Overview
Management's discussion and analysis ("MD&A") of the Company's financial condition, results of operations and outlook should be read in conjunction with its condensed consolidated financial statements and related notes. Various segments of this MD&A contain forward-looking statements, all of which are presented based on current expectations, which may be adversely affected by uncertainties and risk factors (presented throughout this filing and in the Company's Annual Report on Form 10-K for the fiscal 2019 year), that may cause actual results to materially differ from these 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 FPD designs and applications, particularly as they relate to the semiconductor industry's migration to more advanced product innovation, design methodologies, and fabrication processes. We believe that 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 FPD 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 FPD designs could reduce demand for photomasks ‒ even if the demand for semiconductors and FPDs increases. Advances in semiconductor, FPD, and photomask design and semiconductor and FPD 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 downturns 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 first quarter of fiscal 2020, we acquired the remaining 0.2% of noncontrolling interests in PK, Ltd. for $0.6 million.
In the first quarter of fiscal 2020, we adopted ASU 2016-02 and all subsequent amendments, collectively codified in Accounting Standards Codification Topic 842 - “Leases” (“Topic 842”). This guidance requires modified retrospective adoption, either at the beginning of the earliest period presented or at the beginning of the period of adoption; we elected to apply the guidance at the beginning of the period of adoption, and recognized right-of-use leased assets of $6.5 million and corresponding lease liabilities which were discounted at our incremental borrowing rates, on our November 1, 2019 condensed consolidated balance sheet to reflect our adoption of the guidance. Our adoption of Topic 842 did not affect our cash flows or our ability to comply with covenants under our credit agreements.
In the fourth quarter of fiscal 2019, our board of directors declared a dividend of one preferred stock purchase right (a “Right”), payable on or about October 1, 2019, for each share of common stock, par value $0.01 per share, of the Company outstanding on September 30, 2019, to the stockholders of record on that date. In connection with the distribution of the Rights, we entered into a Section 382 Rights Agreement (the “Rights Agreement”), dated as of September 23, 2019, between the Company and Computershare Trust Company, N.A., a federally chartered trust company, as rights agent. The purpose of the Rights Agreement is to deter trading of our common stock that would result in a change in control (as defined in Internal Revenue Code Section 382), thereby preserving our future ability to use our historical federal net operating losses and other Tax Attributes (as defined in the Rights Agreement). Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series A Preferred Stock, par value $0.01 per share, at a price of $33.63, subject to adjustment. The Rights, which are described in the Company’s Current Report on Form 8-K filed on September 24, 2019, are in all respects subject to and governed by the provisions of the Rights Agreement. The Rights will expire at the earliest to occur of (i) the close of business on the day following the certification of the voting results of the Company’s 2020 annual meeting of stockholders, if at that meeting, or any other meeting of stockholders of the Company duly held prior to September 22, 2020, a proposal to approve this Rights Agreement is not passed by the affirmative vote of the majority of the voting interests; (ii) the date on which our board of directors determines, in its sole discretion, that the Rights Agreement is no longer necessary for the preservation of material valuable tax attributes, or the tax attributes have been fully utilized and may no longer be carried forward, and (iii) the close of business on September 22, 2022.
In the fourth quarter of fiscal 2019, PDMC, the Company’s majority-owned IC subsidiary in Taiwan, paid a dividend of which 49.99%, or approximately $18.9 million, was paid to noncontrolling interests.
In the fourth quarter of fiscal 2019, upon our request, a financing entity made an advance payment of $3.5 million to an equipment vendor. We entered into a Master Lease Agreement (“MLA”) with this financing entity, which became effective in July 2019. The MLA enables us to request advance payments or other funds to finance equipment to be leased or purchased in the U.S. In connection with this MLA, we have been approved for financing of $35 million for the purchase of a high-end lithography tool. Interest on this borrowing is payable monthly at thirty-day LIBOR plus 1% (2.67% at February 2, 2020), and will continue to accrue until the borrowing is repaid or, as allowed under the MLA, we enter into a lease for the equipment. We intend to enter into a lease agreement for the related equipment in fiscal year 2020.
In the fourth quarter of fiscal 2019, the Company’s board of directors authorized the repurchase of up to $100 million of its common stock, pursuant to a repurchase plan under Rule 10b5-1 of the Securities Act of 1933 (as amended). As of February 2, 2020, we had repurchased 1.9 million shares, at a cost of $22.0 million (an average price of $11.51 per share), under this authorization. The repurchase program may be suspended or discontinued at any time.
In the second quarter of fiscal 2019, we repaid, upon maturity, the entire $57.5 million principal amount of the convertible senior notes we issued in April 2016.
In the first quarter of fiscal 2019, PDMC paid a dividend, of which 49.99%, or approximately $26.1 million, was paid to noncontrolling interests.
In the first quarter of fiscal 2019, PDMCX was approved for credit of $50 million, subject to certain limitations related to PDMCX registered capital at the time of the initial approval, pursuant to which PDMCX has and will enter into separate loan agreements (“the Project Loans”) for intermittent borrowings. The Project Loans, which are denominated in Chinese renminbi (RMB), are being used to finance certain capital expenditures in China. PDMCX granted liens on its land, building, and certain equipment as collateral for the Project Loans. As of February 2, 2020, PDMCX had borrowed 243.4 million RMB ($35.1 million) against this approval. Payments on these borrowings are due semi-annually through December 2025; the initial payment is scheduled for June 2020. See Note 5 of the condensed consolidated financial statements for additional information on these loans.
In the first quarter of fiscal 2019, PDMCX received approval for unsecured credit of $25.0 million, pursuant to which PDMCX may enter into separate loan agreements. Under this credit agreement (the “Working Capital Loans”), PDMCX can borrow up to 140.0 million RMB to pay value-added taxes (“VAT”) and up to 60.0 million RMB to fund operations; combined total borrowings are limited to $25.0 million. As of February 2, 2020, PDMCX had outstanding 44.8 million RMB ($6.5 million) to fund operations, with repayments due one year from the borrowing dates of the separate loan agreements. As of February 2, 2020, PDMCX had outstanding 64.6 million RMB ($9.3 million) borrowed to pay VAT. Payments on these borrowings are due semiannually, at an increasing rate, through January 2022. See Note 5 of the condensed consolidated financial statements for additional information on these loans.
In the fourth quarter of fiscal 2018, we entered into a five-year amended and restated credit agreement (“the credit agreement”), which has a $50 million borrowing limit, with an expansion capacity to $100 million. The credit agreement is secured by substantially all of our assets located in the United States and common stock we own in certain foreign subsidiaries. The credit agreement includes minimum interest coverage ratio, total leverage ratio, and minimum unrestricted cash balance covenants (all of which we were in compliance with at February 2, 2020), and limits the amount of dividends, distributions, and redemptions we can pay on our stock to an aggregate amount of $50 million. We had no outstanding borrowings against the credit agreement at February 2, 2020, and $50 million was available for borrowing. The interest rate on the credit agreement (2.65% at February 2, 2020) is based on our total leverage ratio at LIBOR plus a spread, as defined in the credit agreement.
In the fourth quarter of fiscal 2018, the Company’s board of directors authorized the repurchase of up to $25 million of its common stock, to have been executed in open-market transactions or in accordance with a repurchase plan under Rule 10b5-1 of the Securities Act of 1933 (as amended). The share repurchase program commenced, under Rule 10b5-1, on October 22, 2018, and was terminated on February 1, 2019. In total, we repurchased 1.5 million shares at a cost of $13.8 million (an average of $9.41 per share) under this authorization.
Results of Operations
Three Months ended February 2, 2020
The following table presents selected operating information expressed as a percent of revenue.
Note: All the following tabular comparisons, unless otherwise indicated, are for the three-months ended February 2, 2020 (Q1 FY20), October 31, 2019 (Q4 FY19), and January 27, 2019 (Q1 FY19).
Revenue
Our quarterly revenues can be affected by the seasonal purchasing tendencies of our customers. As a result, demand for our products is typically negatively impacted during the first, and sometimes the second, quarters 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.
In Q1 FY20, we changed the threshold for the definition of high-end FPD, from G8 and above and active matrix organic light-emitting diode (AMOLED) display screens, to G10.5 and above, AMOLED, and low-temperature polysilicon display screens (LTPS), to reflect the overall advancement of technology in the FPD industry. Our definition of high-end IC products remains as 28 nanometer or smaller. Quarterly changes in revenue by product type for the three-month periods ended October 31, 2019 and January 27, 2019, have been modified to reflect this change. High-end photomasks typically have higher selling prices (ASPs) than mainstream products.
The following tables present changes in disaggregated revenue in Q1 FY20 from revenue in prior reporting periods. Columns may not total due to rounding.
Quarterly Changes in Revenue by Product Type
Quarterly Changes in Revenue by Geographic Origin
Revenue increased 2.2% in Q1 FY20, compared with Q4 FY19, primarily due to increased high-end FPD; the increase in high-end FPD was largely offset by mainstream FPD and both high-end and mainstream IC. High-end FPD increased 56.4% as demand grew for AMOLED and LTPS mobile displays, as well as G10.5+ for large-format televisions. Mainstream FPD decreased 29.0% due to a decline in demand for G8.5 and smaller masks used for LCD displays. High-end and mainstream IC photomasks decreased 8.7%, and 2.4%, respectively as demand was softer, in line with seasonal trends.
Revenue increased 28.1% in Q1 FY20, compared with Q1FY19, primarily due to increased high-end FPD and increased high-end and mainstream IC, partially offset by decreased mainstream FPD. High-end FPD increased 159.1% as the current quarter reflects revenues from our fully ramped FPD facility in China, and an overall increased demand for AMOLED, LTPS, and G10.5+ photomasks. High-end IC increased due to stronger end-market demand. Mainstream IC increased due to stronger demand in the current quarter, a portion of which was met by our new IC facility in China. Mainstream FPD revenues decreased due to a decline in demand for G8.5 and below photomasks
Uncertainty due to Coronavirus Outbreak
We have implemented policies to keep our employees safe while complying with all governmental regulations. We are actively working with our suppliers to minimize any impact to our operations. While we have limited visibility of the impact the virus is having on our customers’ operations, we have seen some design releases delayed in both our Asia IC and FPD businesses, and we believe our second quarter results may reflect the effect of these delays.
Gross Margin
Gross margin decreased in Q1 FY20 from Q4 FY19 primarily as a result of a 5.1% increase in material costs, which were caused by higher glass blank and pellicle costs, and an 11.8% increase in compensation and related expenses. Gross margin increased in Q1 FY20, compared with Q1 FY19, primarily due to the 28% increase in revenue from the prior year. 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 increased by $2.1 million, or 17.1%, to $14.2 million in Q1 FY20, from $12.1 million in Q4 FY19, primarily due to increased compensation and related expenses. Selling, general and administrative expenses increased in Q1 FY20 by $0.4 million, or 3.1%, from $13.8 million in Q1 FY19, primarily as a result of increased compensation and related benefits, primarily resulting from increased share-based compensation expense.
Research and Development Expenses
Research and development expenses consist of development efforts related to high-end process technologies for 28nm and smaller IC nodes. In Asia, in addition to the focus on high-end IC technology nodes, applications are also under development for G10.5 and above, AMOLED, and LTPS FPD.
Research and development expense decreased $0.4 million, to $4.1 million, or 10.2%, in Q1 FY20 from Q4 FY19, primarily as a result of decreased IC development activities in Taiwan and China. Research and development expense decreased $ 0.2 million, or 4.3% in Q1 FY20 from Q1 FY19, due to decreased spending in the U.S. exceeding increased combined expenditures at the two China-based facilities.
Other Income (Expense)
Interest income and other income (expense), net increased in Q1 FY20 by $11.4 million from Q4 FY19, primarily as a result of foreign currency gains of $4.7 million experienced in Q1 FY20, in contrast to losses of $6.2 million recognized in Q4 FY19.
Interest income and other income (expense), net increased in Q1 FY20 by $3.9 million from Q1 FY19, primarily due to $3.6 million greater foreign currency gains experienced in the current quarter than in the prior year quarter.
Income Tax Provision
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 Q1 FY20, compared with Q4 FY19, is primarily attributable to the non-recognition of tax benefits on losses in jurisdictions with valuation allowances, the establishment of a valuation allowance for a non-U.S. based loss carryforward, the expiration of a tax holiday in Q1 FY20, and a net decrease in tax accruals no longer required as a result of the settlement of a non-U.S. income tax audit and statute of limitations expiration in Q4 FY19. The effective income tax rate increase in Q1 FY20, compared with Q1 FY19, is primarily attributable to the aforementioned factors that occurred in Q1 FY20, and the benefit of an alternative minimum tax credit in Q1 FY19.
Net Income Attributable to Noncontrolling Interests
Net income attributable to noncontrolling interests was $0.6 million in Q1 FY20, which represented a decrease of $2.7 million and $1.9 million from Q4 FY19 and Q1 FY19, respectively. The change from Q4 FY19 was due to decreased net income at our Taiwan-based IC facility and an increased loss at our China-based IC facility; we hold 50.01% ownership interests in each of these facilities. The change from Q1 FY19 resulted from an increased loss at our China-based IC facility, which was partially offset by increased net income at our Taiwan-based IC facility.
Liquidity and Capital Resources
We had cash and cash equivalents of $218.3 million at the end of Q1 FY20, compared with $206.5 million at the end of fiscal 2019. The net increase is primarily attributable to:
- $30.8 million provided by operating activities;
- $2.9 million received from exercises of employee stock options;
- $2.4 million received from government incentives in China;
- $1.1 million received from borrowings in China;
- $13.8 million paid for property, plant, and equipment;
- $11.0 million used to repurchase our common stock.
Our working capital at the end of Q1 FY20 was $283.3 million, compared with $275.6 million at the end of fiscal 2019. The $7.7 million net increase is primarily attributable to the below increases (decreases) in working capital:
- Increased cash and cash equivalents of $11.8 million;
- Increased accounts receivable of $7.3 million, the predominance of which were in China reflecting their increased revenue in Q1 FY20;
- Decreased receivables for investment subsidies in China of $(3.2);
- Increased current portion of long-term debt of $(5.8) million;
- Decreased accounts payable of $6.7 million, $4.9 million of which was the result of a reduction in payables for capital assets;
- Increased value added taxes payable of $(3.1) million;
- Increased income taxes payable of $(2.7) million;
- Increased lease liabilities of $(1.7) million, which resulted from our adoption of ASC 842 in Q1 FY20.
The net cash provided by operating activities of $30.8 million in Q1 FY20 was a $50.1 million increase from $19.3 million used in Q1 FY19. The net increase was due primarily to:
- Increased net income of $3.2 million in Q1 FY20;
- Increased non-cash add backs to net income, including depreciation, share-based compensation and deferred income taxes of $10.8 million;
- A comparative decrease in government subsidies receivable in China of $15.2 million;
- A comparative decrease in value added tax prepayments related to our China facilities of $19.9 million in Q1 FY20. These
prepayments are recoverable through future sales transactions of the facilities.
Net cash used in investing activities was $11.5 million in Q1 FY20, a decrease of $90.3 million from the $101.9 million used in Q1 FY19. The net decrease was primarily attributable to decreased capital expenditures of $93.1 million; this was the result of a reduction in payments to equip our China-based facilities, which were in the start-up phase in Q1 FY19.
Net cash flows from financing activities decreased from funds provided of $21.4 million in Q1 FY19 to $7.6 million used in Q1 FY20. Significant components of the $29.0 million net decrease were:
- $26.1 million used to pay dividends to DNP (related to their 49.99% interest in our IC facility in Taiwan) in Q1 FY19;
- $(27.0) million less received from borrowings in China in Q1 FY20 than in the prior year quarter;
- $(29.4) million contributed in Q1 FY19 by DNP to maintain their proportionate ownership interest in our IC joint venture in China.
As of February 2, 2020 and October 31, 2019, our total cash and cash equivalents included $163.2 million and $147.2 million, respectively, held by our foreign subsidiaries. The majority of earnings of our foreign subsidiaries are considered to be indefinitely reinvested. Repatriation of these funds to the U.S. may subject them to U.S. state income taxes and local country withholding taxes in certain jurisdictions. Furthermore, our foreign subsidiaries continue to grow through the reinvestment of earnings in additional manufacturing capacity and capability, particularly in the high-end IC and FPD areas.
Our liquidity, as we operate in a high fixed cost environment, is highly dependent on our revenue, cash conversion cycle, and the timing of our capital expenditures (which can vary significantly from period to period). Depending on conditions in the semiconductor and FPD markets, our cash flows from operations and current holdings of cash may not be adequate to meet our current and long-term needs for capital expenditures, operations and debt repayments. Historically, in certain years, we have used external financing to fund these needs. Due to conditions in the credit markets and covenant restrictions on our existing debt, some financing instruments we have used in the past may not be available to us when required. Consequently, we cannot assure that additional sources of financing would be available to us on commercially favorable terms, should our long-term cash requirements exceed our existing cash and cash available under our credit facility.
As of February 2, 2020, we had outstanding capital commitments of approximately $113.6 million. We intend to finance our capital expenditures with our working capital, contributions from our joint venture partners, borrowings under the Master Lease Agreement we entered into in fiscal 2019 (as discussed in Note 5 to the condensed consolidated financial statements), cash generated from operations and, if necessary, additional borrowings. Our remaining funding commitment for our IC facility in China, which commenced production in the third quarter of fiscal 2019, was approximately $7 million as of February 2, 2020; we will fulfill this commitment over the next several quarters.
Off-Balance Sheet Arrangements
In January 2018, Photronics, through its wholly owned Singapore subsidiary, 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, known as “Xiamen American Japan Photronics Mask Co., Ltd.” (“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 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 February 2, 2020, Photronics and DNP each had net investments in PDMCX of $36.6 million.
Business Outlook
A majority of growth in the IC and FPD markets is expected to continue to come from the Asia region, predominantly in China. We expect to meet these demands both through the utilization of our new facilities in China, and by importing photomasks into China from our other facilities. We make continual assessments of our global manufacturing strategy and monitor our revenue and related cash flows from operations. These ongoing assessments could result in future facility closures, asset redeployments, additional impairments of intangible or long-lived assets, workforce reductions, or the addition of manufacturing facilities, all of which would be based on market conditions and customer requirements.
Our future results of operations and the other forward-looking statements contained in this filing involve a number of risks and uncertainties, some of which are discussed in Part1, Item 1A in our Annual Report on Form 10-K for the year ended October 31, 2019; a number of other unforeseen factors could cause actual results to differ materially from our expectations.
Effect of Recent Accounting Pronouncements
See “Item 1. Condensed Consolidated Financial Statements– Notes to Condensed Consolidated Financial Statements – Note 15 – Recent Accounting Pronouncements” for recent accounting pronouncements that may affect the Company’s financial reporting.