Photronics - 10-Q quarterly report FY2012 Q3

Washington, D.C. 20549

The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements made by or on behalf of Photronics, Inc. ("Photronics" or the "Company"). These statements are based on management's beliefs, as well as assumptions made by, and information currently available to, management. Forward-looking statements may be identified by words like "expect", "anticipate", "believe", "plan", "projects", and similar expressions, or the negative of such terms, or other comparable terminology. All forward-looking statements involve risks and uncertainties that are difficult to predict. In particular, any statement contained in this quarterly report on Form 10-Q, in press releases, written statements, or other documents filed with the Securities and Exchange Commission, or in the Company's communications and discussions with investors and analysts in the normal course of business through meetings, phone calls, or conference calls regarding the consummation and benefits of future acquisitions, expectations with respect to future sales, financial performance, operating efficiencies, or product expansion, are subject to known and unknown risks, uncertainties, and contingencies, many of which are beyond the control of the Company. These factors may cause actual results, performance, or achievements to differ materially from anticipated results, performance, or achievements expressed or implied by such forward-looking statements. Factors that might affect such forward-looking statements include, but are not limited to, overall economic and business conditions; economic and political conditions in international markets; the demand for the Company's products; competitive factors in the industries and geographic markets in which the Company competes; changes in federal, state and international tax requirements (including tax rate changes, new tax laws and revised tax law interpretations); interest rate fluctuations and other capital market conditions, including changes in the market price of the Company's common stock; foreign currency exchange rate fluctuations; changes in technology; the timing, impact, and other uncertainties of future acquisitions; the seasonal and cyclical nature of the semiconductor and flat panel display industries; management changes; damage or destruction to the Company's facilities, or the facilities of its customers or suppliers, by natural disasters, labor strikes, political unrest, or terrorist activity; the ability of the Company to (i) place new equipment in service on a timely basis; (ii) obtain additional financing; (iii) achieve anticipated synergies and other cost savings in connection with acquisitions and productivity programs; (iv) fully utilize its tools; (v) achieve desired yields, pricing, product mix, and market acceptance of its products and (vi) obtain necessary export licenses. Any forward-looking statements should be considered in light of these factors. Accordingly, there is no assurance that the Company's expectations will be realized. The Company does not assume responsibility for the accuracy and completeness of the forward-looking statements and does not assume an obligation to provide revisions to any forward-looking statements, except as otherwise required by securities and other applicable laws.

In March 2012 the Company, in connection with its purchase of the U.S. nanoFab facility (see Note 3 for further discussion), amended its credit facility (“the credit facility”) to include the addition of a $25 million term loan maturing in March 2017 with minimum quarterly principal payments of $0.6 million (quarterly payments commenced in June 2012 and are based on a ten year repayment period). The amendment also included a twenty-five basis point reduction in the interest rate charged on any borrowings under the credit facility. The credit facility bears interest (2.5% at July 29, 2012), based on the Company’s total leverage ratio, at LIBOR plus a spread, as defined in the credit facility.

 

In March 2011 the Company issued through a private offering, pursuant to Rule 144A under the Securities Act of 1933, as amended, $115 million aggregate principal amount of 3.25% convertible senior notes. The notes mature on April 1, 2016, and note holders may convert each $1,000 principal amount of notes to 96.3879 shares of common stock (equivalent to an initial conversion price of $10.37 per share of common stock) at any time prior to the close of business on the second scheduled trading day immediately preceding April 1, 2016.  The conversion rate is subject to adjustment upon the occurrence of certain events, which are described in the indenture dated March 28, 2011.  The Company is not required to redeem the notes prior to their maturity date. Interest on the notes accrues in arrears, and is paid semiannually through the notes’ maturity date. Interest payments on the notes commenced on October 1, 2011. The net proceeds of the notes were approximately $110.7 million, which were used, in part, to acquire $35.4 million of the Company’s 5.5% convertible senior notes which were to mature on October 1, 2014, and to repay, in full, its then outstanding obligations under capital leases of $19.8 million.

 

In March 2011 the Company amended the credit facility which, as amended, included, among other things: i) a reduction of the aggregate commitments of the lenders from $65 million to $30 million; ii) a reduction of the applicable interest rates and modifications of the leverage ratios related thereto; iii) an extension of the maturity date to April 30, 2015; iv) an increase in the permitted amount of certain financed capital assets up to $75 million outstanding at any one time; v) an allowance to issue the 3.25% convertible senior notes; vi) an increase in the investments “basket” from $15 million to $25 million per year; vii) an allowance to repurchase the 5.5% convertible senior notes and other indebtedness and viii) removal of the limitation on maximum last twelve months capital expenditures.

 

In June 2011 the Company acquired $5.0 million of its 5.5% convertible senior notes in exchange for 0.7 million shares of its common stock, with a fair value of $6.5 million, and cash of $3.2 million (the note holders received 147.529 shares and cash of $647 for each $1,000 note). The Company, in connection with this repurchase, recorded an extinguishment loss of $5.0 million, which included the write off of deferred financing fees of $0.3 million. The loss is included in other income (expense) in the Company’s condensed consolidated statements of income.

 

In September 2009 the Company issued, through a public offering, $57.5 million aggregate principal amount of 5.5% convertible senior notes, which were to mature on October 1, 2014.  Under the terms of the offering, the note holders could convert each $1,000 principal amount of notes to 196.7052 shares of common stock (equivalent to an initial conversion price of $5.08 per share of common stock) on, or before, September 30, 2014.  The conversion rate is subject to adjustment upon the occurrence of certain events which are described in the indenture dated September 16, 2009.  The Company is not required to redeem the notes prior to their maturity.  The net proceeds of this offering were approximately $54.9 million, which were used to reduce amounts outstanding under the Company’s credit facility. As discussed above, $35.4 million aggregate principal amount of these notes were acquired by the Company during fiscal year 2011.

 

In January 2010 the Company borrowed $3.7 million from a customer to purchase manufacturing equipment. This loan bears interest at 4.75% and is primarily being repaid with product supplied to the customer. Product valued at $0.4 million and $0.9 million was shipped to the customer and applied against the loan during the three and nine month periods ended July 29, 2012, respectively, and product valued at $0.3 million and $0.9 million was applied against the loan in the respective prior year periods. The Company estimates that the loan will be fully repaid in fiscal 2013.

In September 2009 the Company entered into two warrant agreements with Intel Capital Corporation to purchase a total of 750,000 shares of the Company's common stock. Under one warrant agreement 500,000 shares of the Company's common stock can be purchased at an exercise price of $4.15 per share and under the second warrant agreement 250,000 shares of the Company's common stock can be purchased at an exercise price of $5.08 per share. The warrant agreements expire in September 2014. Also in September 2009, the Company and Intel Corporation entered into an agreement to share technical and operations information regarding the development of the Company's products, the capabilities of the Company's photomask manufacturing lines and the alignment of photomask toolsets. Intel Capital Corporation also invested in the Company's convertible debt offering of September 2009. The warrants were recorded at their fair value on their date of grant, which was determined using the Black-Scholes option pricing model. As of July 29, 2012, none of the warrants issued to Intel Capital Corporation had been exercised.

 

In conjunction with the May 2009 amendment to its then existing credit facility, the Company also entered into a warrant agreement with its lenders. See Note 6 for further discussion of these warrants.

The Company utilizes derivative instruments to reduce its exposure to the effects of the variability of interest rates and foreign currencies on its financial performance when it believes such action is warranted. Historically, the Company has been a party to derivative instruments to hedge either the variability of cash flows of a prospective transaction or the fair value of a recorded asset or liability. In certain instances, the Company has designated these transactions as hedging instruments. However, whether or not a derivative was designated as being a hedging instrument, the Company's purpose for engaging in the derivative has always been for risk management (and not speculative) purposes. The Company historically has not been a party to a significant number of derivative instruments and does not expect its derivative activity to significantly increase in the foreseeable future.

 

In addition to the utilization of derivative instruments discussed above, the Company attempts to minimize its risk of foreign currency exchange rate variability by, whenever possible, procuring production materials within the same country that it will utilize the materials in manufacturing, and by selling to customers from manufacturing sites within the country in which the customers are located.

In May 2009, in connection with an amendment to its credit facility, the Company issued 2.1 million warrants, each exercisable for one share of the Company's common stock at an exercise price of $0.01 per share. Forty percent of the warrants were exercisable upon issuance, and the remaining balance was to become exercisable in twenty percent increments at various points in time after October 31, 2009. As a result of certain net cash settleable put provisions within the warrant agreement, the warrants were recorded as a liability in the Company's consolidated balance sheet. As of the issuance date and for future periods that such warrants remained outstanding, the Company had adjusted the liability based upon the current fair value of the warrants, with any changes in their fair value being recognized in earnings. Due to the warrants' exercise price of $0.01 per share, their fair value approximated the market price of the Company's common stock. Approximately 1.2 million of these warrants were cancelled as a result of the Company's early repayment of certain amounts under its credit facility during the year ended November 1, 2009, and the associated liability was reduced accordingly. During the three month period ended January 29, 2012, all of the 0.2 million of these warrants that remained outstanding were exercised. In connection with this exercise, the Company recognized a gain of $0.1 million, included in investment and other income (expense), net, in its condensed consolidated statements of income. During the three and nine month periods ended July 31, 2011, the Company recognized a gain of $0.2 million and a loss of $0.6 million, respectively, in connection with these warrants, which were also included in investment and other income (expense), net. See Note 5 for disclosures related to other common stock warrants.

In March 2007 shareholders approved a new share-based compensation plan ("Plan"), under which options, restricted stock, restricted stock units, stock appreciation rights, performance stock, performance units, and other awards based on, or related to, shares of the Company's common stock may be granted from shares authorized but unissued or shares previously issued and reacquired by the Company. A maximum of six million shares of common stock may be issued under the Plan. Awards may be granted to officers, employees, directors, consultants, advisors, and independent contractors of the Company or its subsidiaries. In the event of a change in control (as defined in the Plan), the vesting of awards may be accelerated. The Plan, aspects of which are more fully described below, prohibits further awards from being issued under prior plans. The Company incurred total share-based compensation costs for the three and nine month periods ended July 29, 2012, of $0.9 million and $2.3 million, respectively, and $0.7 million and $1.8 million for the three and nine month periods ended July 31, 2011, respectively. The Company received cash from option exercises of $0.1 million and $0.3 million for the three and nine month periods ended July 29, 2012, respectively, and $0.2 million and $0.4 million for the three and nine month periods ended July 31, 2011, respectively. No share-based compensation cost was capitalized as part of an asset and no related income tax benefits were recorded during the periods presented.

Option awards generally vest in one to four years, and have a ten-year contractual term. All incentive and non-qualified stock option grants have an exercise price equal to the market value of the underlying common stock on the date of grant. The grant date fair values of options are based on closing prices of the Company’s common stock on the dates of grant using the Black-Scholes option pricing model. Expected volatility is based on the historical volatility of the Company's stock. The Company uses historical option exercise behavior and employee termination data to estimate expected term, which represents the period of time that the options granted are expected to remain outstanding. The risk-free rate of return for the estimated term of the option is based on the U.S. Treasury yield curve in effect at the date of grant. The weighted-average inputs and risk-free rate of return ranges used to calculate the grant date fair value of options issued during the three and nine month periods ended July 29, 2012 and July 31, 2011, are presented in the following table.

The effective income tax rates for the three and nine month periods ended July 29, 2012, differ from the U.S. statutory rate of 35% primarily due to changes in the deferred tax asset and valuation allowance, combined with income taxed at lower rates in non-U.S. jurisdictions. The effective income tax rates for the three and nine month periods ended July 31, 2011, differ from the U.S. statutory rate primarily due to the impact of the non-deductible debt extinguishment losses recorded in the second and third quarters of fiscal 2011, combined with income taxed at lower rates in non-U.S. jurisdictions, which were offset by the impact of a foreign subsidiary’s tax settlement in the three month period ended July 31, 2011. Entities within certain jurisdictions are excluded from the Company’s effective income tax rate if they are projected to generate a loss for the year and the tax benefits of such losses are not anticipated to be realized in the foreseeable future.

The calculation of basic and diluted earnings per share is presented below.

The Company is typically impacted during its first fiscal quarter by the North American and European holiday periods, as some customers reduce their effective workdays and orders during these periods. Additionally, the Company can be impacted during its first or second quarter by the Asian New Year holiday period, which may also reduce customer orders.

The accounting framework for determining fair value includes a hierarchy for ranking the quality and reliability of the information used to measure fair value, which enables the reader of the financial statements to assess the inputs used to develop those measurements. The fair value hierarchy consists of three tiers as follows: Level 1, defined as quoted market prices in active markets for identical securities; Level 2, defined as inputs other than Level 1 that are observable, either directly or indirectly; and Level 3, defined as unobservable inputs that are not corroborated by market data.

Since the second quarter of fiscal 2011, the board of directors of Photronics Semiconductor Mask Corporation (PSMC), a subsidiary of the Company based in Taiwan, authorized several share repurchase programs for PSMC to purchase for retirement shares of its outstanding common stock. During the three and nine month periods ended July 29, 2012, PSMC purchased 9.1 million and 27.1 million shares, respectively, at a cost of $4.1 million and $11.7 million, respectively and, during the nine month period ended July 31, 2011, PSMC purchased 7.7 million shares at a cost of $3.3 million. These repurchase programs increased the Company’s ownership in PSMC to 59.14% at July 31, 2011, to 62.25% at October 30, 2011, and to 69.40% at July 29, 2012.

The table below presents the effect of the change in the Company’s ownership interest in PSMC on the Company's equity for the three and nine month periods ended July 29, 2012 (9.1 million and 27.1 million shares of common stock of PSMC repurchased, respectively) and July 31, 2011 (7.7 million shares of PSMC stock repurchased).

There have been no recent accounting pronouncements whose adoption would affect the Company’s financial statements or related disclosures.

The following table represents selected operating information expressed as a percentage of net sales.

Note: All of the following tabular comparisons, unless otherwise indicated, are for the three months ended July 29, 2012 (Q3-12) and July 31, 2011 (Q3-11) and for the nine months ended July 29, 2012 (YTD-12) and July 31, 2011 (YTD-11), in millions of dollars.

Net sales for Q3-12 decreased 14.2% to $116.6 million as compared to $135.9 million for Q3-11. The decrease was primarily due to reduced demand for both IC and FPD photomasks as a result of a general slowdown in the semiconductor industry. Revenues attributable to high-end products decreased by $3.8 million to $44.7 million in Q3-12 as compared to $48.5 million in Q3-11. High-end photomask applications include mask sets for 45 nanometer and below for IC products, and G8 and above and active matrix organic light-emitting diode (AMOLED) display screen technologies for FPD products. By geographic area, net sales in Q3-12, as compared to Q3-11, decreased by $8.3 million or 10.4% in Asia, decreased by $9.8 million or 22.2% in North America, and decreased by $1.2 million or 10.1% in Europe. As a percent of total sales, net sales in Q3-12 in Asia were 61%, North America 29% and Europe 10%, and in Q3-11 in Asia were 59%, North America 32%, and Europe 9%.

Net sales for YTD-12 decreased 11.2% to $346.2 million as compared to $389.9 million for YTD-11. The decrease was primarily due to a decrease in demand for mainstream products due to a slowdown in the industry, which was partially offset by increased demand for high-end IC products. Revenues attributable to high-end products increased by $17.5 million to $138.1 million in YTD-12 as compared to $120.6 million in YTD-11 due to increased IC product demand. The Company’s quarterly revenues can be affected by the seasonal purchasing of its customers.

Gross margin percentage decreased to 27.7% in Q3-12 from 28.1% in Q3-11 and decreased to 25.3% in YTD-12 from 27.0% in YTD-11. These decreases were a result of the decreases in sales from the prior year periods, as the Company operates in a high fixed cost environment.  To the extent that the Company's revenues and utilization increase or decrease, gross margin will generally be positively or negatively impacted. The decreases in gross margins as a result of decreases in sales were partially offset by reduced manufacturing expenses related to the Singapore restructuring and the purchase of the U.S. nanoFab facility.

Selling, general and administrative expenses were $11.8 million in Q3-12 and in Q3-11; and increased to $35.3 million in YTD-12 as compared to $34.0 million in YTD-11, primarily due to increased employee compensation and selling-related expenses.

Research and development expenses consist primarily of global development efforts related to high-end process technologies for advanced sub-wavelength reticle solutions for IC technologies. Research and development expenses increased by $1.7 million to $5.2 million in Q3-12, as compared to $3.5 million in Q3-11, and by $2.9 million to $14.1 million in YTD-12, as compared to $11.2 million in YTD-11. The increase in research and development expenses in Q3-12 and YTD-12 as compared to the same periods in the prior year was primarily due to increased activities at advanced nanometer technology nodes for IC photomasks.

In the first quarter of fiscal 2012 the Company ceased the manufacture of photomasks at its Singapore facility and, in connection therewith, recorded charges of $1.2 million during the nine month period ended July 29, 2012. The Company expects that this restructuring will be completed in 2012, and expects its total cost to range between $1.5 million and $1.9 million, with that cost primarily being comprised of employee termination costs and asset write-downs.

Net income attributable to noncontrolling interests decreased to $0.3 million in Q3-12 as compared to $1.4 million in Q3-11, and to $1.6 million in YTD-12 as compared to $4.2 million in YTD-11, primarily due to decreased net income at PSMC, the Company's non-wholly owned subsidiary in Taiwan.

 

As a result of share repurchase programs in 2011 and 2012 by PSMC to purchase for retirement shares of its outstanding common stock, the Company’s ownership percentage in PSMC had, as of July 29, 2012, increased 11.87% to 69.40%. See Note 13 of the Condensed Consolidated Financial Statements for further information. The Company’s ownership percentage in its subsidiary in Korea was 99.7% at July 29, 2012, and did not change over the periods presented.

The Company's working capital was $212.3 million at July 29, 2012, and $209.3 million at October 30, 2011. The increase in working capital was primarily the result of increased cash and cash equivalents, which were partially offset by an increase in the current portion of long-term borrowings at July 29, 2012, as compared to October 30, 2011. Net cash provided by operating activities was $107.5 million for the nine month period ended July 29, 2012, an increase of $3.0 million from $104.5 million for the nine month period ended July 31, 2011, primarily as a result of increased net income. Net cash used in investing activities for the nine month period ended July 29, 2012, was $107.0 million, which was comprised primarily of capital expenditure payments, including $35 million for the U.S. nanoFab facility. Net cash provided by financing activities of $10.0 million for the nine month period ended July 29, 2012, was primarily comprised of the proceeds of a $25 million term loan, which is discussed below, partially offset by payments to repurchase the common stock of a subsidiary and repayments of long-term borrowings.

 

The Company's credit facility ("the credit facility") provides for revolving credit of $30 million through April 2015 and a term loan with a balance of $24.4 million at July 29, 2012. The credit facility bears interest (2.5% at July 29, 2012), based upon the Company's total leverage ratio, at LIBOR plus a spread, as defined in the agreement. As of July 29, 2012, the Company had no revolving loan borrowings against the $30 million available to it. The credit facility is secured by substantially all of the Company's assets located in the United States, as well as common stock the Company owns in certain of its foreign subsidiaries. The credit facility is subject to the following financial covenants: minimum fixed charge ratio, total leverage ratio and minimum unrestricted cash balance.

 

In the second quarter of fiscal 2012 the Company paid $35 million to Micron in connection with the purchase of the U.S. nanoFab facility. In connection therewith, the Company amended its credit facility to include the addition of a $25 million term loan maturing in March 2017, with minimum quarterly principal payments of $0.6 million. The amendment also included a twenty-five basis point reduction in the interest rate charged on any borrowings under the credit facility. As a result of the purchase of the U.S. nanoFab facility, the Company’s lease agreement with Micron for the U.S. nanoFab facility was cancelled, which reduced the Company’s related outstanding  operating lease commitments by a combined total of $15 million for fiscal years 2013 and 2014.

 

At July 29, 2012, the Company had capital commitments outstanding of approximately $86 million. The Company believes that its currently available resources, together with its capacity for growth and its access to equity and other financing sources, will be sufficient to satisfy its currently planned capital expenditures, as well as its anticipated working capital requirements for the next twelve months. However, the Company cannot assure that additional sources of financing would be available to the Company on commercially favorable terms, should the Company's capital requirements exceed cash available from operations, existing cash, and cash available under its credit facility.

 

The Company's liquidity is highly dependent on its sales volume, cash conversion cycle, and the timing of its capital expenditures (which can vary significantly from period to period), as it operates in a high fixed cost environment. Although the Company continues to evaluate further cost reduction initiatives, depending on conditions in the semiconductor and FPD markets, the Company's cash flows from operations and current holdings of cash may not be adequate to meet its current and long-term needs for capital expenditures, operations and debt repayments. Historically, in certain years, the Company has used external financing to fund these needs. Due to conditions in the credit markets, some financing instruments used by the Company in the past may not be currently available to it. The Company cannot assure that additional sources of financing would be available to it on commercially favorable terms should its cash requirements exceed cash available from operations, existing cash, and cash available under its credit facility.