribution agreements provide for semi-annual stock rotation privileges of typically 10% of net sales for the previous three-month period. The contractual stock rotation applies only to shipments at book price. Asian distributors typically buy our product at less than book price and therefore are not entitled to the 10% stock rotation privilege. In order to provide for routine inventory refreshing, for our benefit as well as theirs, we grant Asian distributors stock rotation privileges between 1% and 10% even though we are not contractually obligated to do so. Each month a sales reserve is recorded for the estimated stock rotation privilege anticipated to be utilized by the distributors that month. This reserve is the sum of product of each distributor's net sales for the month and their stock rotation percentage. From time to time, customers may request to return parts for various reasons including the customers' belief that the parts are not performing to specification. Many such return requests are the result of customers incorrectly using the parts, not because the parts are defective. These requests are reviewed by management and when approved result in a RMA being established. We are only obligated to accept returns of defective parts. For customer convenience, we may approve a particular return request even though we are not obligated to do so. Each month a sales reserve is recorded for the approved RMAs that have not yet been returned. We do not keep a general warranty reserve because historically valid warranty returns, which are the result of a part not meeting specifications or being non-functional, have been immaterial and parts can frequently be re-sold to other customers for use in other applications. Price protection is granted solely at the discretion of our management. The purpose of price protection is to reduce the distributor's cost of inventory as market prices fall, thus reducing SSD rates. Our sales management prepares price protection proposals for individual products located at individual distributors. Our general management reviews these proposals and if a particular price protection arrangement is approved, the dollar impact will be estimated based on the book price reduction per unit for the products approved and the number of units of those products in the distributor's inventory. A sales reserve is then recorded in that period for the estimated amount. 27 -------------------------------------------------------------------------------- At the discretion of our management, we may offer rebates on specific products sold to specific end customers. The purpose of the rebates is to allow for pricing adjustments for large programs without affecting the pricing we charge our distributor customers. The rebate is recorded at the time of shipment. Customers are typically granted payment terms of between 30 and 60 days and they generally pay within those terms. Relatively few customers have been granted terms with cash discounts. Distributors are invoiced for shipments at book price. When they pay those invoices, they claim debits for SSDs, stock rotations, cash discounts, RMAs and price protection when appropriate. Once claimed, these debits are then processed against the approvals. The revenue we record for sales to our distributors is net of estimated provisions for these programs. When determining this net revenue, we must make significant judgments and estimates. Our estimates are based on historical experience rates, inventory levels in the distribution channel, current trends and other related factors. However, because of the inherent nature of estimates, there is a risk that there could be significant differences between actual amounts and our estimates. Our financial condition and operating results depend on our ability to make reliable estimates and management believes such estimates are reasonable. PRODUCT WARRANTY. We offer a standard one-year product replacement warranty. In the past we have not had to accrue for a general warranty reserve, but assess the level and materiality of RMAs and we then determine whether it is appropriate to accrue for estimated returns of defective products at the time revenue is recognized. On occasion, we may determine to accept product returns beyond the standard one-year warranty period. In those instances, we accrue for the estimated cost at the time the decision to accept the return is made. As a consequence of our standardized manufacturing processes and product testing procedures, returns of defective product are infrequent and the quantities have not been significant. Accordingly, historical warranty costs have not been material. SHIPPING COSTS. Shipping costs are charged to cost of revenues as incurred. INVENTORIES. Inventories are recorded at the lower of standard cost (which generally approximates actual cost on a first-in, first-out basis) or market value. We adjust the carrying value of inventory for excess and obsolete inventory based on inventory age, shipment history and our forecast of demand over a specific future period of time. Raw material inventory is considered obsolete and reserved if it has not moved in 365 days. We review our assembled devices for excess and write them off if the quantity of assembled devices in inventory is in excess of the greater of the quantity shipped in the previous twelve months, the quantity in backlog or the quantity forecasted to be shipped in the following twelve months. In certain circumstances, we will determine, based on expected usage or other factors, that inventory considered obsolete by these guidelines should not be written off. We occasionally determine that the last twelve months' sales levels will not continue and reserve inventory in line with the quantity forecasted. The semiconductor markets that we serve are volatile and actual results may vary from our forecast or other assumptions, potentially impacting our assessment of excess and obsolete inventory and resulting in material effects on our gross margin. IMPAIRMENT OF INTANGIBLE ASSETS. We perform an impairment review of our intangible assets at least annually and more frequently if certain indicators of impairment are present. In the event that management determines that the value of intangible assets has become impaired, we will record an expense for the amount impaired during the fiscal quarter in which the determination is made. Based on the results of our most recent impairment review, we determined that no impairment of our intangible assets existed as of September 27, 2014. However, future impairment reviews could result in a charge to earnings. INVESTMENTS. We have made investments including loans, bridge loans convertible to equity, or asset purchases as well as direct equity investments. These loans and investments are made with strategic intentions and have been in privately held technology companies, which by their nature are high risk. These investments are included in other assets in the balance sheet and are carried at the lower of cost, or market if the investment has experienced an other-than-temporary decline in value. We monitor these investments quarterly and make appropriate reductions in carrying value if a decline in value is deemed to be other than temporary. 28 -------------------------------------------------------------------------------- DEFERRED TAX ASSETS. Our deferred income tax assets represent temporary differences between the financial statement carrying amount and the tax basis of existing assets and liabilities that will result in deductible amounts in future years, including net operating loss carryforwards. Based on estimates, the carrying value of our net deferred tax assets assumes that it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions. Our judgments regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. If, in the future, we experience losses for a sustained period of time, we may not be able to conclude that it is more likely than not that we will be able to generate sufficient future taxable income to realize our deferred tax assets. If this occurs, we may be required to increase the valuation allowance against the deferred tax assets resulting in additional income tax expense. 29 -------------------------------------------------------------------------------- |