Photronics - 10-Q quarterly report FY2017 Q3

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”, the “Company”, “we”, “our”, or “us”). 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,” “project,” “could,” “should,” “would,” “estimate,” “intend,” “may,” “will” 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 or in other documents filed with the Securities and Exchange Commission in press releases 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, among other things, the consummation and benefits of transactions, joint ventures, business combinations, divestitures and 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. Various factors may cause actual results, performance, or achievements to differ materially from anticipated results, performance, or achievements expressed or implied by forward-looking statements. Factors that might affect 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; the timing of orders received from customers; the gain or loss of significant customers; competition from other manufacturers; changes in accounting standards; federal, state and international tax requirements (including tax rate changes, new tax laws and revised tax law interpretations); changes in the jurisdictional mix of our earnings and changes in tax laws and rates; interest rate and other capital market conditions, including changes in the market price of the Company’s securities; foreign currency exchange rate fluctuations; changes in technology; technology or intellectual property infringement, including cyber-security breaches, and other innovation risks; unsuccessful or unproductive research and development or capital expenditures; the timing, impact, and other uncertainties related to transactions and acquisitions, divestitures, business combinations, and joint ventures as well as decisions the Company may make in the future regarding the Company’s business, capital and organizational structures and other matters; the seasonal and cyclical nature of the semiconductor and flat panel display industries; management changes; changes in laws and government regulation impacting our operations or our products; the occurrence of arbitration, regulatory proceedings, claims or litigation; 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 cost savings; (iv) fully utilize its tools; (v) achieve desired yields, pricing, product mix, and market acceptance of its products or (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.

Inventories are stated at the lower of cost, determined under the first-in, first-out (“FIFO”) method, or market. Presented below are the components of inventory at the balance sheet dates:

Property, plant and equipment consist of the following:

Equipment under capital leases are included in above property, plant and equipment as follows:

Depreciation and amortization expense for property, plant and equipment was $20.6 million and $60.5 million for the three and nine month periods ended July 30, 2017, respectively, and $18.4 million and $56.4 million for the three and nine month periods ended July 31, 2016, respectively.

During the three month period ended January 29, 2017, the Company acquired a business comprised of manufacturing assets and certain intellectual property, that enables the Company to expand its manufacturing capability, primarily in large area masks for IC, for approximately $5.7 million, including a $0.3 million holdback payable one year from the acquisition date. The transaction was accounted for in accordance with ASC 805, “Business Combinations”, with substantially all of the purchase price being allocated to long-lived assets that are being depreciated over five years.

During the three month period ended January 29, 2017, the Company entered into a noncash transaction with a customer which resulted in the acquisition of equipment with a fair value of approximately $0.1 million and $5.1 million in the three and nine month periods ended July 30, 2017, respectively.

In May 2006 Photronics and Micron Technology, Inc. (“Micron”) entered into the MP Mask joint venture (“MP Mask”), which developed and produced photomasks for leading-edge and advanced next generation semiconductors. At the time of the formation of the joint venture, the Company also entered into an agreement to license photomask technology developed by Micron, as well as, certain supply agreements. In May 2016 the Company sold its investment in MP Mask to Micron for $93.1 million and recorded a gain on the sale of $0.1 million. On that same date a supply agreement commenced between the Company and Micron, which provided that we would be the majority outsourced supplier of Micron’s photomasks and related services. The supply agreement had a one year term and expired in May 2017. The Company forevermore has the right to use the technology it acquired under the prior technology license agreement.

This joint venture was a variable interest entity (“VIE”) (as that term is defined in ASC 810) because all costs of the joint venture were passed on to the Company and Micron through purchase agreements they had entered into with the joint venture, and it was dependent upon the Company and Micron for any additional cash requirements. On a quarterly basis the Company reassessed whether its interest in MP Mask gave it a controlling financial interest in this VIE. The purpose of this quarterly reassessment was to identify the primary beneficiary (which is defined in ASC 810 as the entity that consolidates a VIE) of the VIE. As a result of the reassessments in fiscal year 2016, the Company determined that Micron remained the primary beneficiary of the VIE, by virtue of its tie-breaking voting rights within MP Mask’s Board of Managers, thereby having given it the power to direct the activities of MP Mask that most significantly impacted its economic performance, including its decision making authority in the ordinary course of business and its purchasing the majority of products produced by the VIE.

The Company utilized MP Mask for both high-end IC photomask production and research and development purposes. MP Mask charged its variable interest holders based on their actual usage of its facility. MP Mask separately charged for any research and development activities it engaged in at the requests of its owners. The Company recorded cost of sales of $0.8 million and $5.7 million during the three and nine month periods ended July 31, 2016, respectively, and research and development expenses of $0.5 million during the nine month period ended July 31, 2016.

The Company recorded a loss of $0.1 million related to its investment in MP Mask during the nine month period ended July 31, 2016. Income or loss from the VIE is included in “Interest and other income (expense), net” in the condensed consolidated statements of income.

Long-term borrowings consist of the following:

The Company’s credit facility, which expires in December 2018, has a $50 million limit with an expansion capacity to $75 million, and is secured by substantially all of the Company’s assets located in the United States and common stock the Company owns in certain of its foreign subsidiaries. The credit facility stipulates that we may not pay cash dividends on Photronics, Inc. stock, and is subject to a minimum interest coverage ratio, total leverage ratio and minimum unrestricted cash balance financial covenants, all of which the Company was in compliance with at July 30, 2017. The Company had no outstanding borrowings against the credit facility at July 30, 2017, and $50 million was available for borrowing. The interest rate on the credit facility (2.49% at July 30, 2017) is based on the Company’s total leverage ratio at LIBOR plus a spread, as defined in the credit facility. In May 2017 the credit facility was amended primarily for our new joint venture and FPD manufacturing facility in China. See Note 15 for additional discussion of our new joint venture in China and our expansion of FPD manufacturing into China.

The Company adopted Accounting Standard Update (“ASU” or “Update”) 2015-03 “Simplifying the Presentation of Debt Issuance Costs” in the first quarter of its 2017 fiscal year. This ASU requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct reduction from that debt liability, consistent with the presentation of a debt discount. We adopted this ASU on a retrospective basis, as a result of which our October 30, 2016, condensed consolidated balance sheet and its related long-term borrowings note have been adjusted, as necessary, to reflect this Update’s adoption. The effect on our October 30, 2016, condensed consolidated balance sheet is presented below.

In January 2015 the Company privately exchanged $57.5 million in aggregate principal amount of its 3.25% convertible senior notes with a maturity date of April 1, 2016, for new 3.25% convertible senior notes with an aggregate principal amount of $57.5 million with a maturity date of April 1, 2019. The conversion rate of the new notes is the same as that of the exchanged notes, which were issued in March 2011 with a conversion rate of approximately 96 shares of common stock per $1,000 note principal, equivalent to a conversion price of $10.37 per share of common stock, and is subject to adjustment upon the occurrence of certain events, which are described in the indenture dated January 22, 2015. Note holders may convert each $1,000 principal amount of notes at any time prior to the close of business on the second scheduled trading day immediately preceding April 1, 2019, and 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.

In August 2013 a $26.4 million principal amount, five year capital lease commenced to fund the purchase of a high-end lithography tool. Payments under the capital lease, which bears interest at 2.77%, are $0.5 million per month through July 2018. Under the terms of the lease agreement, the Company must maintain the equipment in good working order, and is subject to a cross default with cross acceleration provision related to certain nonfinancial covenants incorporated in its credit facility. As of July 30, 2017, the total amount payable through the end of the lease term was $6.1 million, of which $6.0 million represented principal and $0.1 million represented interest.

In March 2016, shareholders approved a new equity incentive compensation plan (the “Plan”), under which incentive stock options, non-qualified stock options, stock grants, stock-based awards, restricted stock, restricted stock units, stock appreciation rights, performance units, performance stock, and other stock or cash awards may be granted. Shares to be issued under the Plan may be authorized and unissued shares, issued shares that have been reacquired by the Company (in the open-market or in private transactions), shares that are being held in the treasury, or a combination thereof. The maximum number of shares of common stock approved that may be issued under the Plan is four million shares. 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. Total share-based compensation costs for each of the three month periods ended July 30, 2017 and July 31, 2016, was $1.0 million, and was $2.8 million for each of the nine month periods ended July 30, 2017 and July 31, 2016, respectively. The Company received cash from option exercises of $0.1 million and $2.2 million in the three and nine month periods ended July 30, 2017, respectively, and $0.1 million and $2.9 million in the three and nine month periods ended July 31, 2016, 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 no less than 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 30, 2017 and July 31, 2016, are presented in the following table.

Information on outstanding and exercisable option awards as of July 30, 2017, is presented below.

There were no share options granted during the three month period ended July 30, 2017 and there were 45,000 share options granted during the three month period ended July 31, 2016, with a weighted-average grant date fair value of $3.44 per share. There were 348,750 share options granted during the nine month period ended July 30, 2017, with a weighted-average grant date fair value of $3.59 per share and 647,250 share options granted during the nine month period ended July 31, 2016, with a weighted-average grant date fair value of $4.55 per share. As of July 30, 2017, the total unrecognized compensation cost related to unvested option awards was approximately $3.6 million. That cost is expected to be recognized over a weighted-average amortization period of 2.1 years.

The fair value of restricted stock awards is based on the Company’s closing stock price on the date of grant. The restrictions on these awards typically lapse over a service period of less-than-one to four years. There were 5,000 restricted stock awards granted during the three month period ended July 30, 2017, with a grant date fair value of $10.15, and 290,000 restricted stock awards granted during the nine month period ended July 30, 2017, with a weighted-average grant date fair value of $11.28 per share. No restricted stock awards were granted during the three month period ended July 31, 2016 and 115,225 restricted stock awards were granted during the nine month period ended July 31, 2016, with a weighted-average grant date fair value of $12.13 per share. As of July 30, 2017, the total compensation cost not yet recognized related to unvested restricted stock awards was approximately $2.9 million. That cost is expected to be recognized over a weighted-average amortization period of 2.7 years. As of July 30, 2017, there were 324,181 shares of restricted stock outstanding.

The effective tax rate differs from the U.S. statutory rate of 35% in the three and nine month periods ended July 30, 2017 and July 31, 2016, primarily due to earnings being taxed at lower statutory rates in foreign jurisdictions, combined with the benefit of various investment credits in a foreign jurisdiction. Valuation allowances in jurisdictions with historic losses eliminate the tax benefit of these jurisdictions.

As of July 31, 2016, we determined that deferred tax assets of $2.5 million, whose realization was previously not considered to be more likely than not, are realizable and, therefore, reduced their related valuation allowance. During the nine month period ended July 31, 2016, we realized a $2.4 million benefit, which resulted from the reversal of a previously recorded undistributed earnings tax liability in a foreign jurisdiction. As a result of a shareholder action to approve a dividend in this jurisdiction, we determined that we are no longer liable for this tax. In addition, during the nine month period ended July 31, 2016, $0.7 million of withholding tax was incurred upon the completion of a foreign subsidiary’s share redemption.

Unrecognized tax benefits related to uncertain tax positions were $3.2 million at July 30, 2017 and $4.6 million at October 30, 2016, all of which, if recognized, would favorably impact our effective tax rate. Accrued interest and penalties related to unrecognized tax benefits was $0.1 million at July 30, 2017 and October 30, 2016. In the three and nine month periods ended July 30, 2017, the net reduction of unrecognized tax benefits was $0.8 and $1.2 respectively. The net reductions reflect the resolution of tax issues with foreign tax authorities and the expiration of assessment periods. Although the timing of the expirations of statutes of limitations may be uncertain, as they can be dependent upon the settlement of tax audits, we believe that it is reasonably possible that up to $1.1 million of our uncertain tax positions (including accrued interest and penalties, and net of tax benefits) may be resolved over the next twelve months. The resolution of these uncertain tax positions may result from either or both the lapses of statutes of limitations and tax settlements.

PKLT Co. Ltd., our FPD manufacturing facility in Taiwan, has been accorded a tax holiday, which started in 2012 and expires in 2017. This tax holiday had no dollar or per share effect in the three or nine month periods ended July 30, 2017 and July 31, 2016. Photronics DNP Mask Corporation (“PDMC”), our IC manufacturing facility in Taiwan, was accorded a tax holiday that commenced in 2015 and expires in 2019. We realized $0.1 million in tax benefits from this tax holiday in each of the three month periods ended July 30, 2017 and July 31, 2016, and $0.2 million in the nine month periods ended July 30, 2017 and July 31, 2016. This tax holiday had no per share effect in the three and nine month periods ended July 30, 2017 and July 31, 2016.

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

The amortization of the cash flow hedge is included in cost of sales in the condensed consolidated statements of income for all periods presented.

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 (unadjusted) 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.

We did not have any assets or liabilities measured at fair value, on a recurring or a nonrecurring basis, at July 30, 2017 or October 30, 2016. In connection with the acquisition discussed in Note 4, we recorded and measured the assets acquired at fair value.

In April 2017 PDMC, our majority owned IC subsidiary in Taiwan, declared a dividend of $16.6 million which 49.99%, or $8.3 million, was paid to the third party that owns a noncontrolling interest in PDMC in the third quarter fiscal year 2017.

We had a minority interest in a foreign entity. In the first quarter of fiscal year 2016, we sold this investment and realized a gain of $8.8 million.

In May 2017 we announced that we have entered into an agreement with Dai Nippon Printing Co., Ltd. (DNP) to form a joint venture to serve semiconductor manufacturers in China. Under the agreement, our wholly owned Singapore subsidiary will own 50.01% of the joint venture, which will be named Photronics DNP Mask Corporation Xiamen (PDMCX), and a subsidiary of DNP will own the remaining 49.99%. The financial results of the joint venture will be included in Photronics’ consolidated financial statements.

This IC investment in China of $160 million, which we initially announced in August 2016, will be based in Xiamen, China. Construction of the facility is currently underway, and production is anticipated to commence in early 2019. Photronics and DNP will contribute cash, in proportion to their ownership percentages, over five years to fund the equity portion of the investment, which will also receive certain incentives and support from the local industrial development zone. The joint venture, itself, may also fund a portion of the investment with local borrowings. The formation of the joint venture, which is subject to regulatory approvals and customary closing conditions, is expected to be completed by the end of our 2017 fiscal year.

In August 2017 we announced that Photronics, UK, Ltd., a wholly owned subsidiary of ours, signed an investment agreement with Hefei State Hi-tech Industry Development Zone to establish a manufacturing facility in Hefei, China. Under the terms of the agreement, through our subsidiary, we will invest a minimum of $160 million, a portion of which may be funded with local borrowings, to build and operate a research and development and manufacturing facility for high-end and mainstream FPD photomasks. Hefei State Hi-tech Industry Development Zone will provide certain investment incentives and support for this facility, which will have initial capability to produce up to G10.5 large area masks and AMOLED products. Construction is planned to begin in late 2017 and production is anticipated to commence in early 2019.

In January 2017 the Financial Accounting Standards Board (“FASB”) issued ASU 2017-04 “Simplifying the Test for Goodwill Impairment”, which eliminates Step 2 of the goodwill impairment test and requires entities to perform their annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, and to recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. In addition, this ASU eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, in the event the reporting unit fails the qualitative test, to perform Step 2 of the goodwill impairment test. ASU 2017-04 is effective for the Company in its first quarter of its fiscal year 2021, and should be applied on a prospective basis. The impact of this ASU will depend upon the nature of future acquisitions that the Company may make.

In January 2017 the FASB issued ASU 2017-01 “Clarifying the Definition of a Business”, with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. ASU 2017-01 is effective for the Company in its first quarter of fiscal year 2019, and should be applied on a prospective basis. The impact of this ASU will depend upon the nature of future acquisitions or dispositions that the Company may make.

In November 2016 the FASB issued ASU 2016-18 “Restricted Cash”, which requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-18 is effective for the Company in its first quarter of fiscal year 2019 and should be applied on a retrospective transition basis. Early adoption is permitted, including adoption in an interim period. The Company is currently evaluating the effect this ASU will have on its consolidated financial statements.