PHOTRONICS: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL POSITION AND RESULTS OF OPERATIONS (Form 10-Q)
The Management’s Discussion and Analysis (“MD&A”) of the financial condition, results of operations and prospects of the Company should be read in conjunction with its condensed consolidated financial statements and accompanying notes. Various segments of this MD&A contain forward-looking statements, all of which are presented based on current expectations, which may be affected by uncertainties and risk factors (presented throughout this filing and in Form 10-K of the Company for fiscal 2020), which may cause actual results to differ materially from those expectations.
We sell substantially all of our photomasks to semiconductor designers and manufacturers, and manufacturers of FPDs. Photomask technology is also being applied to the fabrication of other higher-performance electronic products such as photonics, microelectronic mechanical systems and certain nanotechnology applications. Our selling cycle is tightly interwoven with the development and release of new semiconductor and display designs and applications, particularly as they relate to the semiconductor industry's migration to more advanced product innovation, design methodologies, and fabrication processes. The demand for photomasks primarily depends on design activity rather than sales volumes from products manufactured using photomask technologies. Consequently, an increase in semiconductor or display sales does not necessarily result in a corresponding increase in photomask sales. However, the reduced use of customized ICs, reductions in design complexity, other changes in the technology or methods of manufacturing or designing semiconductors, or a slowdown in the introduction of new semiconductor or display designs could reduce demand for photomasks - even if the demand for semiconductors and displays increases. Advances in semiconductor, display, and photomask design and production methods that shift the burden of achieving device performance away from lithography could also reduce the demand for photomasks. Historically, the microelectronic industry has been volatile, experiencing periodic downturns and slowdowns in design activity. These negative trends have been characterized by, among other things, diminished product demand, excess production capacity, and accelerated erosion of selling prices, with a concomitant effect on revenue and profitability. We are typically required to fulfill customer orders within a short period of time after receipt of an order, sometimes within twenty-four hours. This results in a minimal level of backlog orders, typically one to two weeks of backlog for IC photomasks and two to three weeks of backlog for FPD photomasks. The global semiconductor and FPD industries are driven by end markets which have been closely tied to consumer-driven applications of high-performance devices, including, but not limited to, mobile display devices, mobile communications, and computing solutions. While we cannot predict the timing of the industry's transition to volume production of next-generation technology nodes, or the timing of up and down-cycles with precise accuracy, we believe that such transitions and cycles will continue into the future, beneficially and adversely affecting our business, financial condition, and operating results as they occur. We believe our ability to remain successful in these environments is dependent upon the achievement of our goals of being a service and technology leader and efficient solutions supplier, which we believe should enable us to continually reinvest in our global infrastructure.
In the second quarter of fiscal 2021, we entered into a five-year
$7.2 millionfinance lease for a high-end inspection tool. Monthly payments on the lease, which commenced in February 2021, are $0.1 millionper month. Upon the payment of the fiftieth monthly payment and prior to payment of the fifty-first monthly payment, we may exercise an early buyout option to purchase the tool at 33.684638% of its original cost. If we do not exercise the early buyout option, then at the end of the five-year lease term, the lease shall continue to renew on a month-to-month basis at the same rental terms; at our option, after the original term or any renewal periods, we may return the tool, elect to extend the lease, or purchase the tool at its fair market value. Since we are reasonably certain that we will exercise the early buyout option, our lease liability reflects such exercise and we have classified the lease as a finance lease. The interest rate implicit in the lease is 1.08%. 26 -------------------------------------------------------------------------------- Table of Contents In the first quarter of fiscal 2021, we entered into a five-year $35.5 millionfinance lease for a high-end lithography tool. Monthly payments on the lease, which commenced in January 2021, increased from $0.04 millionafter the first three months to $0.6 millionfor the following nine months, followed by forty-eight monthly payments of $0.5 million. As of the due date of the forty-eighth monthly payment, we may exercise an early buyout option to purchase the tool at 39.84% of the initial lease liability. If we do not exercise the early buyout option, then at the end of the five-year lease term, at our option, we may return the tool, elect to extend the lease term for a period and a lease payment to be agreed with lessor at the time, or purchase the tool for its then-fair market value as determined by the lessor. Since we are reasonably certain that we will exercise the early buyout option, our lease liability reflects such exercise and we have classified the lease as a finance lease. The interest rate implicit in the lease is 1.58%. The lease agreement incorporates the covenants included in our Corporate Credit Agreement, which are detailed in Note 6, and includes a cross-default provision for any agreement or instrument with an outstanding, committed balance greater than $5.0 millionin which we are the indebted party.
For more information, see section 7 of our Form 10-K for the year ended.
Results of Operations
Three and nine months over
The following table presents certain operating information expressed as a percentage of sales. Columns may not work due to rounding.
Three Months Ended Nine Months Ended August 1, May 2, August 2, August 1, August 2, 2021 2021 2020 2021 2020 Revenue 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Cost of goods sold 73.4 75.4 76.1 76.1 77.7 Gross profit 26.6 24.6 23.9 23.9 22.3 Selling, general and administrative expenses 8.8 8.8 8.4 9.0 8.9 Research and development expenses 3.1 2.7 2.9 3.0 2.8 Other operating income, net 2.1 - - 0.7 - Operating income 16.7 13.0 12.6 12.7 10.6 Other non-operating income (expense), net 2.2 (0.5 ) (1.3 ) 0.8 0.2 Income before income tax provision 18.9 12.5 11.3 13.4 10.8 Income tax provision 4.6 2.3 3.2 3.0 3.9 Net income 14.3 10.2 8.1 10.4 6.9 Net income attributable to noncontrolling interests 4.3 3.6 1.3 1.1 3.0 1.0 Net income attributable to Photronics, Inc. shareholders 10.0 % 6.6 % 6.8 % 7.4 % 5.9 % Note: All tabular comparisons included in the following discussions, unless otherwise indicated, are for the three months ended
August 1, 2021(Q3 FY21), May 2, 2021(Q2 FY21) and August 2, 2020(Q3 FY20), and for the nine months ended August 1, 2021(YTD FY21) and August 2, 2020(YTD FY20), in millions of dollars. The columns may not foot due to rounding.
Our quarterly revenues can be affected by the seasonal purchasing practices of our customers. As a result, demand for our products is typically reduced during the first quarter of our fiscal year, by the North American, European, and Asian holiday periods, as some of our customers reduce their development and, consequently, their buying activities during those periods. 27 -------------------------------------------------------------------------------- Table of Contents The following tables present changes in disaggregated revenue in Q3 FY21 and YTD FY21 from revenue in prior reporting periods.
Evolution of revenues by type of product
Q3 FY21 from Q2 FY21 Q3 FY21 from Q3 FY20 YTD FY21 from YTD FY20 Revenue in Increase Percent Increase Percent Revenue in Increase Percent Q3 FY21 (Decrease) Change (Decrease) Change YTD FY21 (Decrease) Change IC High-end *
$ 42.4 $ 1.12.6 % $ 3.79.5 % $ 120.4 $ 2.42.0 % Mainstream 75.4 4.7 6.6 % 5.4 7.7 % 214.3 19.8 10.2 % Total IC $ 117.8 $ 5.85.2 % $ 9.18.4 % $ 334.7 $ 22.27.1 % FPD High-end * $ 40.6 $ 1.23.1 % $ 4.010.8 % $ 114.7 $ 6.45.9 % Mainstream 12.2 3.9 46.1 % (0.3 ) (2.6 )% 33.1 (6.6 ) (16.6 )% Total FPD $ 52.9 $ 5.110.7 % $ 3.67.4 % $ 147.8 $ (0.2 )(0.1 )% Total Revenue $ 170.6 $ 10.96.8 % $ 12.78.1 % $ 482.5 $ 22.14.8 %
* High-end photomasks generally have higher Average Sales Prices (ASP) than consumer products.
Evolution of revenues by geographic area **
Q3 FY21 from Q2 FY21 Q3 FY21 from Q3 FY20 YTD FY21 from YTD FY20 Revenue in Increase Percent Increase Percent Revenue in Increase Percent Q3 FY21 (Decrease) Change (Decrease) Change YTD FY21 (Decrease) Change Taiwan
$ 63.8 $ 4.88.2 % $ 3.05.0 % $ 179.4 $ (3.0 )(1.7 )% Korea 39.6 (0.7 ) (1.7 )% 0.1 0.2 % 118.6 2.1 1.8 % United States 24.7 (2.5 ) (9.0 )% (3.7 ) (12.9 )% 78.4 0.2 0.2 % China 32.7 8.9 37.6 % 11.7 55.6 % 77.4 19.0 32.6 % Europe 9.4 0.2 2.0 % 1.7 22.8 % 27.3 3.7 15.7 % Other 0.4 0.0 10.1 % (0.1 ) (21.9 )% 1.3 0.1 6.7 % Total Revenue $ 170.6 $ 10.96.8 % $ 12.78.1 % $ 482.5 $ 22.14.8 %
** This table breaks down income according to where it was earned.
Changes in revenue from products shipped to customers in
Q3 FY21 from Q2 FY21 Q3 FY21 from Q3 FY20 YTD FY21 from YTD FY20 Revenue in Increase Percent Increase Percent Revenue in Increase Percent Q3 FY21 (Decrease) Change (Decrease) Change YTD FY21 (Decrease) Change IC
$ 34.5 $ 3.09.5 % $ 10.946.3 % $ 91.6 $ 21.430.5 % FPD 28.1 2.3 8.8 % 0.6 2.0 % 77.9 (8.4 ) (9.8 )% Total $ 62.6 $ 5.39.2 % $ 11.522.5 % $ 169.4 $ 13.08.3 % 28
-------------------------------------------------------------------------------- Table of Contents Revenue in Q3 FY21 of
$170.6 millionrepresents an increase of 6.8% compared to Q2 FY21 and 8.1% from Q3 FY20; on a year-to-date basis, revenue increased 4.8% to $482.5 million, due to increased demand in both IC and FPD, as a robust design environment led to growing photomask demand across our markets. IC revenue increased 5.2% in Q3 FY21, compared with Q2 FY21, 8.4% compared with Q3 FY20, and 7.1% on a year-to-date basis, mainly attributable to continued growth in mainstream on strong demand driven by node migrations, as our customers have looked to take advantage of lower device-lifetime cost and better performance. This positive demand factor has enabled us to realize pricing benefits in Asiaon some nodes. High-end revenue growth was driven by strong logic demand, especially in Taiwanand China. In addition, captive photomask operations continue to dedicate more of their capacity to EUV production, resulting in the increased outsourcing of their non-EUV production to merchant photomask suppliers. FPD revenue increased 10.7% in Q3 FY21, compared with Q2 FY21, driven by increased demand for high-end AMOLED displays used in mobile applications, new designs for G10.5+ panel manufacturing, and mainstream growth as a result of recent capacity expansions. FPD revenue increased 7.4% in Q3 FY21, compared with Q3 FY20, due to increased high-end, driven by growth in AMOLED displays for mobile applications. On a year-to-date basis, FPD revenues were essentially flat when compared to the same period last year, as increased high-end was offset by a decline in mainstream, driven by an increase in AMOLED demand for mobile displays being offset by a weak LCD market. Gross Margin Percent Percent Percent Q3 FY21 Q2 FY21 Change Q3 FY20 Change YTD FY21 YTD FY20 Change Gross profit $ 45.3 $ 39.215.5 % $ 37.720.1 % $ 115.1 $ 102.812.0 % Gross margin 26.6 % 24.6 % 23.9 % 23.9 % 22.3 % Gross margin increased by 2.0 percentage points in Q3 FY21, from Q2 FY21, as a result of the increase in revenue from the prior quarter and higher pricing for certain mainstream IC nodes. Material costs increased 4.3% from the prior quarter, but decreased as a percentage of revenue by 70 basis points. Labor costs increased 3.2% but, as a percentage of revenue, fell 40 basis points. Equipment and other overhead costs increased 4.0%, but decreased 90 basis points as a percentage of revenue, with higher outsourced manufacturing costs most significantly contributing to the cost increase. Gross margin increased by 2.7 percentage points in Q3 FY21, from Q3 FY20, as a result of the increase in revenue from the prior year quarter and higher pricing for certain mainstream IC nodes. Material costs increased 4.2% from the prior year quarter, with the largest increase occurring at our China-based FPD facility, where the increase was in line with that facility's increased revenue. Globally, material costs, as a percentage of revenue, decreased 110 basis points. Labor costs increased 9.1% from the prior year quarter, but only represented a 10 basis point increase as a percent of revenue, while equipment and other overhead costs rose moderately at 2.8%, but fell 170 basis points as a percentage of revenue. Increased equipment service contract and equipment maintenance costs were the most significant contributor to the rise in equipment and other overhead costs. Gross margin increased by 1.6 percentage points in YTD FY21, from YTD FY20, primarily as a result of the increase in revenue from the prior year period and higher pricing for certain mainstream IC nodes. Material costs increased 3.5% from the prior year period, with a notable increase occurring at our China-based IC facility, where the increase was in line with that facility's increased revenue. Globally, material costs decreased 40 basis points as a percentage of revenue. Labor costs increased 10.7% from the prior year, but only 70 basis points when compared to revenue. Equipment and other overhead costs decreased by 0.4%, or 180 basis points as a percentage of revenue, with reduced outsourced manufacturing costs most significantly contributing to the decline. 29 -------------------------------------------------------------------------------- Table of Contents As we operate in a high fixed cost environment, increases or decreases in our revenues and capacity utilization will generally positively or negatively impact our gross margin.
Selling, general and administrative expenses
Selling, general and administrative expenses were
$15.1 millionin Q3 FY21, an increase of $1.0 millionfrom Q2 FY21, and an increase of $1.8 millionfrom Q3 FY20. The increases are primarily the result of increased compensation costs. Selling, general and administrative expenses were $43.2 millionin YTD FY21, as compared with $40.8 millionin YTD FY20, with the increase primarily being the result of increased compensation costs.
Research and development costs
Research and development expenses, which primarily consist of development and qualification efforts related to high-end process technologies for high-end IC and FPD applications, were
$5.3 millionin Q3 FY21, compared with $4.4 millionin Q2 FY21 and $4.5 millionin Q3 FY20. Increased development activities in the U.S.was the primary driver of the increases from both comparative periods, with decreased expenses at our China-based FPD facility partially offsetting the increase from the prior year period. On a year-to-date basis, research and development expenses increased $1.4 million, primarily due to an increase in development activities in the U.S.exceeding a decline in such activities at our China-based FPD facility. Other Operating Income, Net
In the third quarter of fiscal 2021, we recorded a
Other non-operating income (expenses)
Q3 FY21 Q2 FY21 Q3 FY20
cumulative over fiscal year 21 over fiscal year 20
Foreign currency transactions impact, net
$ 4.3 $ (2.1 ) $ (1.6 ) $ 3.6 $ 1.7Interest expense, net (1.1 ) 1.2 (0.6 ) (0.6 ) (1.6 ) Interest income and other income (expense), net 0.5 - - 0.7 0.5
Other income (expenses), net
Other income and expense changed favorably from a loss of
$0.8 millionin Q2 FY21 to income of $3.7 millionin Q3 FY21, primarily as a result of favorable foreign currency exchange movements in Koreaand Taiwanagainst the U.S.dollar. An unfavorable change in interest expense of $2.3 millionwas primarily the result of subsidies (which we recognize at the time of their receipt) we received in Chinain Q2 FY21, the occurrence which was not repeated in Q3 FY21, which partially offset the $6.4 millionnet favorable impact of foreign currency movements. The increase of $0.5 millionin Interest income and other income (expense), net is primarily due to the receipt of a $0.4 millionsubsidy in China. Other income and expense, net changed favorably from a loss of $2.1 millionin Q3 FY20 to income of $3.7 millionin Q3 FY21. The $5.9 millionpositive impact of foreign currency movements was primarily due to favorable movements against the U.S.dollar in Koreaand Taiwan. Increased interest expense of $0.5 millionfrom the prior year quarter reflects our increased average debt level in Q3 FY21. The increase of $0.5 millionin Interest income and other income (expense), net is primarily due to the receipt of a $0.4 millionsubsidy in China. 30
Other income and expense, net changed favorably from net other income of
$0.6 millionin YTD FY20 to net other income of $3.6 millionin YTD FY21. The $1.9 millionpositive impact of foreign currency movements was primarily caused by favorable movements against the U.S.dollar and the Japanese yen in China, which were partially offset by unfavorable movements against the U.S.dollar in Koreaand Taiwan. Interest expense decreased, on a year-to-date basis by $1.0 million, as result of subsidies we received on our debt in China, which we recognize at the time of their receipt. Income Tax Provision Q3 FY21 Q2 FY21 Q3 FY20 YTD FY21 YTD FY20 Income tax provision $ 7.8 $ 3.7 $ 4.9 $ 14.5 $ 17.8Effective income tax rate 24.4 % 18.5 % 27.7 % 22.4 % 35.9 % The effective income tax rate is sensitive to the jurisdictional mix of earnings, due, in part, to the non-recognition of tax benefits on losses in jurisdictions with valuation allowances. The effective income tax rate increase in Q3 FY21, compared with Q2 FY21, is primarily due to changes in the period-to-period mix of jurisdictional earnings.
The decrease in the effective tax rate in Q3 of FY21, compared to Q3 of FY20, is mainly due to the advantages of investment loans in certain
jurisdictions in the third quarter of FY21, as well as changes in the distribution of income by jurisdiction.
The effective income tax rate decreased in YTD FY21, compared with YTD FY20, primarily due to the establishment of a valuation allowance for a loss carryforward in a non-
U.S.jurisdiction in YTD-FY20, as well as changes in the jurisdictional mix of earnings.
Net income attributable to non-controlling interests
Net income attributable to noncontrolling interests was
$7.3 millionin Q3 FY21, compared with $5.8 millionin Q2 FY21, and was primarily the result of increased net income at our Taiwan-based IC facility, which partially offset decreased net income at our China-based IC facility. Net income attributable to noncontrolling interests increased $5.2 millionin Q3 FY21 from Q3 FY20, and $10.1 million, on a year-to-date basis, as a result of increased net income at both our Taiwan-based and China-based IC facilities.
Liquidity and capital resources
Cash and cash equivalents totaled
$283.2 millionand $278.7 millionas of August 1, 2021and October 31, 2020respectively. As of the most recent balance sheet date, total cash and cash equivalents included $217.2 millionheld by foreign subsidiaries. Our primary sources of liquidity are our cash on hand, cash we generate from operations, and borrowing capacity we have available from financial institutions. Our corporate credit agreement has a $50 millionborrowing limit, with an expansion capacity to $100 million. Although we have not accessed funds under our corporate credit facilities since 2011, it continues to afford us financial flexibility. In addition, in China, we currently have approximately $22.9 millionof borrowing capacity to support local operations. See Item 1. Condensed Consolidated Financial Statements - Notes to Condensed Consolidated Financial statements - Note 6 for additional information. We continually evaluate alternatives for efficiently funding our capital expenditures and ongoing operations. These reviews may result in our engagement in a variety of financing transactions, in the transfer of cash among subsidiaries, and/or the repatriation of cash to the U.S.The transfer of funds among subsidiaries could be subject to foreign withholding taxes; in certain jurisdictions, repatriation of these funds to the U.S.may subject them to U.S.state income taxes and/or local country withholding taxes. We believe that our liquidity, including available financing, is sufficient to meet our requirements through the next twelve months and thereafter for the foreseeable future. Through the utilization of cash we generate from operations, our existing liquidity, and (potentially) our borrowing capacity, we will continue to invest in organic growth for our business, with our investments targeted to align with our customers' technology road maps, and stand ready to invest in mergers, acquisitions, or strategic partnerships should the right opportunity present itself. 31 -------------------------------------------------------------------------------- Table of Contents We estimate capital expenditures for Q4 FY21 will be approximately $28 million; these investments will be targeted towards high-end and mainstream point tools that will increase our operating capacity and efficiency, and enable us to support our customers' near-term demands. As of August 1, 2021, we had outstanding capital commitments of approximately $56.9 millionand recognized liabilities related to capital equipment purchases of approximately $9.2 million. Although payment timing could vary, primarily as a result of the timing of tool installation and testing, we currently estimate that we will fund $54 millionof our total $66 millioncommitted and recognized obligations for capital expenditures over the next twelve months. In September 2020, the Company's board of directors authorized the repurchase of up to $100 millionof its common stock, pursuant to a repurchase plan under Rule 10b5-1 of the Securities Act. This authorization does not obligate the Company to repurchase any dollar amount or number of shares of common stock. As of August 1, 2021, our current share repurchase program had approximately $46.8 millionremaining under its authorization. Depending on market conditions, we may utilize some or the entire remaining approved amount to reacquire additional shares. Cash Flows Nine Months Ended August 1, August 2, 2021 2020 Net cash provided by operating activities $ 113.1$
Net cash used in investing activities
$ (86.7 ) $ (31.6 )Net cash (used in) provided by financing activities $ (26.4 )$
Operating Activities: Net cash provided by operating activities reflects net income adjusted for certain non-cash items, including depreciation and amortization, share-based compensation, and the effects of changes in operating assets and liabilities. The increase in net cash provided by operating activities for the nine months ended
August 1, 2021, compared with the nine months ended August 2, 2020, was primarily due to increased net income and net cash-positive changes in working capital in Asia. Investing Activities: Net cash flows used for investing activities primarily consists of purchases of property, plant and equipment. For the nine months ended August 1, 2021, purchases of property, plant and equipment were $92.3 million, compared with $36.7 millionfor the nine months ended August 2, 2020, as we increased our tool purchases in the current year, primarily in response to market demands in Asia. Financing Activities: Net cash flows used in financing activities primarily consist of share repurchases, proceeds from and repayments of debt, and contributions from noncontrolling interests. The increase in net cash used in financing activities during the nine months ended August 2, 2021, compared with the same period ended August 2, 2020, was primarily driven by an $18.9 millionincrease in share repurchases, a $17.6 milliondecrease in contributions from noncontrolling interests, and a $7.4 millionincrease in debt repayments. Increased borrowings of $15.2 millionpartially offset the aforementioned cash-negative impacts. In January 2018, Photronics, through its wholly owned Singaporesubsidiary, and DNP, through its wholly owned subsidiary " DNP Asia Pacific PTE, Ltd." entered into a joint venture under which DNP obtained a 49.99% interest in our IC business in Xiamen, China. The joint venture, which we refer to as PDMCX, was established to develop and manufacture photomasks for leading edge and advanced generation semiconductors. Under the joint venture's operating agreement, DNP is afforded, under certain circumstances, the right to put its interest in PDMCX to Photronics. These circumstances include disputes regarding the strategic direction of PDMCX that may arise after the initial two-year term of the operating agreement that cannot be resolved between the two parties. As of the date of issuance of this report, DNP had not indicated its intention to exercise this right. In addition, both Photronics and DNP have the option to purchase, or put, their interest from, or to, the other party, should their ownership interest fall below 20% for a period of more than six consecutive months. Under all such circumstances, the sales of ownership interests would be at the exiting party's ownership percentage of the joint venture's net book value, with closing to take place within three business days of obtaining required approvals and clearance. Should DNP exercise an option to put their, or purchase our, interest in PDMCX we may, depending on the relationship of the fair and book value of PDMCX's net assets, incur a loss. As of August 1, 2021, Photronics and DNP each had net investments in PDMCX of $60.9 million. 32 -------------------------------------------------------------------------------- Table of Contents Business Outlook When evaluating our views on our outlook, please consider them in the context of our short backlog (which typically does not exceed three weeks), and the significant effect that a variance in high-end orders can have on our results. In addition, government actions to address health concerns, change trade policies, or repatriate manufacturing may also affect our results. Overall, we are encouraged by increased capital spending by both semiconductor and panel makers, as their current investments are a leading indicator of increased demand for photomasks. We believe that the recent favorable trends in IC driving an increase in design activity, including the recovery in high-end logic demand, and continued strength in mainstream demand will continue through the fourth quarter and possibly beyond. In FPD, we expect to see growth from recent capacity expansions, which benefitted us for only a portion of Q3 FY21. We believe this increased capacity will support increased mobile demand, as more smartphones, tablets, and laptops adopt high-value AMOLED technology. We are also encouraged by the emergence of next-generation premium TV technologies (such as Samsung Display Co. LTD'sQD-OLED, and LG Display Co. LTD's WOLED) which may provide growth in the future.
Effect of recent accounting positions
See "Item 1. Condensed Consolidated Financial Statements- Notes to Condensed Consolidated Financial Statements - Note 16 - Recent Accounting Pronouncements" for recent accounting pronouncements that may impact our financial reporting.
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