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SMTC > SEC Filings for SMTC > Form 10-K on 27-Mar-2014All Recent SEC Filings

Show all filings for SEMTECH CORP

Form 10-K for SEMTECH CORP


27-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Item 6 "Selected Consolidated Financial Data" and our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

This Annual Report on Form 10-K contains "forward-looking statements" within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, as amended, based on our current expectations, estimates and projections about our operations, industry, financial condition, performance, results of operations, and liquidity. Forward-looking statements are statements other than historical information or statements of current condition and relate to matters such as future financial performance, future operational performance, the anticipated impact of specific items on future earnings, and our plans, objectives and expectations. Statements containing words such as "may," "believe," "anticipate," "expect," "intend," "plan," "project," "estimate," "should," "will," "designed to," "projections," or "business outlook," or other similar expressions constitute forward-looking statements. Forward-looking statements involve known and unknown risks and uncertainties that could cause actual results and events to differ materially from those projected. Potential factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to: the continuation and/or pace of key trends considered to be main contributors to the Company's growth, such as demand for increased network bandwidth, demand for increasing energy efficiency in the Company's products or end use applications of the products, and demand for increasing miniaturization of electronic components; shifts in demand among target customers, and other comparable changes or protracted weakness in projected or anticipated end-user markets; competitive changes in the marketplace, including, but not limited to the pace of growth or adoption rates of applicable products or technologies; shifts in focus among target customers, and other comparable changes in projected or anticipated end-user markets; adequate supply of components and materials from our suppliers, and of our products from our third-party manufacturers, to include disruptions due to natural causes or disasters, or related extraordinary weather events; the Company's ability to forecast and achieve anticipated revenues and earnings estimates in light of periodic economic uncertainty, to include impacts arising from European and global economic dynamics; the Company's ability to manage expenses to achieve anticipated amounts; and the amount and timing of expenditures for capital equipment deemed necessary or advisable by the Company. Additionally, forward-looking statements should be considered in conjunction with the cautionary statements contained in this Annual Report on Form 10-K, including, without limitation, information under the section "Risk Factors" and additional factors that accompany the related forward-looking statements in this Annual Report on Form 10-K, in the Company's other filings with the SEC, and in material incorporated herein and therein by reference. In light of the significant risks and uncertainties inherent in the forward-looking information included herein that may cause actual performance and results to differ materially from those predicted, any such forward-looking information should not be regarded as representations or guarantees by the Company of future performance or results, or that its objectives or plans will be achieved, or that any of its operating expectations or financial forecasts will be realized. Reported results should not be considered an indication of future performance. Investors are cautioned not to place undue reliance on any forward-looking information contained herein, which reflect management's analysis only as of the date hereof. Except as required by law, the Company assumes no obligation to publicly release the results of any update or revision to any forward-looking statement that may be made to reflect new information, events or circumstances after the date hereof or to reflect the occurrence of unanticipated or future events, or otherwise.

Overview
We are a leading supplier of analog and mixed-signal semiconductor products and were incorporated in Delaware in 1960. We design, produce and market a broad range of products that are sold principally into applications within the high-end consumer, industrial, enterprise computing and communications end-markets. The high-end consumer end-market includes handheld devices, tablets, set-top boxes, digital televisions, digital video recorders, thunderbolt cables and other consumer equipment. Applications for the industrial market include broadcast studio equipment, automated meter reading, military and aerospace, medical, security systems, automotive, industrial and home automation, video security and surveillance and other industrial equipment. Enterprise computing end-markets include desktops, notebooks, servers, graphic boards, monitors, printers, datacenter related equipment, storage networks and computer peripherals. Communications end-market applications include base stations, optical networks, carrier networks, switches and routers, cable modems, signal conditioners, wireless LAN, and other communication infrastructure equipment. Our end-customers are primarily original equipment manufacturers and their suppliers, including Alcatel-Lucent, Cisco Systems, Inc., Huawei Technologies Co., Ltd., LG Electronics, Motorola, Nokia Siemens Networks, Itron, Apple, Phonak International, Research In Motion Limited, Samsung Electronics Co., Google Inc., Amazon.com Inc., and ZTE Corporation.


On March 20, 2012, we, through our wholly-owned subsidiary Semtech Canada Inc., completed the acquisition of all outstanding equity interests of Gennum Corporation ("Gennum") (TSX: GND), a leading supplier of high speed analog and mixed-signal semiconductors for the optical communications and video broadcast markets.
Upon consummation of the acquisition, which constituted a change in control of Gennum, Gennum's stock option awards and restricted shares became fully vested. We acquired 100% of the outstanding shares and vested stock options, restricted shares, and deferred share units of Gennum for CDN$13.55 per share for a total purchase price of $506.5 million. See Note 3 to our audited consolidated financial statements included in Item 8 of this report. The acquisition was initially financed with a combination of cash from our international cash reserves and $347.0 million (net of original issue discount of $3.0 million) of five-year secured term loans with a combined interest rate of approximately 4%. See Note 10 to our audited consolidated financial statements included in Item 8 of this report.
Our primary reasons for the acquisition were to broaden our existing portfolio of high-performance analog products and to acquire a portfolio of high-speed data communications and video platforms to create one of the industry's most complete and robust high-speed analog and mixed signal portfolios. In addition, Gennum's strong position in the emerging HD video surveillance market further diversifies our portfolio of high-performance analog semiconductors and provides cross-selling potential with the combined customer base.
On March 7, 2012, we completed the acquisition of Cycleo SAS ("Cycleo"), a privately held company based in France that develops IP for wireless long-range semiconductor products used in smart metering and other industrial and consumer markets. This transaction, which was accounted for using the acquisition method of accounting, complements our current wireless offerings and will bring customers a set of high-end, digitally enhanced wireless solutions. Under the terms of the agreement, we paid the stockholders of Cycleo $5.0 million in cash at closing. The audited consolidated financial statements for the fiscal years 2014 and 2013 include the results of operations of Gennum and Cycleo commencing as of the acquisition dates.
We operate our business in one enterprise-wide reportable segment. All of our operating segments exhibit similar economic characteristics and we manage our business to a targeted gross margin range which all of our product lines are expected to meet. During fiscal years 2014, 2013 and 2012 the gross margin of our Power Management and High-Reliability group did not fall within our targeted range as their business was negatively impacted by lower sales volumes and an unfavorable product mix. The lower sales volumes are the result of the group's strategic transition away from certain markets (i.e., the personal computer market) that are characterized by non-differentiated offerings in sectors that are highly competitive. Specifically, this group is transitioning its product offerings to better support its current target markets, which include high-end consumer and medical, space, industrial and automotive applications that have historically enjoyed higher gross margins. We are starting to see traction in this endeavor as supported by the pace of new product introductions and customer design win communications. As a result of the lower volumes currently being experienced by this group, their gross margin has been impacted more than our other product groups by lower overhead absorption and fixed costs. In order to support existing customers while developing new cost-efficient products that can be sold at competitive prices, the Power Management and High-Reliability group has sold certain products at lower margins.
Most of our sales to customers are made on the basis of individual customer purchase orders. Many customers include cancellation provisions in their purchase orders. Trends within the industry toward shorter lead-times and "just-in-time" deliveries have resulted in our reduced ability to predict future shipments. As a result, we rely on orders received and shipped within the same quarter for a significant portion of our sales. Orders received and shipped in fiscal year 2014 represented 48% of net sales. Sales made directly to customers during fiscal year 2014 were 57% of net sales. The remaining 43% of net sales were made through independent distributors.
Our business relies on foreign-based entities. Most of our outside subcontractors and suppliers, including third-party foundries that supply silicon wafers, are located in foreign countries, including China, Taiwan, Europe and Israel. For the fiscal year ended January 26, 2014, approximately 38% of our silicon, in terms of cost of wafers purchased, was manufactured in China. Foreign sales for fiscal year 2014 constituted approximately 84% of our net sales. Approximately 86% of foreign sales in fiscal year 2014 were to customers located in the Asia-Pacific region. The remaining foreign sales were primarily to customers in Europe and Canada.


Restructuring
We use several metrics as indicators of future potential growth. The indicators that we believe best correlate to potential future revenue growth are design wins and new product releases. There are many factors that may cause a design win or new product release to not result in revenue, including a customer decision not to go to system production, a change in a customer's perspective regarding a product's value or a customer's product failing in the end-market. As a result, although a design win or new product introduction is an important step towards generating future revenue, it does not inevitably result in us being awarded business or receiving a purchase commitment.
In December 2013, after filing our Form 10-Q for the period ended October 27, 2013, we became aware of changes tied to the decision of a customer, disclosed in our filings as a key customer, to transition from our standard product to their internal application specific integrated circuit ("ASIC") solution. This decision by our key customer to utilize an internal ASIC solution was accelerated by continued delays in the release of capital investment tenders, primarily within China, which also provided other potential customers of ours with additional time to develop their internal solutions. While some of these potential customers had indicated an interest in transitioning to an internal ASIC solution, it was our key customer's decision to do so that prompted our strategic reassessment and resulting restructuring.
Upon completing the reassessment of our strategic options in January 2014, we decided to reduce the level of investments that we are making in the long-haul optical market. This reduction in investment is expected to significantly impact our ability to generate future revenue from the long-haul optical market. This anticipated reduction in potential future revenue resulted in us recording significant impairments of goodwill and other intangibles. Additionally, certain long-lived assets were determined to be impaired. As a result of our communications to our customers regarding our operational changes, we expect our customers to take action to transition away from some of our current platforms, including certain products in the 40Gbps and 100Gbps SerDes class which resulted in us reducing the cost basis of inventories in the fourth quarter of fiscal year 2014. Additionally, we incurred significant costs to terminate certain contract commitments and to provide for certain severance benefits to employees who were terminated prior to January 26, 2014 as a result of these investment reductions. The financial impact of these actions for the twelve month period ending January 26, 2014 is presented below:

Restructuring charges
(in thousands)
Employee terminations and related costs $ 1,841
Contract termination costs                1,245
Total restructuring costs               $ 3,086


Impairment of finite and
indefinite-lived intangibles
                                           Finite-lived          Indefinite-lived
(in thousands)                           intangible assets      intangible assets           Total
Intangible asset impairments            $          29,938     $                  -     $      29,938
Goodwill impairment                                     -                  116,686           116,686
Total                                   $          29,938     $            116,686     $     146,624


Other charges
                                                    Selling general and     Product development
(in thousands)                  Cost of sales         administrative          and engineering         Total
Inventory write-downs         $        15,047     $                   -     $               -     $     15,047
Long-lived asset impairments            4,341                       314                 4,541            9,196
Contract commitments                    1,729                         -                 3,197            4,926
Total other charges           $        21,117     $                 314     $           7,738     $     29,169

We completed most of the restructuring activities in the fourth quarter of fiscal year 2014, however, we expect to take additional actions in the first quarter of fiscal year 2015 that are expected to result in approximately $0.5 million of additional restructuring charges, primarily for lease consolidation and additional severance paid to employees who entered into stay agreements.


We do not expect any significant changes to our liquidity as a result of our restructuring activities as most of the charges associated with these actions do not require settlement in cash.

As a result of these restructuring actions we expect to realize significant operating cost savings beginning in the first quarter of fiscal year 2015, including an annual reduction in compensation costs of approximately $10.0 million, development costs of approximately $10.0 million and depreciation and amortization costs of approximately $5.2 million. These savings are expected to be offset by an anticipated $70.0 to $80.0 million reduction in revenues from long-haul optical products which are included in our Signal Integrity and Timing product group. We expect the gross margins for this product group to return to normalized levels beginning in the first quarter of fiscal year 2015.


Results of Operations
Fiscal Year 2014 Compared With Fiscal Year 2013 Presented below is our estimate of the end-market classification of net sales.

                                                Fiscal Years
(in thousands, except percentages)        2014                 2013          Change
High-End Consumer (1)              $ 170,203     29 %   $ 169,847     29 %      -  %
Communications                       160,302     27 %     181,791     31 %    (12 )%
Industrial and Other                 149,039     25 %     141,243     25 %      6  %
Enterprise Computing                 115,433     19 %      85,945     15 %     34  %
Total                              $ 594,977    100 %   $ 578,826    100 %      3  %

(1) Approximately $43.8 million and $36.4 million of our total sales to Samsung Electronics (and Affiliates), one of our significant customers, in fiscal year 2014 and 2013, respectively, were for products that target the handheld market (which includes mobile phones). These revenues are included in the high-end consumer end-market category.

Net Sales. Net sales for fiscal year 2014 were $595.0 million, an increase of 3% compared to $578.8 million for fiscal year 2013. Fiscal year 2014 revenues within the Enterprise Computing end-market benefited from a full year of Gennum revenue, with particular strength from optical communications which was well positioned for the upgrading of data centers and the build-out of wireless infrastructure. Strength from these areas was primarily offset by a decline in the Communications market with particular weakness in 40Gbps and 100Gbps SerDes devices. The weakness in the Communications market was the result of continued delays in the release of capital investment tenders, primarily in China, and pricing pressure in this space as current suppliers to this market compete for the existing business. Higher revenue in the Industrial end-market was attributed to higher sales of video broadcast products. Revenue from the licensing of intellectual property was $2.5 million and $8.6 million in fiscal years 2014 and 2013, respectively. Licensing revenue in fiscal year 2013 benefited from a single licensing arrangement that resulted in the recognition of $7.5 million of revenue.

The decline in Communications end-market activity discussed above is expected to continue through fiscal year 2015 and be partially offset by the continued demand from the upgrade of data centers and build-out of communications infrastructure, including wireless base stations and the Internet-of-Things. Gross Profit. Gross profit was $335.2 million and $314.6 million in fiscal years 2014 and 2013, respectively. Our gross margin was 56.3% for fiscal year 2014, up from 54.4% in fiscal year 2013. In the fourth quarter of fiscal year 2014, as a result of a significant reduction in forecasted demand for 40Gbps and 100Gbps SerDes products that support the long-haul optical market, we recorded inventory lower of cost or market write-downs of $15.0 million, asset impairment charges of $4.3 million and contract commitment settlement charges of $1.7 million. Gross profit margins for fiscal year 2013 were negatively impacted by the inventory fair value step-up of $39.4 million associated with inventory acquired as part of the Gennum acquisition that was recorded to cost of sales as the acquired inventory was sold. We expect overall gross margins to strengthen to approximately 59.0% in the first quarter of fiscal year 2015 as a result of lower levels of impairment charges and the absence of purchase accounting charges.


Operating Costs and Expenses.
                                                     Fiscal Years
(in thousands, except
percentages)                             2014                            2013
                               Cost/Exp.      % net sales      Cost/Exp.      % net sales      Change
Selling, general and
administrative               $   125,379           21 %      $   149,070           26 %           (16 )%
Product development and
engineering                      137,437           23 %          120,009           21 %            15  %
Intangible amortization           29,002            5 %           29,244            5 %            (1 )%
Intangible asset impairments      32,538            5 %              700            - %         4,548  %
Goodwill impairment              116,686           20 %                -            - %             *
Restructuring                      3,086            1 %                -            - %             *
Total operating costs and
expenses                     $   444,128           75 %      $   299,023           52 %            49  %

* Percentage is not applicable

Selling, General & Administrative Expenses Selling, general and administrative ("SG&A") expenses for fiscal year 2014 decreased by $23.7 million or (16)% as a result of lower expenses related to our acquisition of Gennum and Cycleo and by lower equity compensation expense. In fiscal year 2013, we incurred transaction and integration expenses related to the Gennum and Cycleo acquisitions of $24.8 million, including severance costs of $13.4 million. Fiscal year 2013 also included approximately $2.5 million of environmental reserves and $1.5 million of legal contingencies associated with a contract dispute.
SG&A stock-based compensation expense was $12.1 million and $15.0 million in fiscal years 2014 and 2013, respectively. The year over year decrease in equity compensation was principally driven by the impact of a lower stock price on awards that are classified as liability awards and must be marked to market at the end of each financial period and lower anticipated vesting for awards that have a performance vesting condition.
Product Development and Engineering Expenses Product development and engineering expenses for fiscal years 2014 and 2013 were $137.4 million and $120.0 million, respectively or an increase of 15%. The increase resulted from the inclusion of a full year of spending for Gennum and Cycleo and our decision in the fourth quarter of fiscal year 2014 to reduce our investments in the long-haul optical market. Specifically, our decision to reduce our investments in the long-haul optical market resulted in us recording an impairment charge against long-lived assets of $5.3 million and contract settlement charges of $2.4 million in the fourth quarter of fiscal year 2014. The levels of product development and engineering expenses reported in a fiscal period can be significantly impacted, and therefore experience period over period volatility, by the number of new product tape-outs and by the timing of recoveries from third parties for non-recurring engineering services which are typically recorded as a reduction to product development and engineering expense. As a result of the actions taken to reduce our investments in the long-haul optical market, we expect product development and engineering expenses to decline to approximately $28.0 million in the first quarter of fiscal year 2015.
Intangible Amortization and Impairments

Intangible amortization was $29.0 million and $29.2 million in fiscal years 2014 and 2013, respectively. Intangible asset impairments was $32.5 million and $0.7 million in fiscal years 2014 and 2013, respectively. The increase in intangible asset impairments reflects the impact of $32.5 million of intangible impairment charges primarily related to our decision in the fourth quarter of fiscal year 2014 to reduce the level of investment in the long-haul optical market.

As a result of the impairments recorded in the fourth quarter of fiscal year 2014, we expect intangible amortization to decline to approximately $6.4 million in the first quarter of fiscal year 2015. Goodwill Impairment
As a result of the actions taken to reduce our investments in the long-haul optical market, the Company recorded an impairment charge of $116.7 million in the fourth quarter of fiscal year 2014 to write-off the value of all goodwill associated with our Advanced Communications group.


Restructuring
We incurred $3.1 million for restructuring charges in fiscal year 2014 for severance and contract cancellation liabilities related to our decision to reduce our investment in the long haul optical market, realign product groupings, and align spending with anticipated demand levels.
Interest Expense. Interest expense was $18.2 million and $14.4 million for fiscal year 2014 and 2013, respectively. The increase was primarily due to a $7.1 million write-off of unamortized original issue discount and debt issuance cost associated with the debt modification in the second quarter of fiscal year 2014, partially offset by lower interest rates associated with modified credit facilities.
Interest Income and Other Expense, Net. Interest income and other expense, net was expense of $1.4 million in fiscal year 2014 compared to expense of $1.0 million in fiscal year 2013. The net increase in fiscal year 2014, was due to higher levels of other interest expense and volatility of foreign exchange related to cash denominated in foreign currencies.
Provision for Taxes. The provision for income taxes was $36.0 million for fiscal year 2014 compared to a benefit of $41.7 million for fiscal year 2013. The effective tax rate for fiscal year 2014 and 2013 was a tax provision of 28.0% and a tax benefit of 16,470.4%, respectively. The effective tax rate for fiscal year 2014 reflects the impact of a valuation reserve against our deferred tax assets of $52.9 million. The effective tax rate for fiscal year 2013 reflects the impact of a one-time $23.4 million benefit related to our change in assertion to permanently reinvest $70.0 million of foreign subsidiary earnings. During fiscal year 2014, we recognized a one-time tax benefit of $2.7 million related to the revaluation of our net Swiss deferred tax liabilities. The revaluation of these liabilities was required to reflect the impact of a new Swiss tax ruling, which was formally approved by Swiss tax authorities during the third quarter of fiscal year 2014.
Our effective tax rate in fiscal year 2014 differs from the statutory federal income tax rate of 35% due primarily to the non-deductibility of goodwill impairment charges, a valuation reserve against our deferred tax assets, certain undistributed foreign earnings for which no U.S taxes are provided because such earnings are indefinitely reinvested outside of the U.S. and a change in the tax rates in Switzerland due to a new Swiss tax ruling. We receive an income tax benefit from tax differentials due to our presence in foreign jurisdictions such as Switzerland and Canada where statutory rates are lower than U.S. federal tax rates. We are currently not aware of any uncertainties or trends relating to foreign tax differential or the new Swiss tax ruling that could significantly impact our income taxes in future periods.
We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of the assets and liabilities.
As of January 26, 2014, we have a valuation allowance against our U.S. and . . .

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