PART I
Forward-looking Statements
The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words “believes”, “expects”, “projects,” “anticipates,” “plan,” “continue,” “will,” “may” and similar words, constitute forward looking statements that are subject to a number of risks and uncertainties. Forward-looking statements include but are not limited to any statements regarding anticipated sales, expected shipments of backlog, our profitability in future periods, our expectations regarding customer processes and our products, our strategies and beliefs regarding the markets in which we compete or may compete and our product development plans to address these markets, the sufficiency of our financial resources to meet our working capital needs for at least the next 12 months, our expectations regarding taxes and tax adjustments, particularly with respect to the Tax Act, our expectations regarding various legal matters, our ability to rapidly increase our production capacity to accommodate demand, sources of our future revenue, the effect of new accounting standards on our financial results, our ability to leverage our corporate restructuring and continue our new functional structure, our expectations regarding goodwill, our expectations regarding our relationships with suppliers and customers, our expectations regarding trends in applications for laser processing, our expectations regarding production capabilities, our ability to maintain and expand our core technologies and product applications, our expectations regarding payment of cash dividends, and our expectations regarding cyclicality or trends. These forward-looking statements are based on information available to us on the date of this report and we undertake no obligation to update these forward-looking statements for any reason. Actual results may differ materially from those in the forward-looking statements. Risks and uncertainties that may affect the forward-looking statements include but are not limited to the items discussed in “Risk Factors” in this Annual Report on Form 10-K.
Item 1. Business
Fiscal Year
Our fiscal year consists of 52 or 53-week periods ended on the Saturday nearest March 31. Accordingly, our fiscal
2018
reporting period consisted of a
52
-week period ending on
March 31, 2018
, our fiscal
2017
consisted of a
52
-week period ending on
April 1, 2017
and our fiscal
2016
reporting period consisted of a
53
-week period ending on
April 2, 2016
.
All references to years or quarters relate to fiscal years or fiscal quarters unless otherwise noted.
Overview of Business
Electro Scientific Industries, Inc. and its subsidiaries (ESI, we, our, or the Company)
is a leading supplier of innovative laser-based microfabrication solutions for industries reliant on microtechnologies. ESI enables its customers to commercialize technology using precision laser processes. ESI's solutions produce the industry's highest quality and throughput, and we target the lowest total cost of ownership. Founded in 1944, ESI is headquartered in Portland, Oregon, with global operations and subsidiaries in Asia, Europe and North America.
Laser microfabrication is comprised of a set of precise micron-level processes, including drilling, scribing, dicing, singulation, cutting, ablating, trimming, and precision marking on multiple types of materials. These processes require application-specific laser systems that are able to meet our customers’ exacting performance and productivity requirements. Our laser-based systems are utilized in the production of flexible and rigid printed circuit board (PCB), semiconductor devices, advanced semiconductor packaging, consumer electronics, electronic sensors, touch-panel glass, flat panel liquid crystal displays (LCDs), organic light emitting diode (OLEDs) displays, applications within the automotive, aerospace, medical and display end markets as well as other high-value components and devices to enable functionality, increase performance and improve production yields.
Additionally, we produce high-capacity test and inspection equipment that is critical to the quality control process during the production of multilayer ceramic capacitors (MLCCs). Our equipment ensures that each component meets the electrical and physical tolerances required to perform properly.
Between the fourth quarter of 2015 and the third quarter of 2017, the Company operated in two segments, Component Processing and Micromachining. In the fourth quarter of 2017, the Company reorganized into a functional structure and now operates and reports as a single segment. Within this single segment we sell products into a variety of end markets that may be grouped into four major categories: 1) PCB, 2) Semiconductor, 3) Component Test, and 4) Industrial Machining. PCB includes flexible circuits (Flex), high density interconnect (HDI), and packaging products targeting this market; Semiconductor includes all wafer-based products; Component Test includes our MLCC products and tooling; and Industrial Machining includes our machining and inspection tools that address a broader market including not just consumer electronics, but also automotive,
aerospace, medical, and display end markets. See Note 21: Product and Geographic Information, to our Consolidated Financial Statements for further discussion.
Industry Overview
The PCB, semiconductor and other microelectronics industries are driven by demand for improved functionality in increasingly smaller and smarter consumer devices such as smart phones, tablets, wearable technologies, personal computers, mobile computing devices, video game systems and high-definition televisions. In addition to the consumer markets, PCB, semiconductor and other advanced technologies are being used in a broadening set of industrial markets and applications, including automotive, aerospace, medical and display.
These dynamics in turn are driving the microelectronics supply base for faster, smaller, more complex, less expensive and higher-quality electronic devices and sub-components. To achieve these improvements, manufacturers increase circuit densities and shrink feature geometries while increasing the interconnect flexibility. These advances drive our customer base to innovate in terms of materials, manufacturing processes, and topologies.
For example, smaller semiconductor devices are driving the need to shrink the physical dimensions of the semiconductor packages. As the physical dimensions of the package shrink, the ability to physically and electrically connect these devices becomes more challenging. The PCB manufacturers are forced to utilize new techniques such as HDI circuit boards on which connections are made. These HDI circuits require smaller, more accurate, and precisely tapered or shaped holes, known as vias, to create connections between layers within the circuit board and to the interconnecting devices. We are seeing these trends in varying markets including mobile devices and the coming move to 5G, consumer electronics and the increasing use of internet-of-things devices, and self-driving automobiles which are requiring more complex flexible interconnect circuits. The continual trend toward smaller and smarter devices also requires the use of an increasing amount of flexible interconnect material to enable higher data flow among the internal components such as the processor, memory, display, antenna, and camera.
The rate of data flow among components within a device is expected to rise dramatically, in devices ranging from mobile devices to automobiles. In mobile devices and other wearable devices, we anticipate 5G network technologies will dramatically increase the network speed, and the rate in data flow within the devices. In the automobile industry, the trend toward self-driving cars is expected to have a similar effect on the data traffic from the sensors to the main processor to the display of the automobile. These trends indicate strong growth in the PCB interconnect market, which is ESI's primary target market.
In addition, new materials are being developed, such as aromatic polymers and low-k films, to help drive signal integrity improvements, temperature tolerance, and physical stability. We believe these materials may drive additional applications for laser processing, including scribing of next generation thin films.
Passive components, such as MLCCs, are also under the same pressure to improve performance while reducing size and are also becoming prevalent in new applications. Manufacturers must test MLCCs electrically and optically to characterize performance and ensure reliability. Automated equipment to test these MLCCs in the manufacturing environment, like our high capacitance tester, can test and sort up to one million parts per hour on parts with dimensions as small as 0.4 by 0.2 millimeters.
Our business also includes specialized microfabrication applications. Many materials that can be cut, drilled, marked or joined using a mechanical process can be microfabricated with greater precision and accuracy using a laser-based solution. As consumer electronics and industrial products or devices become more compact, traditional mechanical processes will not be able to meet the stringent specifications demanded by producers. We believe the capabilities of laser-based solutions for microfabrication will enable our customers to continue to move beyond the limitations of mechanical processes and generate incremental demand for our laser solutions.
Our Solutions
We believe our products address the needs of PCB, semiconductor, and other microelectronics and industrial manufacturers by providing them with laser-based tools that enable the precise features and high speed processing. These capabilities enable our tools to meet our customer’s technology needs and yield a high return on their investment due to measurable production benefits such as lower cost of ownership, higher performance, greater reliability, and improved production yield compared to other mechanical or competitive solutions.
Our core competencies enable us to design, manufacture, and market a variety of integrated laser-based solutions for microfabrication applications in high-volume manufacturing environments. These core competencies include a deep understanding of:
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laser/material interaction;
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laser beam positioning;
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optics and illumination including image processing and optical character recognition;
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micron-level defect detection;
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high-speed motion control;
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proprietary laser technology including laser power control; and
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We combine this expertise with manufacturing agility and a thorough understanding of our customers’ process needs that enable us to respond rapidly to customer demand to develop and deliver integrated solutions and products that address multiple markets and applications.
Our customers manufacture components, interconnect/packaging devices, semiconductors, displays or other parts that serve a wide range of electronic applications. Our systems enable the manufacturing of these components and devices. The primary end-market applications for our customers are consumer electronics, including smart mobile devices such as smart phones and tablets, computers and semiconductors. These devices and applications are also utilized in a variety of other industries including automotive, aerospace, medical and display.
Our Strategy
Our strategy is to leverage our core competencies to be a cost of ownership leader in laser-based microfabrication for micro-technology industries, including PCB, semiconductor, microelectronics, and other industrial applications within the automotive, aerospace, medical and display markets. These core competencies, combined with an understanding of our customers’ processes and the use of common platforms, enable us to address a broad range of laser-based applications and end markets within these industries. We intend to focus our efforts on businesses and applications where our differentiated capability enables us to be a market leader. The elements of our strategy are to (1) expand our addressable market by focusing on large, existing, near-adjacent applications in the growing laser-microfabrication market, (2) focus on areas where we can apply our differentiated capability, (3) leverage proprietary laser technology to create competitive advantage, (4) strengthen marketing capability and broaden customer focus, (5) develop and leverage flexible platforms and technology for cost of ownership and time to market advantage in new applications and (6) maintain a scalable business model that delivers positive earnings in down market cycles and leveraged earnings growth in up cycles.
Expand our addressable market by focusing on large, existing, near-adjacent applications in the growing laser microfabrication market
Growth and the increasing complexity and functionality in consumer electronics, smart phones, tablets, notebook computers and other smart devices is driving increased miniaturization and complexity of the underlying components and materials. These materials and components are being adopted in electronic devices, sensors, displays, and other technologies across many markets and industries. As a result, we believe there are many large, existing, near-adjacent opportunities for laser micromachining for both the devices themselves and components within them. Our strategy is to expand our addressable market in these near-adjacent applications where we can utilize our technology for a cost of ownership advantage for our customers. Our primary areas of focus are to defend and grow our presence in the flexible PCB and interconnect laser drilling markets and enter and grow our presence in the rigid high density interconnect PCB and interconnect laser drilling markets. Both of these markets require similar high speed, high precision laser drilling capabilities that leverage our core competencies. We also will continue to expand our capabilities in the semiconductor capital environment by providing industry leading tools that mark, trim and scribe wafers as required by the wafer fabrication process. We believe our growth will be driven by overall growth in the market for electronic and other industrial devices, expanding the applications and customers we address, and growing our share in these adjacent markets.
Focus on markets where we can apply our differentiated capability
Following the completion of our reorganization this year, we have refocused our strategy to concentrate our efforts on established markets where we can leverage our differentiated capability to provide high and differentiated value to our customers. As a result, we will focus our investments on applications where laser machining adds key technology enabling functionality rather than purely aesthetic value. These capabilities can be applied to a broad set of industries beyond consumer electronics including automotive, aerospace, medical and display. We believe this change is better aligned with our expertise and strengths and will use our unique and differentiated technology to achieve greater success that better aligns with our expertise and strengths and will help us better leverage our investments in resources and technology.
Leverage proprietary laser technology to create competitive advantage
ESI is a pioneer in laser-material interaction and has developed deep expertise in the use of multiple types of laser technology to develop customer solutions. We have invested in proprietary laser technology primarily through the acquisition of Eolite Systems. The acquisition of Eolite provides us access to high power ultraviolet (UV) nanosecond and low-cost picosecond fiber lasers with a unique, scalable architecture. These lasers address multiple micromachining applications within the PCB interconnect drilling and semiconductor fabrication process that provide us unique differentiation. We intend to continue to utilize these lasers internally to provide differentiated capability and lower cost of ownership. Our strategy is to expand the utilization of these technologies to enable differentiated capability within our systems at a lower cost when compared to available third party commercial lasers.
Strengthen marketing capability and broaden customer focus
The Company’s close collaboration with key industry leading customers has enabled ESI to develop world-class technologies that meet the emerging needs of these demanding customers. Our strategy is to modify our approach to product development so we can meet needs across broader markets as opposed to a few key customers. We believe this new approach will enable our products to serve the needs of a far larger portion of the laser microfabrication market. Through our reorganization and enhanced focus on marketing and sales competencies, we believe we will continue to strengthen our market understanding that will enable the successful development of products that address broad market requirements.
Leverage flexible platforms and technology for cost of ownership and time to market advantage
Our key technological capabilities include laser-material interaction, laser beam positioning, optics and illumination, defect detection, high-speed motion control systems, small parts handling systems and systems integration. Our strategy is to incorporate these capabilities into a series of flexible platforms that have multiple common elements but are tailored to specific applications and to leverage our investment in these platforms to address multiple new applications and market opportunities. In addition, we believe that leveraging common platforms will increase efficiency in the Company through greater use of common parts, lower inventory requirements, shorter cycle times, and leveraged engineering investment across the Company.
Create scalable business model to deliver earnings in both strong and weak market cycles
Historically, our business has been highly cyclical and seasonal resulting in only short periods of profitability followed by periods of losses. As part of our reorganization in 2017 and 2018 we lowered our cost structure and our operating break-even point to improve overall profitability and increase consistency of earnings over time. As a result, we have closed multiple sites across the world, refocused and re-prioritized our investments, and reorganized the Company into a functional, streamlined structure. In addition, we made several changes to our executive management team. We believe these changes accomplished two things, (1) focused more resources on the most promising growth opportunities; and (2) lowered our fixed cost base, allowing us to generate positive earnings even in down market cycles and generate leveraged earnings during market upturns.
Our Products
Printed Circuit Board
Our PCB laser drilling products address multiple applications and materials on a broad set of substrates, panels, and continuous-feed reels primarily for the PCB and packaging industries. Our laser via drilling systems target electrical interconnect applications that require high accuracy and small via (hole) dimensions to create electrical connections between layers in flexible circuits, high-density circuit boards and interconnect packages. Our micro via drilling technology addresses the rapidly changing applications in interconnect packages, multichip modules and HDI circuit boards. Our UV laser processing systems employ state-of-the-art technology in lasers, optics and motion control. These products include single-beam and multi-beam systems that produce high-quality vias with the best-in-class placement accuracy for improved yield of packages and substrates.
These same technologies can be used to singulate individual PCBs (depaneling), rout copper openings on PCB material, precisely cut flexible circuit material, and mark individual packages or circuit boards.
Semiconductor
Our semiconductor manufacturing products address multiple applications that utilize laser energy to process materials on wafer-based substrates and semiconductor devices and packages. Applications include processing of silicon wafers, memory devices, mixed signal devices, hybrid circuits, sensors, and resistors.
The advent of 3D chip packaging technologies is driving the need for silicon wafers to become thinner in order to allow for stacking of wafers within the same packaging geometry. As wafers become thinner, they become more challenging to singulate into discrete chips using traditional mechanical saws. During 2016, we introduced the Ultrus
TM
platform that scribes next-generation thin film materials thereby increasing the manufacturing yields through increased control and quality of the singulation process. As 3D technologies are developed, we believe the use of advanced laser technology will become increasingly important to productivity and performance.
Our semiconductor manufacturing products also include industry-leading wafer marking equipment and wafer and circuit trim tools. Wafer marking equipment is used for serialization and wafer identification by manufacturers of semiconductor wafers within semiconductor factories. Wafer and circuit trim tools are laser systems that adjust the electrical performance of semiconductor devices or hybrid circuits by removing a precise amount of material from one or more circuit components. In addition, the Company continues to sell a limited number of memory yield improvement systems and related laser upgrades.
Component Test
Our component test products combine high-speed small parts handling technology with real-time control systems to provide highly automated, cost-effective inspection solutions for manufacturers of MLCCs and other passive components such as capacitor arrays, inductors, resistors, varistors and hybrid circuits. These components, produced in quantities of trillions of units per year, process analog, digital and high-frequency signals and are used extensively in nearly all electronic products. As an example, leading smartphones can have over 1,000 MLCCs while self-driving electric automobiles can have over 10,000 MLCCs. Our MLCC test systems employ high-speed handling and positioning techniques to precisely load, test and sort MLCCs based on their electrical energy storage capacity, or capacitance, and their electrical energy leakage, or dissipation factor. Our 35XX series is the most productive tester in the market today. Our latest Allegro
TM
model enables high-speed testing of the industry’s smallest metric 0402 capacitors used primarily in advanced cell phone and tablet designs. We also produce consumable products such as carrier plates and termination belts for both our own and competitive testing products in the market, both of which are used to hold MLCCs during the manufacturing and testing process.
Industrial Machining
Industrial machining products are comprised of laser systems that are used primarily by manufacturers of end devices across multiple industries to drill, cut or mark features on a variety of materials, generally on the casing or external surface of the end device. In addition, industrial machining products tend to serve markets that require fewer features, less stringent design requirements, and lower cost.
We offer several platforms that enable customers to perform precision drilling, scribing, cutting, etching, routing or marking on many different types of materials and devices including glass, metal, plastic, paint and ceramics. We also offer laser products for integration into customers' tools or processes that are useful for applications such as thin film processing, glass processing, material trimming, precision drilling, and cutting of organic materials and metals.
During 2018, as part of our initiative to focus our efforts on our core applications, we divested our laser ablation products, which ablate material for identification and analysis applications, including forensics, mineral analysis and research.
Customers
Our top ten customers for
2018
,
2017
and
2016
accounted for approximately
59%
,
47%
and
51%
of total net sales, respectively. In
2018
, two customers, Career Technology (Mfg.). Co., Ltd. and Top Unique Trading Co., Ltd., accounted for approximately
17%
and
13%
of total net sales, respectively. In
2017
, two customers, Sumitomo Corporation and Zhen Ding Technologies, accounted for approximately
12%
and
11%
of total net sales, respectively. One customer, Apple Inc. and its affiliates, accounted for approximately
15%
of total net sales in
2016
. No other customer individually accounted for more than
10%
of total net sales in
2018
,
2017
or
2016
.
Sales, Marketing and Service
We sell our products worldwide through direct sales and service offices, value-added resellers and independent representatives located around the world. ESI has direct sales and service personnel in Oregon, California and several other states; China, Japan, Korea, Singapore and Taiwan in Asia; and France, Germany and the United Kingdom in Europe. We serve select customers in Asia, the Americas, Europe and additional countries through manufacturers’ representatives.
We have a substantial base of installed products in use by leading PCB, semiconductor, and microelectronics manufacturers. We emphasize strong working relationships with these customers to meet their needs for additional systems and to facilitate the successful development and sale of new products to these customers.
We provide a portfolio of service offerings including service contracts, time and material arrangements, and parts supply arrangements to support this installed base and the requirements of our customers’ high-volume manufacturing environments throughout the product life. Much of the infrastructure supporting our service offerings is localized in our primary sales regions to enhance responsiveness to our customers. We generally employ service personnel wherever we have a significant installed base. We believe the integration between our systems and service offerings is a key differentiator for cost of ownership and overall product support.
Business Seasonality and Product Introductions
The Company has historically experienced higher net sales in the first half of the calendar year due in part to customers adding capacity in advance of seasonal holiday demand for electronic products. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, future net sales or financial performance.
Backlog
Backlog consists of purchase orders for products and spare parts that we expect to ship within the next 12 months and service contracts for performance generally within the next 24 months. Backlog does not include deferred system revenue. Backlog was
$148.4 million
at
March 31, 2018
compared to
$69.5 million
at
April 1, 2017
, representing
an increase
of
113%
primarily as a result of favorable market conditions for our flexible circuit products. Our backlog is not necessarily indicative of sales for any specific future period, because of possible order cancellations or deferrals, shipping or acceptance delays, and backlog does not represent any assurance that we will realize a profit from filling the orders.
Research, Development and Technology
We believe that our ability to compete effectively and deliver customer solutions depends, in part, on our ability to maintain and expand our expertise in core technologies and product applications. Our primary core competencies and capabilities include:
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laser/material interaction;
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laser beam positioning;
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optics and illumination including image processing and optical character recognition;
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micron-level defect detection;
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high-speed motion control;
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proprietary laser technology including laser power control; and
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We spend a considerable amount of our net sales proceeds to maintain and expand our expertise in core technologies and product applications. Our research and development expenditures for
2018
,
2017
and
2016
were
$34.4 million
(
9%
of net sales),
$31.7 million
(
20%
of net sales) and
$32.4 million
(
18%
of net sales), respectively. We primarily conduct our focused research and development efforts in Portland, Oregon.
Competition
Our markets are dynamic, cyclical and highly competitive. The principal competitive factors in our markets are total cost of ownership, product performance, ease of use, reliability, service, technical support, product roadmap, price, proprietary technology, manufacturing responsiveness and relationships with customers. We believe our products compete favorably with respect to these factors. Some of our competitors have greater financial, engineering and manufacturing resources and larger distribution networks than we do. Some of our customers or potential customers develop, or have the ability to develop, manufacturing equipment similar to our products. Competition in our markets may intensify and our technological advantages may be reduced or lost as a result of technological advances by competitors or customers or changes in electronic device processing technology.
Our PCB processing products primarily compete with laser systems provided by Via Mechanics, Ltd., EO Technics Co. Ltd., LPKF Laser & Electronics AG, Mitsubishi Electric Corporation, and Orbotech Ltd. Our semiconductor products primarily compete with InnoLas Systems GmbH and DISCO Corporation. Our component test products primarily compete with Laser Solutions, Inc., Quantel USA, Inc., HOYA Corporation, and Humo Laboratory Ltd., as well as component manufacturers that develop systems for internal use. Our industrial machining products primarily compete with laser systems provided by Han's Laser Technology Industry Group Co Ltd., HG Laser, and several Chinese and Korean companies who compete within their local markets; optical measuring machine providers such as Micro-Vu Corporation, OGP, and Werth, Inc.; and systems integrators such as GDO and IMS Technology Services.
Manufacturing and Supply
Our primary production facilities are located in Singapore; Portland, Oregon; and Klamath Falls, Oregon. Our leased Singapore facility is our primary systems manufacturing facility and manufactures the majority of our systems and lasers. The Portland facility primarily provides advanced manufacturing and prototype capability. The Klamath Falls facility manufactures component test consumable products.
We use qualified manufacturers to supply many components and sub-system modules for our systems. Our systems use high-performance computers, peripherals, lasers and other components from various suppliers. Some of the components we use are obtained from a single source or a limited group of suppliers. An interruption in the supply of a particular component would have a temporary adverse impact on us. We believe our supplier relationships are good.
Patents and Other Intellectual Property
We have a policy of seeking patents, when appropriate, on inventions relating to products and methods that are discovered or developed as part of our ongoing research, development and manufacturing activities. We owned
348
United States patents and
620
patents issued outside of the United States as of
March 31, 2018
. Additionally, as of
March 31, 2018
, we had
32
patent applications pending in the United States and
133
patent applications pending outside of the United States. Although our patents are important, we believe the competitiveness of our products also depends on the technical competence and innovation of our employees.
We rely on copyright protection for our proprietary software. We also rely upon trade secret protection for our confidential and proprietary information. Others may independently develop substantially equivalent proprietary information and techniques, and we may be unable to meaningfully protect our trade secrets.
Employees
As of
March 31, 2018
, we employed
655
people, of whom
615
were full-time ESI employees and
40
were temporary. Many of our employees are highly skilled, and our success will depend in part upon our ability to attract and retain such employees, who are in great demand. We have never had a work stoppage or strike, and no employees are represented by a labor union or covered by a collective bargaining agreement. We consider our employee relations to be good.
Environmental Compliance
Compliance with international, federal, state and local provisions that have been enacted or adopted related to the discharge of materials into the environment or otherwise relating to protection of the environment are not expected to have a material effect on our capital expenditures, earnings or ability to compete in the marketplace.
Where You Can Find More Information
We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 as amended (Exchange Act). You can inspect and copy our reports, proxy statements and other information filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. The SEC maintains an Internet site at
www.sec.gov
where you can obtain most of our SEC filings. We also make available, free of charge on our website at
www.esi.com
, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after they are filed electronically with the SEC. The information found on our website is not part of this Form 10-K. You can also obtain copies of these reports by contacting Investor Relations at (503) 641-4141.
Item 1A. Risk Factors
The following risks and uncertainties should be read carefully with the other information included in this Annual Report. If any of the risks described below occur, our business, financial condition, operating results and cash flows could be materially and adversely affected. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations and financial results.
All references to years or quarters relate to fiscal years or fiscal quarters unless otherwise noted.
Risks Related to Our Competition and Customers
Substantial competition in markets in which we operate may result in price reductions, reduced profit margins and loss of market share.
We face substantial competition from established competitors throughout the world, some of which have greater financial, engineering, manufacturing and marketing resources than we do. Competitors with greater resources may better withstand periodic downturns, compete more effectively on the basis of price and technology, utilize better established sales channels and customer relationships, or more quickly enhance or develop new generations of products that compete with our products, in addition to other advantages. New companies may enter the markets in which we compete, or industry consolidation may occur, further increasing competition in those markets. We have also experienced new entrants to our markets offering aggressive price and payment terms in an attempt to gain market share. Some competitors, particularly in China, also develop low-cost products employing processes or technology developed by us. In addition, because we frequently price our products in U.S. dollars, a strong U.S. dollar can make our products less price-competitive outside of the United States to products priced in other currencies. We believe that to be competitive, we must continue to expend significant financial resources in order to invest in new product development and enhancements, among other things. We may not be able to compete successfully in the future and increased competition may result in price reductions, reduced profit margins and loss of market share.
Our future success depends on our ability to expand into new markets.
Our future success and growth plans depend in large part on our successful entry into new markets adjacent to our existing markets, such as high-density interconnect drilling, interconnect packaging, advanced wafer scribing, and other industrial and consumer electronics markets, including automotive, aerospace, medical and display. These markets are new to us and our success depends on our displacing entrenched competitors who are familiar with these markets and are known to customers. In many cases, we are attempting to enter or expand our presence in these new markets with newly introduced products that are not yet proven in the industry. In addition, in some cases we need to develop or expand our sales channels and customer relationships in order to execute on this strategy. We cannot provide assurance that we will succeed in gaining significant, or any, market share in these new markets. If we fail to successfully expand into these markets, we will have difficulty growing our business and may lose business to our competitors.
Volatility in our customers’ industries and capital spending can have a direct and material impact on our business.
Our business depends upon the capital equipment expenditures of manufacturers of microelectronics, PCBs, semiconductors, computers, wireless communications and other electronic products. The capital equipment market for the production of those products has historically been characterized by cyclical variations in capital equipment demand. These sometimes sudden and severe cycles may result from a number of factors, including overall consumer and industrial spending and demand for electronic products that drive manufacturer production, as well as the manufacturer's capacity utilization, timing of new product introductions and demand for customers’ products, inventory levels relative to demand and access to affordable capital. The timing, severity and duration of these market cycles are difficult to predict. As a result, our business can vary significantly from quarter to quarter or year to year, as evidenced, for example, by comparing 2018 to 2017.
Downturns particularly affect our profitability given the relative fixed cost structure of our business and the need to continually invest in product technology and support and service for our products. For example, in the first and second quarters of 2017, we experienced a significant decline in orders due to reduced demand from PCB manufacturers that significantly impacted our results in the second and third quarters.
Increased pressure on price may result in pricing concessions, extended payment terms and decreased margins.
We have experienced and continue to experience pricing pressure from both competitors and customers in the sale of our products. Pricing pressures typically have become more intense during cyclical downturns when competitors seek to maintain or increase market share, reduce inventory or introduce more technologically advanced or lower-cost products. In addition, we may agree to pricing concessions or extended payment terms with our customers in connection with expanding into new markets or gaining volume orders, or to improve our customer cost of ownership in highly competitive applications. Our business, financial condition, margins or results of operations may be materially and adversely affected by competitive pressure and price-based competition.
Because our revenues largely depend on few customers and certain end markets, we have a greater degree of risk if we lose one of those customers, if we fail to win on new product designs, or if end markets are negatively impacted.
We depend on a few significant customers for a large portion of our revenues, and certain of these customers may be suppliers to relatively few end manufacturers. In
2018
, our top ten customers accounted for approximately
59%
of total net sales and two customers, Career Technology (Mfg.). Co., Ltd. and Top Unique Trading Co., Ltd., accounted for approximately
17%
and
13%
of total net sales, respectively. These concentrations can vary significantly from quarter to quarter and materially impact revenues and results from operations. For example, in 2018, we had one quarter where our concentration with a single customer was 50% of net sales. We anticipate that sales of our products to a relatively small number of customers will continue to account for a significant portion of our revenues.
Consolidation between customers, changes in technologies or solutions used by customers, changes in products manufactured by customers or in end-user demand for those products, selection of suppliers other than us, customer bankruptcies or customer departures from their respective industries all may result in even fewer customers accounting for a high percentage of our revenue and reduced demand from any single major customer. A change in demand from end manufacturers, or the customers of our direct customers, may impact the demand we receive across multiple direct customers. Additionally, if the end manufacturers have significant share in their end markets, demand from ESI's customer base could be sensitive to, and be broadly impacted by, negative movements in those end markets. The level of sales to our top customers often depends on winning bids on new designs and features each product cycle, and there is no guarantee of future business based on past design wins.
None of our customers have any long-term obligation to continue to buy our products or services and may therefore delay, reduce or cease ordering our products or services at any time. The cancellation, reduction or deferral of purchases of our products by even a single customer could significantly reduce our revenues in any particular quarter. If we lose any of our significant customers, including as a result of any shipment delays due to heightened production levels, or suffer a material reduction in their purchase orders, revenue could decline and our business, financial condition and results of operations could be materially and adversely affected.
Because our revenues are largely based on the sale of a small quantity of product units, our operating results could fluctuate significantly from quarter to quarter.
We derive a substantial portion of our revenue from the sale of a relatively small quantity of products. Accordingly, our revenues, margins and other operating results could fluctuate significantly from quarter to quarter depending upon a variety of factors in addition to those described above, including:
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the timing of orders and terms or acceptance of product shipments by our customers;
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the mix of products and services that we sell in a given quarter;
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timing and market acceptance of our new product introductions; and
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delays or problems in the planned introduction of new products, or in the performance of any such products following delivery to customers.
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As a result of these risks, we believe that quarter-to-quarter comparisons of our revenue and operating results may not be meaningful, and that these comparisons may not be an accurate indicator of our future performance.
Risks Related to Our Supply Chain and Production
Limitations on our ability to rapidly change our production capacity in a cost effective manner could result in lower gross margins during sudden downturns and an inability to meet demand in sudden upturns.
To meet rapid changes in demand, such as we have experienced recently, we must effectively manage our resources and production capacity. When upturns occur, it may be difficult to rapidly and effectively increase our manufacturing capacity, or may be unable to do so, or may have difficulty procuring sufficient materials to meet sudden increases in customer demand. This could result in shipping delays or the loss of business to our competitors and harm to our relationships with our customers, which may result in penalties or other costs to the Company. Conversely, during periods of decreasing demand for our products, we must be able to appropriately align our cost structure with prevailing market conditions and effectively manage our supply chain. Our ability to timely and effectively reduce our costs in response to rapid downturns is limited by the fixed nature of many of our expenses in the near term, by our need to continue investing in product technology and support and service our products, and by our need to have sufficient production capacity and supply available to respond to sudden increases in demand. This could result in unavoidable short-term costs or excessive inventory levels, including increased risk of inventory obsolescence. If we are not able to timely and cost effectively adapt to changes in our business environment, our business, financial condition or results of operations may be materially and adversely affected.
Our reliance on critical suppliers for key components could lead to production and service interruptions and shortages.
We use a wide range of components from numerous suppliers in the manufacturing of our products, including custom electronic, laser, optical and mechanical components. We generally do not have guaranteed supply arrangements with our suppliers. We seek to reduce the risk of production and service interruptions and shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key suppliers and maintaining appropriate inventories of key parts. However, some key parts are available only from a single supplier or a limited group of suppliers in the short term. In addition, some of the lasers we use in our products are difficult to manufacture, and as a result we may not receive an adequate supply of lasers in a timely fashion to fill orders. Operations at our suppliers’ facilities are subject to disruption or discontinuation for a variety of reasons, including changes in business relationships, competition, financial difficulties, work stoppages, fire, natural disasters, customer prioritization, component end of life decisions or other causes. Any such disruption or discontinuation to our suppliers’ operations could interrupt or reduce our manufacturing activities and delay delivery of our products, any or all of which could materially and adversely affect our results of operations. This risk is particularly acute when we rely on a single or a limited group of suppliers. In addition, during periods of increased demand for our products, there is a heightened risk that one or more of our suppliers may not meet our increased demand requirements, adversely affecting our ability to fulfill orders and win business with our customers.
Our product delivery schedules may cause us to incur significant expenses without offsetting revenues.
During our sales cycle, our customers generally evaluate, test and qualify our products before making a decision to purchase them. Before a potential customer purchases our products, we may incur significant expenses related to sales and marketing, product development and research and development prior to receiving a customer order that may be delayed or never get placed. We may incur these expenses without receiving revenues to offset such expenses soon thereafter or at all, which could materially and adversely affect our business, financial condition, or results of operations.
We may incur charges for excess or obsolete inventory as a result of having to forecast product demand without firm orders.
To effectively compete, we must deliver products on schedules required by our customers. Management forecasts demand, both in type and number of products, for us to timely meet customer delivery schedules. We use these forecasts to purchase inventory, some of which have exceptionally long lead times, in advance of our receiving firm customer orders. We also order materials based on our technology roadmap, which represents management’s assessment of technology we will utilize in new product developments. Certain types of inventory, such as lasers and optical equipment, are particularly expensive and may only be used in the production of a single type of product. If actual demand is lower than forecast, we may have excessive working capital and slow-turning inventory. In addition, we may incur material charges for excess and obsolete inventory if we cannot sell the inventory. Also, if we alter our technology or product development strategy, we may have unusable inventory, which may also result in material accounting charges. For example, during
2018
, we recorded approximately
$13.6 million
of charges in cost of sales, primarily due to inventory write offs associated with discontinued products.
We may be unable to timely deliver certain products made by contract manufacturers.
We have arrangements with contract manufacturers to complete the manufacturing of certain of our product subcomponents. Any significant interruption in our contract manufacturers’ ability to provide quality manufacturing services to us as a result of contractual disputes with us or another party, labor disruptions, financial difficulties, natural disasters, delay or interruption in the receipt of inventory, or other causes could result in reduced manufacturing quality or delayed deliveries for certain of our products, any or all of which could materially and adversely affect our business. Additionally, should a contract manufacturer no longer be able to perform for any reason or we need to add a contract manufacturer, it may require substantial time and resources, including the potential of incurring substantial cost, to replace or add the associated manufacturing capabilities, which could materially and adversely affect our business.
Increasing regulations or environmental requirements on our product components could negatively affect our ability to sell our products or source materials.
Many countries, including the United States, China and those in the European Union, have implemented directives that restrict the sale of new electrical and electronic equipment containing certain hazardous substances and require disclosures if certain metals used in products are not from a conflict-free source. The directives could restrict our ability to sell our products in certain countries and affect sourcing at competitive prices and availability in sufficient quantities of certain minerals used in the manufacture of our products. In addition, our reputation could suffer if we are required to disclose that metals in our products are not from conflict-free sources.
Risks Related to Our Organization
Our significant international trade subjects us to greater risks.
International shipments accounted for
95%
of net shipments in
2018
, with
90%
of our net shipments to customers in Asia. We expect that international shipments will continue to represent a significant percentage of net sales in the future. In addition, we obtain supplies through an international supply chain. Our non-U.S. sales and purchases are subject to risks inherent in international trade, many of which are outside our control and include the following:
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periodic local or geographic economic downturns;
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price and currency exchange controls;
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fluctuation in the relative values of currencies;
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difficulty in repatriating money, whether as a result of tax laws or otherwise;
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difficulties protecting intellectual property;
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shipping delays and disruptions, including as a result of border controls;
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retaliatory trade practices, trade tensions, and changes in or inconsistency in application of trading policies, regulatory requirements, export control regulations, tariffs and other barriers, the termination or renegotiation of existing trade agreements; and
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difficulties in managing a global enterprise, including staffing, collecting accounts receivable, and managing suppliers, distributors and representatives.
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Our success depends, in part, on hiring and retaining key personnel.
Our continued success depends in part upon the services of our key managerial, financial and technical personnel. The loss of key personnel, or our inability to attract, assimilate and retain qualified personnel, could result in the loss of customers, inhibit our ability to operate and grow our business and otherwise have a material adverse effect on our business and results of operations. We have previously had to, and may in the future have to, impose salary reductions on employees during economic downturns in an effort to maintain our financial position. On several occasions in recent years, executives and other employees have received limited or no annual bonuses due to our financial performance relative to the performance parameters in our annual bonus plans. These events may have an adverse effect on employee loyalty and may make it more difficult for us to attract and retain key personnel. Competition for qualified personnel in the industries and locations in which we compete for talent is intense, and we may not be successful in attracting and retaining qualified personnel. We may incur significant costs in our efforts to recruit and retain key personnel, which could affect our financial position and results of operations.
In February 2017, we announced a reorganization and restructuring, which resulted in site closures in Montreal, Canada, Napa and Sunnyvale, California, and reductions in headcount in all functions and geographies. Additionally, we have replaced key executives. These events may adversely disrupt operating activities, may negatively affect employee morale and loyalty, and may make it more difficult to retain or rehire key personnel.
Our business and reputation could be negatively impacted by cyber-attacks and other security breaches.
We electronically store sensitive data, including intellectual property, and our customers’, suppliers’ and business partners’ proprietary business information, and our employees’ personally identifiable information. The secure maintenance and transmission of this information is critical to our operations and business strategy. Despite our security measures, our information technology and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other actions. Further, the increasingly international, mobile-device, internet, and email-based environment in which we do business may subject the Company to new risks, such as email phishing attempts, or other activities designed to defraud the Company of funds or sensitive information, and may also provide multiple points of entry for cyber-attacks. Additionally, we rely on a number of third-party “cloud-based” providers of corporate infrastructure services relating to, among other things, human resources, electronic communication services and some financial functions, and we are therefore dependent on the security systems of these providers. Any breach or other unauthorized access to either our systems or our service-providers’ systems through viruses, loggers, malfeasant code in data or software, or other means could expose us to information loss or disclosure of confidential information and could compromise our networks such that the information stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information, disrupt our operations, damage our reputation, or hurt our competitive position, which could adversely affect our business, financial position and results of operations.
Our implementation of an updated enterprise resource planning software may result in unintended consequences that could negatively impact our business.
We expect to upgrade our enterprise resource planning software and related systems that support our operating and financial functions. We may experience difficulties in connection with such upgrades, including loss or corruption of data, compatibility issues, decreases in productivity as our personnel implement and become familiar with the upgrades, higher than expected upgrade costs and other integration challenges or delays. If encountered, a significant problem with the system upgrades could negatively impact our business by disrupting our operations. In addition, a significant problem with the system upgrades, integration with other systems or ongoing management of our enterprise resource planning software and related systems could have an adverse effect on our ability to generate and interpret accurate management and financial reports and other information on a timely basis, which could adversely affect our business, financial position and results from operations
Our success could be negatively impacted if we fail to effectively control, oversee and direct foreign subsidiaries and our global footprint may result in a substantial amount of management effort, cost and uncertainty.
We are a global company operating in multiple jurisdictions. We have significant foreign operations and subsidiaries, including manufacturing facilities in Singapore and China, research and application development facilities in France, China and Korea, and sales and service offices in various countries to enhance responsiveness and access to customers local to these regions. In 2018, certain additional customer-facing operational resources were moved to countries in Asia, and changes were implemented to our supply chain in regions outside the U.S. Our global presence and any changes thereto may subject us to a variety of complexities and risks, many of which may divert a substantial amount of management’s time. These risks include:
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exposure to local labor disputes, potential corruption, and noncompliance with labor laws and other laws governing employees;
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unpredictable costs, redundancy costs and cost overruns for developing facilities and acquiring equipment;
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challenges in building local management teams, technical personnel and other staff for functions that we have not previously conducted outside of the United States;
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technical obstacles such as poor production or process yield and loss of quality control during the ramp of a new facility;
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re-qualifications and other procedures that our customers may require;
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our ability to bring up local suppliers to meet our quality and cycle-time needs;
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rapidly changing business conditions that may require us to change or abandon plans before we fully implement them;
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complexity of managing our financial reporting and internal controls and procedures; and
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the ability to understand and comply with many different laws, infrastructures, ways of doing business, and surmount other challenges posed by distance and differences in language and culture.
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If we are unable to manage these risks effectively, it could negatively affect our operating performance and our reputation. These and other factors could delay the continuing development, expansion and implementation of our strategy, as well as decrease our gross margins, delay shipments and deliveries, cause us to lose sales, require us to write off investments already made, damage our reputation and harm our business, financial condition and results of operations. For example, we announced restructuring plans in 2015 and 2017 that led to the impairment of leasehold improvements and other assets for several of our facilities, some of which were in international locations.
Our global operations expose us to a greater variety of natural disasters and political and social strife, each of which could directly impact our properties, operations and personnel.
Our business and operating results could be impacted, directly or indirectly, by natural disasters, outbreaks of infectious disease, military action, international conflicts, terrorist activities, civil unrest and associated political instability and policy changes. Many of our facilities, including our Portland, Oregon headquarters, are in areas with known earthquake risk. Some of these events or circumstances may also result in heightened security concerns with respect to domestic and international travel and commerce, including more frequent instances of shipping delays, which may further affect our business and operating results. In particular, recent and potential future tightening of immigration and travel controls may adversely affect the residence status of non-U.S. engineers and other key technical employees in our U.S. facilities, our ability to attract, hire and retain new non-U.S. employees in such facilities or our ability to bring our non-U.S. employees into the United States for business related activities.
Our acquisition activities could result in operational disruptions, integration difficulties and other complications.
We may acquire or make significant investments in other businesses with complementary products, services or technologies, such as our January 2015 acquisition of Wuhan Topwin Optoelectronics Technology Co., Ltd. (Topwin) and our August 2016 acquisition of Visicon Technologies, Inc. (Visicon). Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including:
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increased costs in connection with integration of personnel, operations, technologies and products of the acquired businesses;
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difficulties in implementation of our enterprise resource planning (ERP) system into the acquired company’s operations;
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diversion of management’s attention from other operational matters;
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the potential loss of key employees of the acquired company;
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lack of synergy or inability to realize expected synergies resulting from the acquisition;
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the inability to successfully enter new markets expected to result from the acquisition;
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acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company;
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establishing satisfactory internal controls and accounting practices at the acquired company;
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difficulties implementing internal manufacturing processes at the acquired company;
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achieving our anticipated financial and operational performance for the acquired company or the performance of the combined company following the transaction;
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acquiring unanticipated liabilities; and
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potential litigations arising out of breach of contract terms.
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The means by which we finance an acquisition may also significantly affect our business or the value of our common stock. If we issue common stock to pay for an acquisition, the ownership percentage of our existing shareholders will be diluted and the value of the shares held by our existing shareholders could decrease. If we use cash on hand to pay for an acquisition, the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. If we borrow funds in connection with an acquisition, we would be required to use cash to service the debt and to comply with financial and other covenants, which may reduce our flexibility.
Risks Related to Technology
We may be unable to realize growth opportunities if we cannot strengthen our marketing and channel capabilities.
The laser microfabrication industry is comprised of broad sets of markets and applications and presents significant opportunities for growth. In order to access these growth opportunities, we are strengthening our approach from customer-centric to market-based. We have reorganized into a functional structure and expanded our marketing team to drive improved process and disciplines across the organization. We believe our ability to successfully access and compete in these broader markets partially depends on our successful development of new marketing capabilities, sales and distribution channel access and customer relationships. Our inability to do so would limit our growth opportunities and profitability. In addition, any new strategy may cause disruption and ultimately prove unsuccessful.
We may be unable to keep up with rapid technological changes in our markets, which could result in customers purchasing fewer of our products.
The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes and the requirements of current and potential customers. The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We may not be able to identify, develop, manufacture, market or support new or enhanced products on a timely basis, if at all. If our competitors introduce new or enhanced products, or alternative technologies, our customers may defer, change or cancel orders for our existing products or cease purchasing our products altogether. Further, our new products may not gain timely market acceptance, and we may not be able to respond effectively to product announcements by competitors, technology changes or emerging industry standards. If we are unable to develop new or enhanced products to address customer requirements, technology changes or new industry standards on a timely basis, if our new or enhanced products are not accepted by the market, or if our customers adopt alternative technologies, our business, financial condition and results of operations may be adversely affected due to loss of market share or due to concentrations in impacted areas.
Our industry requires continued investment in research and development, and we may fail to optimally allocate our resources in this area.
The intense competition in our industry requires us to continue to invest in research and development. If we fail to invest sufficiently in research and development, our products could become obsolete or less attractive to our current and potential customers. Because of our need to maintain our research and development spending levels, our operating margins could be materially decreased if our net sales decline. In addition, our emphasis on research and development and technological innovation could cause our operating costs to increase in the future, and research and development expenses to increase as a percentage of total operating expenses and as a percentage of net sales. Conversely, if we have competing needs for our financial resources, we could spend less on research and development than we believe would be optimal for long-term competitiveness.
Because our products are highly complex, we may experience quality control issues that could result in decreased sales and harm our reputation.
Our products are highly complex, and our extensive product development, manufacturing and testing processes may not be adequate to detect all defects, errors, failures and quality issues that could impact customer satisfaction or result in claims against us. Our strategy to leverage proprietary laser technology to create competitive advantage may increase the probability and impact of these risks. As a result, we may have to replace certain components or provide remediation in response to the discovery of defects in products after they are shipped. The occurrence of any defects, errors, failures or quality issues could result in cancellation of orders, product returns, diversion of our resources, legal actions by our customers and other losses to us or to our customers. These occurrences could also result in the loss of, or delay in, market acceptance of our products, loss of sales and increased expenses and warranty costs.
Risks Related to Legal Matters
Our business depends on proprietary rights that may be difficult to protect, and the loss of any proprietary rights could affect our ability to compete effectively.
Our success depends significantly upon the protection of our proprietary rights. We attempt to protect our proprietary rights through patents, copyrights, trademarks, maintenance of trade secrets and other measures, including entering into confidentiality agreements. Although we incur substantial costs to obtain and maintain patents and to defend our intellectual property rights, we may be unsuccessful in protecting these rights. Additionally, our proprietary rights may not provide the competitive advantages we expect, or other parties may challenge, invalidate or circumvent these rights.
We rely upon the laws of the United States and foreign countries where we develop, manufacture or sell our products to protect our proprietary rights. However, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States. For example, the patent prosecution and enforcement system within China is less mature than the systems in other jurisdictions and therefore we may be limited in our ability to enforce our rights. This disadvantage would likely be compounded by the challenge of any enforcement attempts by us as a foreign entity seeking protection against a Chinese company infringing on our proprietary rights in China. If we fail to adequately protect our intellectual property abroad, it could be easier for our competitors to sell competing products in foreign countries, which could result in reduced sales and gross margins.
Our products may subject us to intellectual property infringement claims that could increase our costs and restrict our ability to do business.
Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products. Competitors or others have asserted in the past, and may assert in the future, infringement claims against our customers or us with respect to current or future products or uses. These assertions may result in costly litigation, and if claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur.
If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms, or successfully defend our position, our financial condition and results of operations could be materially and adversely affected.
As a global company, we are subject to adverse fluctuations in our effective taxes due to tax audits, changes in tax law, certain preferential tax concessions, and other regulatory requirements.
Our tax liabilities may fluctuate from one period to the next because we operate in numerous tax jurisdictions with a broad range of income tax rates and regulations. Further, we are also periodically under audit by United States and foreign tax authorities and may have exposure to additional tax liabilities as a result. Although we believe our tax estimates are reasonable, the final outcome of tax audits and the impact of changes in tax laws or the interpretation of tax laws could result in a material effect on our financial results, tax positions or cash flows in the period or periods in which the determination is made. For example, in 2018 we recorded an expense of $2.5 million for a value added tax and duty audit by the South Korean government.
We benefit from a tax incentive program in Singapore pursuant to which we paid no Singapore income tax with respect to our Singapore manufacturing operations. The incentive period ends June 30, 2021 and is conditioned on achieving certain business and investment levels. If we do not achieve these criteria, we may lose the incentive benefits.
We have tax losses and tax credits with remaining lives between 5 and 20 years. In the fourth quarter of 2018, we generated
$75.1 million
of net income, which resulted in three years of cumulative income. This, combined with our backlog position at March 31, 2018 and our expected ability to utilize certain deferred tax assets and credits prior to their expiration, we believe provided sufficient positive evidence to release $42.3 million of our valuation allowance as of March 31, 2018. A release of the valuation allowance resulted in the recognition of certain deferred tax assets and an income tax benefit for 2018.
The Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law in the U.S. on December 22, 2017. We have elected the Staff Accounting Bulletin No. 118 measurement period and will continue to evaluate the impact the new legislation will have on our consolidated financial condition, results of operations, and cash flows. While not limited to the following, we believe the following risks exist:
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Rule-making and additional technical guidance from the Department of Treasury, the FASB, and other relevant rule-making bodies continues to evolve and is likely to impact the treatment of the impact of the Tax Act.
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The Company’s assessment remains ongoing; therefore, the final impact of the Tax Reform may differ due to changes in interpretations, assumptions and we are not able to fully quantify the impact on the Consolidated Financial Statements at this time.
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Reaction to the new regulations by states and international trading partners is not yet clear, and could have a material impact on our business and results of operations.
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The change in statutory tax rates in the United States also impacts the gross values of the deferred tax assets and valuation allowance. The release of the valuation allowance and the future utilization of deferred tax assets are recognized at the new, lower rate.
Risks Related to Financial Matters
If we cannot meet our liquidity needs, we may not have sufficient working capital to continue our business operations.
We may require greater working capital to operate than similar size businesses in many other industries. At
March 31, 2018
, we had working capital of
$203.2 million
, including
$123.9 million
in cash, cash equivalents and short-term investments. Our operating cash flows were negative for most quarters between September 2013 and March 2017. Operating cash flows for 2018 were positive and we generated $67.4 million of operating cash. If cash levels were to decline below our working capital requirements due to investment in inventories as a result of production, less favorable collections, or less favorable payment terms, or a combination of these circumstances, among others, we may need additional cash to sustain operations. In addition, many of our contracts to acquire inventory represent purchase commitments. As a result, if we experience lower than anticipated demand for our products we may not avoid the cost of purchasing the associated inventory.
While we have a credit facility in place, if we fail to meet the covenants in our credit facility or our lenders fail to fund, access to the facility may be limited or the facility may become unavailable altogether. Losses, such as those experienced in the second and third quarters of 2017, negatively impact our ability to maintain compliance with these covenants.
If we have a material decrease in available cash, or require additional cash for operations, and we do not have available credit or other funds and are unable to obtain financing on acceptable terms, or at all, our business and our ability to fully fund operations could be materially and adversely affected.
Our existing indebtedness may limit our business opportunities.
In the fourth quarter of 2017, we incurred $14.0 million of long-term indebtedness in the form of secured mortgage. This indebtedness is secured by our headquarters in Portland, Oregon. We also have access to a credit facility under which we may borrow up to a maximum of $30 million, subject to meeting certain availability requirements. Nothing was outstanding under this agreement and the full amount was available under the terms of the agreement as of
March 31, 2018
. This credit facility is secured by our non-real estate assets and we are required to comply with certain financial covenants under the debt agreements, including maintaining a certain level of earnings, a stated debt service coverage ratio and a specified level of certain types of liquid assets, as well as limiting our discretion to make capital expenditures or acquisitions. If we are unable to comply with the covenants in our debt agreements or make payments when due and the lender declares an event of default, any outstanding indebtedness would likely be immediately due and owing and the lenders could foreclose on the collateral securing the debt.
Unfavorable currency exchange rate fluctuations could reduce our net sales abroad or cause us to incur losses on our forward exchange contracts.
Unfavorable currency fluctuations could require us to increase prices to foreign customers, which could result in lower net sales by us to those customers. Alternatively, if we do not adjust the prices for our products in response to unfavorable currency fluctuations, we could be forced to sell our products at a lower margin or at a net loss. A weak dollar may lead to impairment of inventories if costs begin to exceed selling prices as translated to the functional currency. In addition, some of our foreign sales are denominated in the currency of the country in which these products are sold and that currency could be less valuable at the time of receipt as a result of exchange rate fluctuations. From time to time, we enter into forward exchange contracts to hedge the value of accounts receivable primarily denominated in euros and other currencies. However, our efforts may not be adequate to protect us against significant currency fluctuations and such efforts may expose us to additional exchange rate risks, which could adversely affect our results of operations.
An impairment of our investments could reduce our available liquidity.
Our investment portfolio is primarily comprised of commercial paper, corporate bonds, debt securities issued by U.S. governmental agencies and money market securities. These investments are intended to be highly liquid and low risk. If the markets for these securities deteriorated for any reason, including as a result of a downgrade in the credit rating of U.S. government securities, the liquidity and value of these investments could be negatively affected, which could result in impairment charges and a material impact to our financial condition and results of operations. In addition, if our investments become illiquid or materially decrease in value, we may not have access to sufficient cash to meet or working capital and liquidity needs.
An impairment of Goodwill, Intangible and Long-Lived Assets could negatively impact our consolidated earnings.
We held a total of
$5.2 million
in acquired intangible assets, net of accumulated amortization, and
$2.6 million
in goodwill at
March 31, 2018
. As with the impairment recognized in the fourth quarter of 2017, events may occur or circumstances change such that the carrying value is not recoverable or it becomes more likely than not that the fair value of long-lived assets is reduced below the carrying value of the reporting unit, which could result in a further write-down of the fair-value of our assets. For example, the performance of our Topwin reporting unit did not meet expectations and, as a result, an impairment of goodwill and intangibles associated with that reporting unit was triggered in 2017, impacting consolidated earnings.
In addition, certain of our long-lived assets such as leasehold improvements, machinery, equipment, and loan and demo assets may experience impairment as a result of events such as the closure of sites, introduction of new products, decisions to exit certain products or markets, and changes in technology. We depreciate long-lived assets and amortize intangible assets at levels we believe are adequate; however, an impairment of these assets could have a material adverse impact on our business, financial condition and results of operations. For example, due to the 2017 restructuring plan, $3.0 million of non-current assets were impaired since the beginning of the plan through 2018 and included in operating expenses.
If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud and our stock price and our business may be adversely affected.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our operating results could be harmed.
Although we are committed to continue to improve our internal control processes and to diligently and vigorously review our internal control over financial reporting in order to ensure compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. Therefore, we cannot be certain that in the future any material weaknesses or significant deficiencies will be avoided. If such weaknesses or deficiencies occur, they could result in misstatements of our results of operations, restatements of our Consolidated Financial Statements, a decline in our stock price and investor confidence, or other material negative effects on our business, reputation, financial condition or liquidity.
We may have difficulty implementing new revenue recognition requirements, which could adversely affect our reported financial results or the timeliness thereof.
Although we have spent considerable time preparing to implement the new Accounting Standards Update (ASU) 2014-09,
Revenue from Contracts with Customers: Topic 606 (ASU 2014-09)
, we do not have extensive experience with the new requirements in practice. The SEC requires us to publish our financial results in short time frames, which could result in
our having difficulty implementing the new requirements as intended within the prescribed financial reporting periods. Untimely or inaccurate implementation of ASU 2014-09 could adversely affect our reported financial results. We provide no assurance that the anticipated effects of ASU No. 2014-09 contained in this Annual Report are accurate.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
Our executive and administrative headquarters, which houses our primary engineering and marketing functions, advanced manufacturing capability for new products, and manufacturing of select legacy products are located in a three-building complex with 197,838 square feet of space on 10.15 acres in Portland, Oregon. Additionally, our component test consumables are manufactured at a 53,000 square-foot plant on 31 acres in Klamath Falls, Oregon. We own all of the buildings located in Oregon. We believe the productive capacity of these facilities to be adequate and suitable for the requirements of our business for the foreseeable future.
Our primary system manufacturing facilities are located in leased facilities in Singapore. We lease approximately 35,216 square feet of facilities in Singapore where the majority of ESI systems are manufactured; this is an increase from 26,000 square feet in previous years. Additionally, we lease other office and facility space in various locations throughout the United States and various foreign countries.
We lease approximately 32,500 square feet of facilities in Chelmsford, Massachusetts. As a part of the Company’s 2015 plan to streamline its manufacturing and development activities, the Company transitioned the manufacturing and development activities to other U.S. facilities during 2016 and accordingly this property is not being used.
Item 3. Legal Proceedings
In the ordinary course of business, the Company is involved in various legal matters, either asserted or unasserted. In the opinion of management, ultimate resolution of these matters will not have a material effect on the Company's consolidated financial position, results of operations or cash flows.
Item 4. Mine Safety Disclosures
Not Applicable.