WOLFSPEED, INC. - Quarter Report: 2020 September (Form 10-Q)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 27, 2020
or
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-21154
__________________________________________
CREE, INC.
(Exact name of registrant as specified in its charter)
| North Carolina | 56-1572719 | ||||||||||
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | ||||||||||
| 4600 Silicon Drive | |||||||||||
| Durham | North Carolina | 27703 | |||||||||
| (Address of principal executive offices) | (Zip Code) | ||||||||||
(919) 407-5300
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| Title of each class | Trading Symbol(s) | Name of each exchange on which registered | ||||||
| Common Stock, $0.00125 par value | CREE | The Nasdaq Stock Market LLC | ||||||
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
| Large accelerated filer | ☒ | Accelerated filer | ☐ | ||||||||
| Non-accelerated filer | ☐ | Smaller reporting company | ☐ | ||||||||
| Emerging growth company | ☐ | ||||||||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Securities Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ☐ No ☒
The number of shares outstanding of the registrant’s common stock, par value $0.00125 per share, as of October 23, 2020, was 110,340,000.
CREE, INC.
FORM 10-Q
For the Quarterly Period Ended September 27, 2020
Table of Contents
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
3
CREE, INC.
UNAUDITED CONSOLIDATED BALANCE SHEETS
| in millions of U.S. Dollars, except share data in thousands | September 27, 2020 | June 28, 2020 | |||||||||
| Assets | |||||||||||
| Current assets: | |||||||||||
| Cash and cash equivalents | $436.4 | $448.8 | |||||||||
| Short-term investments | 702.1 | 802.9 | |||||||||
| Total cash, cash equivalents and short-term investments | 1,138.5 | 1,251.7 | |||||||||
| Accounts receivable, net | 108.5 | 114.0 | |||||||||
| Inventories | 187.3 | 179.1 | |||||||||
| Income taxes receivable | 6.7 | 6.6 | |||||||||
| Prepaid expenses | 28.4 | 26.3 | |||||||||
| Other current assets | 14.6 | 13.8 | |||||||||
| Current assets held for sale | 1.3 | 1.3 | |||||||||
| Total current assets | 1,485.3 | 1,592.8 | |||||||||
| Property and equipment, net | 940.9 | 831.1 | |||||||||
| Goodwill | 424.3 | 530.0 | |||||||||
| Intangible assets, net | 175.4 | 179.6 | |||||||||
| Other long-term investments | 53.0 | 55.9 | |||||||||
| Deferred tax assets | 7.3 | 6.3 | |||||||||
| Other assets | 37.1 | 35.3 | |||||||||
| Total assets | $3,123.3 | $3,231.0 | |||||||||
| Liabilities and Shareholders' Equity | |||||||||||
| Current liabilities: | |||||||||||
| Accounts payable and accrued expenses | $273.9 | $220.8 | |||||||||
| Accrued contract liabilities | 36.2 | 38.3 | |||||||||
| Income taxes payable | 2.9 | 3.2 | |||||||||
| Finance lease liabilities | 0.4 | 3.6 | |||||||||
| Other current liabilities | 30.0 | 25.3 | |||||||||
| Total current liabilities | 343.4 | 291.2 | |||||||||
| Long-term liabilities: | |||||||||||
| Convertible notes, net | 793.6 | 783.8 | |||||||||
| Deferred tax liabilities | 3.1 | 1.8 | |||||||||
| Finance lease liabilities - long-term | 10.3 | 11.4 | |||||||||
| Other long-term liabilities | 57.8 | 53.6 | |||||||||
| Total long-term liabilities | 864.8 | 850.6 | |||||||||
| Commitments and contingencies | |||||||||||
| Shareholders’ equity: | |||||||||||
Preferred stock, par value $0.01; 3,000 shares authorized at September 27, 2020 and June 28, 2020; none issued and outstanding | — | — | |||||||||
Common stock, par value $0.00125; 200,000 shares authorized at September 27, 2020 and June 28, 2020; 110,296 and 109,230 shares issued and outstanding at September 27, 2020 and June 28, 2020, respectively | 0.1 | 0.1 | |||||||||
| Additional paid-in-capital | 3,116.2 | 3,106.2 | |||||||||
| Accumulated other comprehensive income | 16.0 | 16.0 | |||||||||
| Accumulated deficit | (1,223.6) | (1,039.2) | |||||||||
| Total shareholders’ equity | 1,908.7 | 2,083.1 | |||||||||
| Non-controlling interest | 6.4 | 6.1 | |||||||||
| Total equity | 1,915.1 | 2,089.2 | |||||||||
| Total liabilities and shareholders’ equity | $3,123.3 | $3,231.0 | |||||||||
The accompanying notes are an integral part of the consolidated financial statements
4
CREE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
| Three months ended | |||||||||||
| September 27, 2020 | September 29, 2019 | ||||||||||
| in millions of U.S. Dollars, except share data | |||||||||||
| Revenue, net | $216.6 | $242.8 | |||||||||
| Cost of revenue, net | 162.6 | 168.6 | |||||||||
| Gross profit | 54.0 | 74.2 | |||||||||
| Operating expenses: | |||||||||||
| Research and development | 49.6 | 43.7 | |||||||||
| Sales, general and administrative | 51.9 | 57.6 | |||||||||
| Amortization or impairment of acquisition-related intangibles | 3.6 | 3.6 | |||||||||
| (Gain) loss on disposal or impairment of other assets | (0.2) | 1.0 | |||||||||
| Goodwill impairment | 105.7 | — | |||||||||
| Other operating expense | 13.4 | 7.2 | |||||||||
| Operating loss | (170.0) | (38.9) | |||||||||
| Non-operating expense (income), net | 14.0 | (1.6) | |||||||||
| Loss before income taxes | (184.0) | (37.3) | |||||||||
| Income tax expense | 0.1 | 0.5 | |||||||||
| Net loss | (184.1) | (37.8) | |||||||||
| Net income attributable to noncontrolling interest | 0.3 | — | |||||||||
| Net loss attributable to controlling interest | ($184.4) | ($37.8) | |||||||||
| Basic and diluted loss per share | |||||||||||
| Net loss attributable to controlling interest | ($1.68) | ($0.35) | |||||||||
| Weighted average shares - basic and diluted (in thousands) | 109,705 | 107,113 | |||||||||
The accompanying notes are an integral part of the consolidated financial statements
5
CREE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Net loss | ($184.1) | ($37.8) | |||||||||
| Other comprehensive loss: | |||||||||||
| Net unrealized gain on available-for-sale securities | — | 0.5 | |||||||||
| Comprehensive loss | (184.1) | (37.3) | |||||||||
| Net income attributable to non-controlling interest | 0.3 | — | |||||||||
| Comprehensive loss attributable to controlling interest | ($184.4) | ($37.3) | |||||||||
The accompanying notes are an integral part of the consolidated financial statements
6
CREE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
| Common Stock | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income | Total Equity - Controlled Interest | Non-controlling Interest | Total Equity | |||||||||||||||||||||||||||||||||||||||||
| (in millions of U.S Dollars, except share data) | Number of Shares | Par Value | |||||||||||||||||||||||||||||||||||||||||||||
| Balance at June 28, 2020 | 109,230 | $0.1 | $3,106.2 | ($1,039.2) | $16.0 | $2,083.1 | $6.1 | $2,089.2 | |||||||||||||||||||||||||||||||||||||||
| Net loss | — | — | — | (184.4) | — | (184.4) | 0.3 | (184.1) | |||||||||||||||||||||||||||||||||||||||
| Unrealized gain on available-for-sale securities | — | — | — | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||
| Comprehensive loss | (184.4) | 0.3 | (184.1) | ||||||||||||||||||||||||||||||||||||||||||||
| Tax withholding on vested equity awards | — | — | (22.7) | — | — | (22.7) | — | (22.7) | |||||||||||||||||||||||||||||||||||||||
| Stock-based compensation | — | — | 16.2 | — | — | 16.2 | — | 16.2 | |||||||||||||||||||||||||||||||||||||||
| Exercise of stock options and issuance of shares | 1,066 | — | 16.5 | — | — | 16.5 | — | 16.5 | |||||||||||||||||||||||||||||||||||||||
| Balance at September 27, 2020 | 110,296 | $0.1 | $3,116.2 | ($1,223.6) | $16.0 | $1,908.7 | $6.4 | $1,915.1 | |||||||||||||||||||||||||||||||||||||||
The accompanying notes are an integral part of the consolidated financial statements
7
CREE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
| Common Stock | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income | Total Equity - Controlled Interest | Non-controlling Interest | Total Equity | |||||||||||||||||||||||||||||||||||||||||
| (in millions of U.S. Dollars, except share data) | Number of Shares | Par Value | |||||||||||||||||||||||||||||||||||||||||||||
| Balance at June 30, 2019 | 106,570 | $0.1 | $2,874.1 | ($847.5) | $9.5 | $2,036.2 | $5.0 | $2,041.2 | |||||||||||||||||||||||||||||||||||||||
| Net loss | — | — | — | (37.8) | — | (37.8) | — | (37.8) | |||||||||||||||||||||||||||||||||||||||
| Unrealized gain on available-for-sale securities | — | — | — | — | 0.5 | 0.5 | — | 0.5 | |||||||||||||||||||||||||||||||||||||||
| Comprehensive loss | (37.3) | — | (37.3) | ||||||||||||||||||||||||||||||||||||||||||||
| Tax withholding on vested equity awards | — | — | (14.3) | — | — | (14.3) | — | (14.3) | |||||||||||||||||||||||||||||||||||||||
| Stock-based compensation | — | — | 17.4 | — | — | 17.4 | — | 17.4 | |||||||||||||||||||||||||||||||||||||||
| Exercise of stock options and issuance of shares | 1,127 | — | 18.6 | — | — | 18.6 | — | 18.6 | |||||||||||||||||||||||||||||||||||||||
| Balance at September 29, 2019 | 107,697 | $0.1 | $2,895.8 | ($885.3) | $10.0 | $2,020.6 | $5.0 | $2,025.6 | |||||||||||||||||||||||||||||||||||||||
The accompanying notes are an integral part of the consolidated financial statements
8
CREE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Operating activities: | |||||||||||
| Net loss | ($184.1) | ($37.8) | |||||||||
| Adjustments to reconcile net loss to net cash provided by (used in) operating activities: | |||||||||||
| Depreciation and amortization | 33.9 | 28.6 | |||||||||
| Amortization of debt issuance costs and discount, net of capitalized interest | 9.4 | 5.6 | |||||||||
| Stock-based compensation | 15.7 | 16.9 | |||||||||
| Goodwill impairment | 105.7 | — | |||||||||
| Loss on disposal or impairment of long-lived assets | 0.2 | 1.0 | |||||||||
| Amortization of premium/discount on investments | 1.5 | — | |||||||||
| Loss (gain) on equity investment | 3.4 | (3.5) | |||||||||
| Foreign exchange (gain) loss on equity investment | (0.5) | 0.1 | |||||||||
| Deferred income taxes | 0.3 | — | |||||||||
| Changes in operating assets and liabilities: | |||||||||||
| Accounts receivable, net | 5.5 | (8.8) | |||||||||
| Inventories | (7.7) | 5.0 | |||||||||
| Prepaid expenses and other assets | 3.5 | 7.9 | |||||||||
| Accounts payable, trade | (3.7) | (21.7) | |||||||||
| Accrued salaries and wages and other liabilities | 19.4 | (20.5) | |||||||||
| Accrued contract liabilities | (2.1) | 7.2 | |||||||||
| Cash provided by (used in) operating activities | 0.4 | (20.0) | |||||||||
| Investing activities: | |||||||||||
| Purchases of property and equipment | (114.0) | (42.0) | |||||||||
| Purchases of patent and licensing rights | (1.9) | (1.1) | |||||||||
| Proceeds from sale of property and equipment | 0.6 | — | |||||||||
| Purchases of short-term investments | (65.7) | (134.0) | |||||||||
| Proceeds from maturities of short-term investments | 157.8 | 93.0 | |||||||||
| Proceeds from sale of short-term investments | 7.2 | 31.8 | |||||||||
| Cash used in investing activities | (16.0) | (52.3) | |||||||||
| Financing activities: | |||||||||||
| Payments on long-term debt borrowings, including finance lease obligations | (0.1) | — | |||||||||
| Proceeds from issuance of common stock | 16.5 | 18.6 | |||||||||
| Tax withholding on vested equity awards | (12.8) | (13.2) | |||||||||
| Commitment fee on long-term incentive agreement | (0.5) | — | |||||||||
| Cash provided by financing activities | 3.1 | 5.4 | |||||||||
| Effects of foreign exchange changes on cash and cash equivalents | 0.1 | (0.3) | |||||||||
| Net change in cash and cash equivalents | (12.4) | (67.2) | |||||||||
| Cash and cash equivalents, beginning of period | 448.8 | 500.5 | |||||||||
| Cash and cash equivalents, end of period | $436.4 | $433.3 | |||||||||
The accompanying notes are an integral part of the consolidated financial statements
9
CREE, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
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Note 1 – Basis of Presentation and New Accounting Standards
Overview
Cree, Inc. (the Company) is an innovator of wide bandgap semiconductors, focused on silicon carbide and gallium nitride materials, devices for power and radio-frequency (RF) applications and specialty lighting-class light emitting diode (LED) products. The Company's silicon carbide and gallium nitride (GaN) materials and devices are targeted for applications such as transportation, power supplies, inverters and wireless systems. The Company's LEDs are targeted for use in indoor and outdoor lighting, electronic signs and signals and video displays.
The Company operates in two reportable segments:
•Wolfspeed, which consists of silicon carbide and GaN materials, power devices and RF devices based on wide bandgap semiconductor materials and silicon. The Company's materials products and power devices are used in electric vehicles, motor drives, power supplies, solar and transportation applications. The Company's materials products and RF devices are used in military communications, radar, satellite and telecommunication applications.
•LED Products, which consists of LED chips and LED components. The Company's LED products enable its customers to develop and market LED-based products for lighting, video screens, automotive and specialty lighting applications.
The majority of the Company's products are manufactured at its production facilities located in North Carolina, California, Arkansas and China. The Company also uses contract manufacturers for certain products and aspects of product fabrication, assembly and packaging. Additionally, the Company is in the process of building a silicon carbide fabrication facility in New York. The Company operates research and development facilities in North Carolina, Arizona, Arkansas, New York, California and China (including Hong Kong).
Cree, Inc. is a North Carolina corporation established in 1987, and its headquarters are in Durham, North Carolina.
As discussed more fully below in Note 16, “Subsequent Events,” on October 18, 2020, the Company entered into a definitive agreement to sell certain assets and subsidiaries comprising its LED Products segment (the LED Business) to SMART Global Holdings, Inc. (SGH) and its wholly owned subsidiary Chili Acquisition, Inc. (collectively with SGH, SMART) for up to $300 million, including fixed upfront and deferred payments and contingent consideration (the LED Business Divestiture). Following the completion of the LED Business Divestiture, the Company will operate solely in the Wolfspeed segment.
Basis of Presentation
The consolidated financial statements presented herein have been prepared by the Company and have not been audited. In the opinion of management, all normal and recurring adjustments necessary to fairly state the consolidated financial position, results of operations, comprehensive loss, shareholders' equity and cash flows at September 27, 2020, and for all periods presented, have been made. All material intercompany accounts and transactions have been eliminated. The consolidated balance sheet at June 28, 2020 has been derived from the audited financial statements as of that date.
These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim information and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for annual financial statements. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2020 (fiscal 2020). The results of operations for the three months ended September 27, 2020 are not necessarily indicative of the operating results that may be attained for the entire fiscal year ending June 27, 2021 (fiscal 2021). Additionally, the impact of the COVID-19 pandemic to the results of operations is uncertain.
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and the disclosure of contingent assets and liabilities. Actual amounts could differ materially from those estimates.
Certain accounting matters that generally require consideration of forecasted financial information were assessed regarding impacts from the COVID-19 outbreak as of September 27, 2020 and through the date of this Quarterly Report using reasonably available information as of those dates. The accounting matters assessed included, but were not limited to, allowance for doubtful accounts, the carrying value of goodwill and other long-lived tangible and intangible assets, the potential impact to earnings of unrealized losses on investments, valuation allowances for tax assets and the ability to estimate an annual effective tax rate. While the assessments resulted in no material impacts to the consolidated financial statements as of and for the quarter
11
ended September 27, 2020, the Company believes the full impact of the outbreak remains uncertain and will continue to assess if ongoing developments related to the outbreak may cause future material impacts to our consolidated financial statements.
Recently Adopted Accounting Pronouncements
Credit Losses
In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update , Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13). This standard replaces the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses.
The Company adopted this standard using the modified retrospective transition method on June 29, 2020, the first day of the Company's 2021 fiscal year. Upon adoption, prior period balances were not adjusted and the Company determined no cumulative-effect adjustment to retained earnings as of June 29, 2020 was required.
Under this new standard, expected credit losses for the Company's receivables are evaluated on a collective (pool) basis and aggregated on the basis of similar risk characteristics. These aggregated risk pools are reassessed at each measurement date. A combination of factors is considered in determining the appropriate estimate of expected credit losses, including broad-based economic indicators as well as customers' financial strength, credit standing, payment history and any historical defaults.
Available-for-sale debt securities in an unrealized loss position at each measurement date are individually evaluated for expected credit losses. The Company evaluates whether the unrealized loss is due to market factors or changes in the investment holdings' credit rating. An expected credit loss will be recorded when an investment in an unrealized loss position is determined to have lost value from a decreased credit rating and the Company does not expect to recover the fair value of the security.
Accounting Pronouncements Pending Adoption
Convertible Debt Instruments
In August 2020, the FASB issued ASU 2020-06, Debt – Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40). This standard simplifies the accounting for convertible instruments by eliminating the cash conversion and the beneficial conversion accounting models. This update also amends the guidance for the derivatives scope exception for contracts in an entity’s own equity. The update requires an entity to use the if-converted method for all convertible instruments in the diluted earnings per share calculation. An entity may use either a modified or full retrospective approach for adoption. The Company expects to adopt this standard by June 27, 2022 and is currently evaluating the impact on its consolidated financial statements.
Note 2 – Discontinued Operations
The Company did not have any discontinued operations activity for the three months ended September 27, 2020 and September 29, 2019.
Note 3 – Revenue Recognition
In accordance with FASB Accounting Standards Codification 606 "Revenue from Contracts with Customers" (ASC 606), the Company follows a five-step approach defined by the new standard for recognizing revenue, consisting of the following: (1) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, the entity satisfies a performance obligation.
Contract liabilities primarily include various rights of return and customer deposits, as well as deferred revenue, price protection guarantees and the Company's liability under the LED Supply Agreement. Contract liabilities were $78.3 million as of September 27, 2020 and $80.3 million as of June 28, 2020. The decrease was primarily due to lower reserve liabilities and continued fulfillment on the LED Supply Agreement. Contract liabilities are recorded within accrued contract liabilities and other long-term liabilities on the balance sheet. Before the adoption of ASC 606, liabilities relating to various rights of return were recorded as a deduction to accounts receivable.
12
Disaggregated revenue by geography is presented in Note 14, "Reportable Segments". For the three months ended September 27, 2020, the Company recognized revenue of $1.0 million that was included in contract liabilities as of June 28, 2020. The amount recognized primarily related to the recognition of contingent liabilities related to the LED Supply Agreement and deferred revenue. Revenue recognized related to performance obligations that were satisfied or partially satisfied in previous periods was not material for the three months ended September 27, 2020.
Note 4 – Leases
The Company primarily leases manufacturing, office and warehousing space. Lease agreements frequently include renewal provisions and require the Company to pay real estate taxes, insurance and maintenance costs. Variable costs include lease payments that were volume or usage-driven in accordance with the use of the underlying asset, as well as non-lease components incurred with respect to actual terms rather than contractually fixed amounts.
The Company's finance lease obligations primarily relate to Wolfspeed manufacturing space in Malaysia and a 49-year ground lease on a future silicon carbide fabrication facility in New York.
Balance Sheet
Lease assets and liabilities and the corresponding balance sheet classifications are as follows (in millions of U.S. Dollars):
| Operating Leases: | September 27, 2020 | June 28, 2020 | |||||||||
Right-of-use asset (1) | $14.4 | $14.0 | |||||||||
Current lease liability (2) | 5.7 | 5.2 | |||||||||
Non-current lease liability (3) | 8.9 | 8.7 | |||||||||
| Total operating lease liabilities | 14.6 | 13.9 | |||||||||
| Finance Leases: | |||||||||||
Finance lease assets (4) | 11.4 | 15.4 | |||||||||
| Current portion of finance lease liabilities | 0.4 | 3.6 | |||||||||
| Finance lease liabilities, less current portion | 10.3 | 11.4 | |||||||||
| Total finance lease liabilities | 10.7 | 15.0 | |||||||||
(1) Within other assets on the consolidated balance sheets.
(2) Within other current liabilities on the consolidated balance sheets.
(3) Within other long-term liabilities on the consolidated balance sheets.
(4) Within property and equipment, net on the consolidated balance sheets.
Statement of Operations
Operating lease expense was $1.6 million and $1.4 million for the three months ended September 27, 2020 and September 29, 2019, respectively.
Short-term lease expense, variable lease expense and lease income were immaterial for the three months ended September 27, 2020 and September 29, 2019.
Finance lease amortization was $0.2 million and interest expense was $0.1 million for the three months ended September 27, 2020. Finance lease amortization and interest expense were not recorded for the three months ended September 29, 2019.
Cash Flows
Cash flow information consisted of the following:
13
| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Cash used in operating activities: | |||||||||||
| Cash paid for operating leases | $1.3 | $1.5 | |||||||||
| Cash paid for interest portion of financing leases | 0.1 | — | |||||||||
| Cash used in financing activities: | |||||||||||
| Cash paid for principal portion of finance leases | 0.1 | — | |||||||||
| Non-cash operating activities: | |||||||||||
| Operating lease additions due to adoption of ASC 842 | — | 12.2 | |||||||||
| Operating lease additions and modifications, net | 1.8 | 0.5 | |||||||||
| Finance lease additions | — | — | |||||||||
Non-cash investing activities (1): | |||||||||||
| Transfer of finance lease liability to accounts payable and accrued expenses | 4.2 | — | |||||||||
(1) In the first quarter of fiscal 2021, the Company executed the available bargain purchase option for certain finance leases relating to property and equipment, net, in order to purchase the assets.
Lease Liability Maturities
Maturities of operating and finance lease liabilities as of September 27, 2020 were as follows (in millions of U.S. Dollars):
| Fiscal Year Ending | Operating Leases | Finance Leases | Total | ||||||||
| June 27, 2021 (remainder of fiscal 2021) | $4.9 | $0.5 | $5.4 | ||||||||
| June 26, 2022 | 4.9 | 0.6 | 5.5 | ||||||||
| June 25, 2023 | 3.0 | 0.7 | 3.7 | ||||||||
| June 30, 2024 | 1.2 | 0.7 | 1.9 | ||||||||
| June 29, 2025 | 1.0 | 0.7 | 1.7 | ||||||||
| Thereafter | 0.4 | 15.3 | 15.7 | ||||||||
| Total lease payments | 15.4 | 18.5 | 33.9 | ||||||||
| Imputed lease interest | (0.8) | (7.8) | (8.6) | ||||||||
| Total lease liabilities | $14.6 | $10.7 | $25.3 | ||||||||
Supplemental Disclosures
| Operating Leases | Finance Leases | |||||||
Weighted average remaining lease term (in months) (1) | 39 | 470 | ||||||
Weighted average discount rate (2) | 3.32 | % | 2.77 | % | ||||
(1) Weighted average remaining lease term of finance leases without the 49-year ground lease is 77 months.
(2) Weighted average discount rate of finance leases without the 49-year ground lease is 3.40%.
14
Note 5 – Financial Statement Details
Accounts Receivable, net
Accounts receivable, net consisted of the following:
| (in millions of U.S. Dollars) | September 27, 2020 | June 28, 2020 | |||||||||
| Billed trade receivables | $106.7 | $111.3 | |||||||||
| Unbilled contract receivables | 0.8 | 1.2 | |||||||||
| Royalties | 2.2 | 2.8 | |||||||||
| 109.7 | 115.3 | ||||||||||
| Allowance for bad debts | (1.2) | (1.3) | |||||||||
| Accounts receivable, net | $108.5 | $114.0 | |||||||||
Changes in the Company’s allowance for bad debts were as follows:
| (in millions of U.S. Dollars) | September 27, 2020 | ||||
| Balance at beginning of period | $1.3 | ||||
| Current period provision change | — | ||||
| Write-offs, net of recoveries | (0.1) | ||||
| Balance at end of period | $1.2 | ||||
Inventories
Inventories consisted of the following:
| (in millions of U.S. Dollars) | September 27, 2020 | June 28, 2020 | |||||||||
| Raw material | $47.5 | $47.0 | |||||||||
| Work-in-progress | 101.1 | 95.4 | |||||||||
| Finished goods | 38.7 | 36.7 | |||||||||
| Inventories | $187.3 | $179.1 | |||||||||
Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consisted of the following:
| (in millions of U.S. Dollars) | September 27, 2020 | June 28, 2020 | |||||||||
| Accounts payable, trade | $123.7 | $106.9 | |||||||||
| Accrued salaries and wages | 72.3 | 47.4 | |||||||||
| Accrued expenses | 70.3 | 60.5 | |||||||||
| Other | 7.6 | 6.0 | |||||||||
| Accounts payable and accrued expenses | $273.9 | $220.8 | |||||||||
15
Other Operating Expense
Other operating expense consisted of the following:
| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Factory optimization restructuring | $1.6 | $1.2 | |||||||||
| Severance and other restructuring | 3.2 | 0.8 | |||||||||
| Total restructuring costs | 4.8 | 2.0 | |||||||||
| Project, transformation and transaction costs | 5.6 | 2.6 | |||||||||
| Factory optimization start-up costs | 3.0 | 1.4 | |||||||||
| Non-restructuring related executive severance | — | 1.2 | |||||||||
| Other operating expense | $13.4 | $7.2 | |||||||||
Accumulated Other Comprehensive Income, net of taxes
Accumulated other comprehensive income, net of taxes, consisted of the following:
| (in millions of U.S. Dollars) | September 27, 2020 | June 28, 2020 | |||||||||
| Currency translation gain | $9.5 | $9.5 | |||||||||
Net unrealized gain on available-for-sale securities (1) | 6.5 | 6.5 | |||||||||
| Accumulated other comprehensive income, net of taxes | $16.0 | $16.0 | |||||||||
(1) Amounts as of September 27, 2020 and June 28, 2020 include a $2.4 million loss related to tax on unrealized gain (loss) on available-for-sale securities.
Reclassifications Out of Accumulated Other Comprehensive Income
Less than $0.1 million was reclassified for each of the three month periods ended September 27, 2020 and September 29, 2019. Amounts were reclassified to non-operating expense, net on the consolidated statements of operations.
Non-Operating Expense, net
The following table summarizes the components of non-operating expense, net:
| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Foreign currency loss, net | $— | $0.1 | |||||||||
| Loss (gain) on equity investment, net | 3.4 | (3.5) | |||||||||
| Interest income | (2.7) | (5.5) | |||||||||
| Interest expense, net of capitalized interest | 13.1 | 7.4 | |||||||||
| Other, net | 0.2 | (0.1) | |||||||||
| Non-operating expense, net | $14.0 | ($1.6) | |||||||||
The change in loss (gain) on equity investment, net is due to the decrease in the Lextar Electronics Corporation (Lextar) stock price.
16
Statements of Cash Flows - non-cash activities
| Three months ended | |||||||||||
| Non-cash operating activities | September 27, 2020 | September 29, 2019 | |||||||||
Lease asset and liability additions (1) | $— | $12.2 | |||||||||
| Lease asset and liability modifications, net | 1.8 | 0.5 | |||||||||
| Non-cash investing and financing activities | |||||||||||
Transfer of finance lease liability to accounts payable and accrued expenses (2) | 4.2 | — | |||||||||
(1) The total amount of lease asset and liability additions for the three months ended September 29, 2019 relates to the increase of right-of-use assets and matching lease liabilities as a result of adopting ASC 842. See Note 4, "Leases", for further information.
(2) In the first quarter of fiscal 2021, the Company executed the available bargain purchase option for certain finance leases relating to property and equipment, net, in order to purchase the assets.
Accrued property and equipment as of September 27, 2020 and September 29, 2019 was $108.2 million and $8.8 million, respectively.
Note 6 – Investments
Investments consist of municipal bonds, corporate bonds, U.S. agency securities, U.S. treasury securities, variable rate demand notes, commercial paper and certificates of deposit. All short-term investments are classified as available-for-sale. Other long-term investments consist of the Company's ownership interest in Lextar.
Short-term investments as of September 27, 2020 and June 28, 2020 consisted of the following:
| September 27, 2020 | ||||||||||||||||||||||||||||||||
| Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Credit Loss Allowance (1) | Estimated Fair Value | ||||||||||||||||||||||||||||
| Municipal bonds | $119.6 | $2.3 | $— | $— | $121.9 | |||||||||||||||||||||||||||
| Corporate bonds | 456.3 | 6.2 | — | — | 462.5 | |||||||||||||||||||||||||||
| U.S. agency securities | 18.2 | — | (0.1) | — | 18.1 | |||||||||||||||||||||||||||
| U.S. treasury securities | 58.9 | 0.5 | — | — | 59.4 | |||||||||||||||||||||||||||
| Certificates of deposit | 33.7 | — | — | — | 33.7 | |||||||||||||||||||||||||||
| Commercial paper | 6.5 | — | — | — | 6.5 | |||||||||||||||||||||||||||
| Total short-term investments | $693.2 | $9.0 | ($0.1) | $— | $702.1 | |||||||||||||||||||||||||||
| June 28, 2020 | ||||||||||||||||||||||||||||||||
| Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses (2) | Estimated Fair Value | |||||||||||||||||||||||||||||
| Municipal bonds | $130.0 | $2.0 | $— | $132.0 | ||||||||||||||||||||||||||||
| Corporate bonds | 473.8 | 6.3 | — | 480.1 | ||||||||||||||||||||||||||||
| U.S. agency securities | 29.1 | — | — | 29.1 | ||||||||||||||||||||||||||||
| U.S. treasury securities | 52.3 | 0.6 | — | 52.9 | ||||||||||||||||||||||||||||
| Certificates of deposit | 95.3 | — | — | 95.3 | ||||||||||||||||||||||||||||
| Variable rate demand note | 2.5 | — | — | 2.5 | ||||||||||||||||||||||||||||
| Commercial paper | 11.0 | — | — | 11.0 | ||||||||||||||||||||||||||||
| Total short-term investments | $794.0 | $8.9 | $— | $802.9 | ||||||||||||||||||||||||||||
(1) Credit loss allowance is applicable beginning in the first quarter of fiscal 2021 due to adoption of ASU 2016-13, which replaced the Company's other than temporary impairment analysis with an expected credit losses model.
(2) The Company had an unrealized loss of less than $0.1 million as of June 28, 2020.
17
The Company does not include accrued interest in estimated fair values of short-term investments and does not record an allowance for credit losses on receivables related to accrued interest. Accrued interest receivable was $4.1 million and $4.3 million as of September 27, 2020 and June 28, 2020, respectively, and is recorded in other current assets on the consolidated balance sheets. When necessary, write offs of noncollectable interest income are recorded as a reversal to interest income. There were no write offs of noncollectable interest income for each of the three month periods ended September 27, 2020 and September 29, 2019.
The following tables present the gross unrealized losses and estimated fair value of the Company’s short-term investments, aggregated by investment type and the length of time that individual securities have been in a continuous unrealized loss position:
| September 27, 2020 | ||||||||||||||||||||||||||||||||||||||
| Less than 12 Months | Greater than 12 Months | Total | ||||||||||||||||||||||||||||||||||||
| Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | |||||||||||||||||||||||||||||||||
| Municipal bonds | $4.0 | $— | $— | $— | $4.0 | $— | ||||||||||||||||||||||||||||||||
| Corporate bonds | 7.8 | — | — | — | 7.8 | — | ||||||||||||||||||||||||||||||||
| U.S. agency securities | 16.0 | (0.1) | — | — | 16.0 | (0.1) | ||||||||||||||||||||||||||||||||
| U.S. treasury securities | 23.8 | — | — | — | 23.8 | — | ||||||||||||||||||||||||||||||||
| Total | $51.6 | ($0.1) | $— | $— | $51.6 | ($0.1) | ||||||||||||||||||||||||||||||||
| Number of securities with an unrealized loss | 16 | — | 16 | |||||||||||||||||||||||||||||||||||
| June 28, 2020 | ||||||||||||||||||||||||||||||||||||||
| Less than 12 Months | Greater than 12 Months | Total | ||||||||||||||||||||||||||||||||||||
| Fair Value | Unrealized Loss (1) | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | |||||||||||||||||||||||||||||||||
| Municipal bonds | $14.3 | $— | $— | $— | $14.3 | $— | ||||||||||||||||||||||||||||||||
| Corporate bonds | 29.1 | — | — | — | 29.1 | — | ||||||||||||||||||||||||||||||||
| U.S. agency securities | 8.6 | — | — | — | 8.6 | — | ||||||||||||||||||||||||||||||||
| U.S. treasury securities | 13.8 | — | — | — | 13.8 | — | ||||||||||||||||||||||||||||||||
| Total | $65.8 | $— | $— | $— | $65.8 | $— | ||||||||||||||||||||||||||||||||
| Number of securities with an unrealized loss | 46 | — | 46 | |||||||||||||||||||||||||||||||||||
(1) Securities with an unrealized loss of less than 12 months as of June 28, 2020 have an unrealized loss value of less than $0.1 million, individually and in the aggregate.
The Company utilizes specific identification in computing realized gains and losses on the sale of investments. There were less than $0.1 million of realized losses on the sale of investments for each of the three month periods ended September 27, 2020 and September 29, 2019. Realized losses are included in non-operating expense in the consolidated statements of operations. Unrealized gains and losses are included as a separate component of equity, net of tax, unless the Company evaluates there is an expected credit loss.
The Company evaluates its investments for expected credit losses. The Company believes it is able to and intends to hold each of the investments held with an unrealized loss as of September 27, 2020 until the investments fully recover in market value. None of the investments with an unrealized loss as of September 27, 2020 had credit downgrades in the current period. No allowance for credit losses was recorded as of September 27, 2020.
18
The contractual maturities of short-term investments as of September 27, 2020 were as follows:
| Within One Year | After One, Within Five Years | After Five, Within Ten Years | After Ten Years | Total | ||||||||||||||||||||||||||||
| Municipal bonds | $24.1 | $97.8 | $— | $— | $121.9 | |||||||||||||||||||||||||||
| Corporate bonds | 197.1 | 265.4 | — | — | 462.5 | |||||||||||||||||||||||||||
| U.S. agency securities | 8.5 | 9.6 | — | — | 18.1 | |||||||||||||||||||||||||||
| U.S. treasury securities | 44.7 | 14.7 | — | — | 59.4 | |||||||||||||||||||||||||||
| Certificates of deposit | 33.7 | — | — | — | 33.7 | |||||||||||||||||||||||||||
| Commercial paper | 6.5 | — | — | — | 6.5 | |||||||||||||||||||||||||||
| Total short-term investments | $314.6 | $387.5 | $— | $— | $702.1 | |||||||||||||||||||||||||||
Note 7 – Fair Value of Financial Instruments
Under U.S. GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the exit price) in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various valuation approaches, including quoted market prices and discounted cash flows. U.S. GAAP also establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are obtained from independent sources and can be validated by a third party, whereas unobservable inputs reflect assumptions regarding what a third party would use in pricing an asset or liability. The fair value hierarchy is categorized into three levels based on the reliability of inputs as follows:
•Level 1 - Valuations based on quoted prices in active markets for identical instruments that the Company is able to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
•Level 2 - Valuations based on quoted prices in active markets for instruments that are similar, or quoted prices in markets that are not active for identical or similar instruments, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
•Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
The financial assets for which the Company performs recurring fair value remeasurements are cash equivalents, short-term investments and long-term investments. As of September 27, 2020 and June 28, 2020, financial assets utilizing Level 1 inputs included money market funds and U.S. treasury securities. Financial assets utilizing Level 2 inputs included municipal bonds, corporate bonds, certificates of deposit, commercial paper, U.S. agency securities, variable rate demand notes and common stock of non-U.S. corporations. Level 2 assets are valued based on quoted prices in active markets for instruments that are similar or using a third-party pricing service’s consensus price, which is a weighted average price based on multiple sources. These sources determine prices utilizing market income models which factor in, where applicable, transactions of similar assets in active markets, transactions of identical assets in infrequent markets, interest rates, bond or credit default swap spreads and volatility. The Company did not have any financial assets requiring the use of Level 3 inputs as of September 27, 2020 and June 28, 2020.
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The following table sets forth financial instruments carried at fair value within the U.S. GAAP hierarchy:
| September 27, 2020 | June 28, 2020 | ||||||||||||||||||||||||||||||||||||||||||||||
| (in millions of U.S. Dollars) | Level 1 | Level 2 | Level 3 | Total | Level 1 | Level 2 | Level 3 | Total | |||||||||||||||||||||||||||||||||||||||
| Assets: | |||||||||||||||||||||||||||||||||||||||||||||||
| Cash equivalents: | |||||||||||||||||||||||||||||||||||||||||||||||
| Money market funds | $176.6 | $— | $— | $176.6 | $199.9 | $— | $— | $199.9 | |||||||||||||||||||||||||||||||||||||||
| U.S. agency securities | — | 13.0 | — | 13.0 | — | 19.6 | — | 19.6 | |||||||||||||||||||||||||||||||||||||||
| U.S. treasury securities | 35.7 | — | — | 35.7 | 19.0 | — | — | 19.0 | |||||||||||||||||||||||||||||||||||||||
| Certificates of deposit | — | — | — | — | — | 54.3 | — | 54.3 | |||||||||||||||||||||||||||||||||||||||
| Commercial paper | — | 33.3 | — | 33.3 | — | 11.1 | — | 11.1 | |||||||||||||||||||||||||||||||||||||||
| Total cash equivalents | 212.3 | 46.3 | — | 258.6 | 218.9 | 85.0 | — | 303.9 | |||||||||||||||||||||||||||||||||||||||
| Short-term investments: | |||||||||||||||||||||||||||||||||||||||||||||||
| Municipal bonds | — | 121.9 | — | 121.9 | — | 132.0 | — | 132.0 | |||||||||||||||||||||||||||||||||||||||
| Corporate bonds | — | 462.5 | — | 462.5 | — | 480.1 | — | 480.1 | |||||||||||||||||||||||||||||||||||||||
| U.S. agency securities | — | 18.1 | — | 18.1 | — | 29.1 | — | 29.1 | |||||||||||||||||||||||||||||||||||||||
| U.S. treasury securities | 59.4 | — | — | 59.4 | 52.9 | — | — | 52.9 | |||||||||||||||||||||||||||||||||||||||
| Certificates of deposit | — | 33.7 | — | 33.7 | — | 95.3 | — | 95.3 | |||||||||||||||||||||||||||||||||||||||
| Commercial paper | — | 6.5 | — | 6.5 | — | 11.0 | — | 11.0 | |||||||||||||||||||||||||||||||||||||||
| Variable rate demand note | — | — | — | — | — | 2.5 | — | 2.5 | |||||||||||||||||||||||||||||||||||||||
| Total short-term investments | 59.4 | 642.7 | — | 702.1 | 52.9 | 750.0 | — | 802.9 | |||||||||||||||||||||||||||||||||||||||
| Other long-term investments: | |||||||||||||||||||||||||||||||||||||||||||||||
| Common stock of non-U.S. corporations | — | 53.0 | — | 53.0 | — | 55.9 | — | 55.9 | |||||||||||||||||||||||||||||||||||||||
| Total assets | $271.7 | $742.0 | $— | $1,013.7 | $271.8 | $890.9 | $— | $1,162.7 | |||||||||||||||||||||||||||||||||||||||
Note 8 – Goodwill and Intangible Assets
Goodwill
The following table summarizes changes in goodwill during the three months ended September 27, 2020:
| (in millions of U.S. Dollars) | Wolfspeed | LED Products | Total | ||||||||
| Balance at June 28, 2020 | $349.7 | $180.3 | $530.0 | ||||||||
| Impairment | — | (105.7) | (105.7) | ||||||||
| Balance at September 27, 2020 | $349.7 | $74.6 | $424.3 | ||||||||
The Company reviews goodwill for impairment whenever events or circumstances indicate potential impairment. In the first quarter of fiscal 2021, the Company determined it would more likely than not sell all or a portion of the assets comprising the LED Products segment below carrying value. As a result of this triggering event, the Company recorded an impairment to goodwill of $105.7 million as of September 27, 2020. As of September 27, 2020, the potential sale had not met the held-for-sale criteria.
On October 18, 2020, the Company entered into a definitive agreement with SMART related to the LED Business Divestiture. See Note 16, "Subsequent Events," for additional information on the transaction.
20
Intangible Assets, net
The following table presents the components of intangible assets, net:
| September 27, 2020 | June 28, 2020 | ||||||||||||||||||||||||||||||||||
| (in millions of U.S. Dollars) | Gross | Accumulated Amortization | Net | Gross | Accumulated Amortization | Net | |||||||||||||||||||||||||||||
| Customer relationships | $147.8 | ($71.5) | $76.3 | $147.8 | ($70.0) | $77.8 | |||||||||||||||||||||||||||||
| Developed technology | 74.9 | (31.1) | 43.8 | 74.9 | (29.7) | 45.2 | |||||||||||||||||||||||||||||
| Non-compete agreements | 12.2 | (7.8) | 4.4 | 12.2 | (7.1) | 5.1 | |||||||||||||||||||||||||||||
| Trade names | 0.5 | (0.5) | — | 0.5 | (0.5) | — | |||||||||||||||||||||||||||||
| Acquisition related intangible assets | 235.4 | (110.9) | 124.5 | 235.4 | (107.3) | 128.1 | |||||||||||||||||||||||||||||
| Patent and licensing rights | 114.8 | (63.9) | 50.9 | 114.6 | (63.1) | 51.5 | |||||||||||||||||||||||||||||
| Total intangible assets | $350.2 | ($174.8) | $175.4 | $350.0 | ($170.4) | $179.6 | |||||||||||||||||||||||||||||
Total amortization of acquisition-related intangibles assets was $3.6 million and $3.6 million for the three months ended September 27, 2020 and September 29, 2019, respectively. Total amortization of patents and licensing rights was $2.3 million and $2.2 million for the three months ended September 27, 2020 and September 29, 2019.
Total future amortization expense of intangible assets is estimated to be as follows:
(in millions of U.S. Dollars) Fiscal Year Ending | Acquisition Related Intangibles | Patents | Total | ||||||||||||||
| June 27, 2021 | $10.9 | $6.6 | $17.5 | ||||||||||||||
| June 26, 2022 | 13.5 | 7.9 | 21.4 | ||||||||||||||
| June 25, 2023 | 11.0 | 6.9 | 17.9 | ||||||||||||||
| June 30, 2024 | 10.4 | 6.0 | 16.4 | ||||||||||||||
| June 29, 2025 | 10.4 | 4.8 | 15.2 | ||||||||||||||
| Thereafter | 68.3 | 18.7 | 87.0 | ||||||||||||||
| Total future amortization expense | $124.5 | $50.9 | $175.4 | ||||||||||||||
Note 9 – Long-term Debt
Revolving Line of Credit
As of September 27, 2020, the Company had a $125.0 million secured revolving line of credit (the Credit Agreement) under which the Company can borrow, repay and reborrow loans from time to time prior to its scheduled maturity date of January 9, 2023. The Credit Agreement requires the Company to maintain a ratio of certain cash equivalents and marketable securities to outstanding loans and letter of credit obligations greater than 1.25:1, with no other financial covenants.
The Company classifies balances outstanding under the Credit Agreement as long-term debt in the consolidated balance sheets. As of September 27, 2020, the Company had no outstanding borrowings under the Credit Agreement, $125.0 million in available commitments under the Credit Agreement and $125.0 million available for borrowing. For the three months ended September 27, 2020, the average interest rate was 0.00%. As of September 27, 2020, the unused line fee on available borrowings is 25 basis points.
2023 Convertible Notes
On August 24, 2018, the Company sold $500.0 million aggregate principal amount of 0.875% convertible senior notes due September 1, 2023 to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the Securities Act), and an additional $75.0 million aggregate principal amount of such notes pursuant to the exercise in full of the over-allotment options of the underwriters (the 2023 Notes). The total net proceeds from the debt offering was approximately $562.1 million.
21
The conversion rate will initially be 16.6745 shares of common stock per one thousand dollars in principal amount of 2023 Notes (equivalent to an initial conversion price of approximately $59.97 per share of common stock). The conversion rate will be subject to adjustment for some events, but will not be adjusted for any accrued and unpaid interest. In addition, following certain corporate events that occur prior to the maturity date, or following the Company's issuance of a notice of redemption, the Company will increase the conversion rate for a holder who elects to convert its 2023 Notes in connection with such a corporate event, or who elects to convert any 2023 Notes called for redemption during the related redemption period in certain circumstances. The Company may not redeem the 2023 Notes prior to September 1, 2021. The Company may redeem for cash all or any portion of the 2023 Notes, at its option, on a redemption date occurring on or after September 1, 2021 and on or before the 40th scheduled trading day immediately before the maturity date, if the last reported sales price of its common stock has been at least 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive), including the trading day immediately preceding the date on which the Company provides a notice of redemption, during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides notice of redemption. The redemption price will be 100% of the principal amount of the 2023 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If the Company undergoes certain fundamental changes related to the Company's common stock, holders may require the Company to repurchase for cash all or any portion of their 2023 Notes at a fundamental change repurchase price equal to 100% of the principal amount of the 2023 Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date.
Holders may convert their 2023 Notes at their option at any time prior to the close of business on the business day immediately preceding March 1, 2023 only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending December 31, 2018 (and only during such calendar quarter), if the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; (2) during the business day period after any consecutive trading day period in which the trading price per one thousand dollars in principal amount of 2023 Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of its common stock and the conversion rate on each such trading day; (3) if the Company calls such 2023 Notes for redemption, at any time prior to the close of business on the second business day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events. On or after March 1, 2023 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their 2023 Notes at any time, regardless of the foregoing circumstances. Upon conversion, the Company will pay or deliver cash, shares of its common stock, or a combination of cash and shares of its common stock, at the Company's election.
2026 Convertible Notes
On April 21, 2020, the Company sold $500.0 million aggregate principal amount of 1.75% convertible senior notes due May 1, 2026 to qualified institutional buyers pursuant to Rule 144A under the Securities Act and an additional $75.0 million aggregate principal amount of such notes pursuant to the exercise in full of the over-allotment options of the underwriters (the 2026 Notes). The total net proceeds from the debt offerings was approximately $561.4 million.
The conversion rate will initially be 21.1346 shares of common stock per one thousand dollars in principal amount of 2026 Notes (equivalent to an initial conversion price of approximately $47.32 per share of common stock). The conversion rate will be subject to adjustment for some events, but will not be adjusted for any accrued and unpaid interest. In addition, following certain corporate events that occur prior to the maturity date, or following the Company's issuance of a notice of redemption, the Company will increase the conversion rate for a holder who elects to convert its 2026 Notes in connection with such a corporate event, or who elects to convert any 2026 Notes called for redemption during the related redemption period in certain circumstances. The Company may not redeem the 2026 Notes prior to May 1, 2023. The Company may redeem for cash all or any portion of the 2026 Notes, at its option, on a redemption date occurring on or after May 1, 2023 and on or before the 40th scheduled trading day immediately before the maturity date, if the last reported sales price of its common stock has been at least 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive), including the trading day immediately preceding the date on which the Company provides a notice of redemption, during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides notice of redemption. The redemption price will be 100% of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If the Company undergoes certain fundamental changes related to the Company's common stock, holders may require the Company to repurchase for cash all or any portions of their 2026 Notes at a fundamental repurchase price equal to 100% of the principal amount of the 2026 Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date.
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Holders may convert their 2026 Notes at their option at any time prior to the close of business on the business day immediately preceding November 3, 2025 only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending June 30, 2020 (and only during such calendar quarter), if the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; (2) during the business day period after any consecutive trading day period in which the trading price per $1.0 thousand principal amount of 2026 Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of its common stock and the conversion rate on each such trading day; (3) if the Company calls such 2026 Notes for redemption, at any time prior to the close of business on the second business day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events. On or after November 3, 2025 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their 2026 Notes at any time, regardless of the foregoing circumstances. Upon conversion, the Company will pay or deliver cash, shares of its common stock, or a combination of cash and shares of its common stock, at the Company's election.
The Company used approximately $144.3 million of the net proceeds from the sale of the 2026 Notes to repurchase approximately $150.2 million aggregate principal amount of the 2023 Notes, including approximately $0.2 million of accrued interest on such notes, in privately negotiated transactions.
Accounting for 2023 Notes and 2026 Notes (collectively, the Notes)
In accounting for the issuance of the 2023 Notes and 2026 Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability of the equity component representing the conversion option was $110.6 million and $145.4 million for the 2023 and 2026 Notes, respectively. The amounts were determined by deducting the fair value of the liability component from the par value of each of the Notes. Due to the partial extinguishment of the 2023 Notes, the equity component of the 2023 Notes was reduced by $27.7 million.
The equity component is not remeasured as long as it continues to meet the conditions for equity classification. The excess of the principal amount of the liability component over its carrying amount (the debt discount), along with related issuance fees, are amortized to interest expense over the term of the Notes at an effective annual interest rate of 5.87% and 7.45% for the 2023 and 2026 Notes, respectively.
The net carrying amount of the liability component of the Notes is as follows:
| (in millions of U.S. Dollars) | September 27, 2020 | June 28, 2020 | |||||||||
| Principal | $999.8 | $999.8 | |||||||||
| Unamortized discount and issuance costs | (206.2) | (216.0) | |||||||||
| Net carrying amount | $793.6 | $783.8 | |||||||||
The net carrying amount of the equity component of the Notes is as follows:
| (in millions of U.S. Dollars) | September 27, 2020 | June 28, 2020 | |||||||||
| Discount related to value of conversion option | $262.3 | $262.3 | |||||||||
| Partial extinguishment of 2023 Notes | (27.7) | (27.7) | |||||||||
| Debt issuance costs | (6.3) | (6.3) | |||||||||
| Net carrying amount | $228.3 | $228.3 | |||||||||
The interest expense, net recognized related to the Notes is as follows:
| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Interest expense, net of capitalized interest | $3.2 | $1.3 | |||||||||
| Amortization of discount and issuance costs, net of capitalized interest | 9.4 | 5.6 | |||||||||
| Total interest expense, net | $12.6 | $6.9 | |||||||||
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The Company capitalizes interest related to the Notes in connection with the building of a new silicon carbide fabrication facility in New York. For the three months ended September 27, 2020, the Company capitalized $0.2 million of interest expense and $0.4 million of amortization of discount and issuance costs. No interest expense was capitalized for the three months ended September 29, 2019.
The estimated fair value of the Notes is $1,333.2 million as of September 27, 2020, as determined by a Level 2 valuation.
Note 10 – Loss Per Share
The details of the computation of basic and diluted loss per share are as follows:
| Three months ended | |||||||||||
| (in millions of U.S. Dollars, except share data) | September 27, 2020 | September 29, 2019 | |||||||||
| Net loss attributable to controlling interest | ($184.4) | ($37.8) | |||||||||
| Weighted average shares - basic and diluted (in thousands) | 109,705 | 107,113 | |||||||||
| Loss per share - basic and diluted: | |||||||||||
| Net loss attributable to controlling interest | ($1.68) | ($0.35) | |||||||||
Diluted net loss per share is the same as basic net loss per share for the periods presented due to potentially dilutive items being anti-dilutive given the Company's net loss.
For the three months ended September 27, 2020 and September 29, 2019, 4.5 million and 5.9 million, respectively, of weighted average shares were excluded from the calculation of diluted loss per share because their effect would be anti-dilutive.
Future earnings per share of the Company are also subject to dilution from conversion of its Notes under certain conditions as described in Note 9, “Long-term Debt.”
Note 11 – Stock-Based Compensation
Overview of Employee Stock-Based Compensation Plans
The Company currently has one equity-based compensation plan, the 2013 Long-Term Incentive Compensation Plan (2013 LTIP), from which stock-based compensation awards can be granted to employees and directors. The 2013 LTIP provides for awards in the form of incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units and other awards. The Company has other equity-based compensation plans that have been terminated so that no future grants can be made under those plans, but under which stock options, restricted stock and restricted stock units are currently outstanding.
The Company’s stock-based awards can be either service-based or performance-based. Performance-based conditions are generally tied to future financial and/or operating performance of the Company and/or external based market metrics. The compensation expense with respect to performance-based grants is recognized if the Company believes it is probable that the performance condition will be achieved. The Company reassesses the probability of the achievement of the performance condition at each reporting period, and adjusts the compensation expense for subsequent changes in the estimate or actual outcome. As with non-performance based awards, compensation expense is recognized over the vesting period. For performance awards with market conditions, the Company estimates the grant date fair value using the Monte Carlo valuation model and expenses the awards over the vesting period regardless of whether the market condition is ultimately satisfied.
The Company also has an Employee Stock Purchase Plan (ESPP) that provides employees with the opportunity to purchase common stock at a discount. The ESPP limits employee contributions to 15% of each employee’s compensation (as defined in the plan) and allows employees to purchase shares at a 15% discount to the fair market value of common stock on the purchase date two times per year. The ESPP provides for a twelve-month participation period, divided into two equal -month purchase periods, and also provides for a look-back feature. At the end of each six-month period in April and October, participants purchase the Company’s common stock through the ESPP at a 15% discount to the fair market value of the common stock on the first day of the twelve-month participation period or the purchase date, whichever is lower. The plan also provides for an automatic reset feature to start participants on a new twelve-month participation period if the fair market value of common stock declines during the first six-month purchase period.
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Stock Option Awards
A summary of stock option awards outstanding as of September 27, 2020 and changes during the three months then ended is as follows:
| (shares in thousands) | Number of Shares | Weighted Average Exercise Price | |||||||||
| Outstanding at June 28, 2020 | 983 | $37.88 | |||||||||
| Granted | — | $— | |||||||||
| Exercised | (374) | $44.27 | |||||||||
| Forfeited or expired | (9) | $63.67 | |||||||||
| Outstanding at September 27, 2020 | 600 | $33.49 | |||||||||
Restricted Stock Awards and Units
A summary of nonvested restricted stock awards (RSAs) and restricted stock unit awards (RSUs) outstanding as of September 27, 2020 and changes during the three months then ended is as follows:
| (awards and units in thousands) | Number of RSAs/RSUs | Weighted Average Grant-Date Fair Value | |||||||||
| Nonvested at June 28, 2020 | 2,932 | $43.89 | |||||||||
| Granted | 998 | $67.10 | |||||||||
| Vested | (1,053) | $37.44 | |||||||||
| Forfeited | (103) | $37.75 | |||||||||
| Nonvested at September 27, 2020 | 2,774 | $55.10 | |||||||||
Stock-Based Compensation Valuation and Expense
The Company accounts for its employee stock-based compensation plans using the fair value method. The fair value method requires the Company to estimate the grant-date fair value of its stock-based awards and amortize this fair value to compensation expense over the requisite service period or vesting term.
The Company uses the Black-Scholes option-pricing model to estimate the fair value of the Company’s stock option and ESPP awards. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the expected stock price volatility over the term of the awards, projected employee stock option exercise term, the risk-free interest rate and expected dividends. Due to the inherent limitations of option-valuation models, future events that are unpredictable and the estimation process utilized in determining the valuation of the stock-based awards, the ultimate value realized by award holders may vary significantly from the amounts expensed in the Company’s financial statements.
For RSAs and RSUs, the grant-date fair value is based upon the market price of the Company’s common stock on the date of the grant. This fair value is then amortized to compensation expense over the requisite service period or vesting term. Compensation expense for awards that have performance-based conditions is recognized if the Company believes it is probable that the performance condition will be achieved. The Company reassesses the probability of the achievement of the performance condition at each reporting period and adjusts the compensation expense for subsequent changes in the estimate or actual outcome. For performance awards with market conditions, the Company estimates the grant date fair value using the Monte Carlo valuation model and expenses the awards over the vesting period regardless of whether the market condition is ultimately satisfied. The Monte Carlo option pricing models require the input of highly subjective assumptions. The estimates involve inherent uncertainties and the application of judgment. As a result, if other assumptions had been used, recorded stock-based compensation expense could have been materially different from that depicted below.
Stock-based compensation expense is recognized net of estimated forfeitures such that expense is recognized only for those stock-based awards that are expected to vest. A forfeiture rate is estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates.
Total stock-based compensation expense was classified in the consolidated statements of operations as follows:
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| Three months ended | |||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | |||||||||
| Cost of revenue, net | $3.6 | $2.2 | |||||||||
| Research and development | 3.0 | 2.4 | |||||||||
| Sales, general and administrative | 9.1 | 12.3 | |||||||||
| Total stock-based compensation expense | $15.7 | $16.9 | |||||||||
Stock-based compensation expense may differ from the impact of stock-based compensation to additional paid in capital due to manufacturing related stock-based compensation capitalized within inventory.
Note 12 – Income Taxes
In general, the variation between the Company's effective income tax rate and the U.S. statutory rate of 21% is primarily due to: (i) changes in the Company’s valuation allowances against deferred tax assets in the U.S. and Luxembourg, (ii) projected income for the full year derived from international locations with differing tax rates than the U.S. and (iii) projected tax credits generated.
The Company did not record an income tax benefit related to the goodwill impairment described in Note 8, “Goodwill and Intangible Assets,” as the impairment is non-deductible for income tax purposes.
The Company assesses all available positive and negative evidence to estimate if sufficient future taxable income will be generated to utilize the existing deferred tax assets by jurisdiction. The Company has concluded that it is necessary to recognize a full valuation allowance against its U.S. and Luxembourg deferred tax assets, as of the three months ended September 27, 2020.
U.S. GAAP requires a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is cumulatively more than 50% likely to be realized upon ultimate settlement.
As of June 28, 2020, the Company's liability for unrecognized tax benefits was $7.4 million. During the three months ended September 27, 2020, the Company did not record any material movement in its unrecognized tax benefits. As a result, the total liability for unrecognized tax benefits as of September 27, 2020 was $7.4 million. If any portion of this $7.4 million is recognized, the Company will then include that portion in the computation of its effective tax rate. Although the ultimate timing of the resolution and/or closure of audits is highly uncertain, the Company believes it is reasonably possible that $0.3 million of gross unrecognized tax benefits will change in the next 12 months as a result of statute requirements or settlement with tax authorities.
The Company files U.S. federal, U.S. state and foreign tax returns. For U.S. federal purposes, the Company is generally no longer subject to tax examinations for fiscal years prior to 2017. For U.S. state tax returns, the Company is generally no longer subject to tax examinations for fiscal years prior to 2016. For foreign purposes, the Company is generally no longer subject to examination for tax periods prior to 2010. Certain carryforward tax attributes generated in prior years remain subject to examination, adjustment and recapture.
Note 13 – Commitments and Contingencies
Litigation
The Company is currently a party to various legal proceedings. While management presently believes that the ultimate outcome of such proceedings, individually and in the aggregate, will not materially harm the Company’s financial position, cash flows, or overall trends in results of operations, legal proceedings are subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or, in matters for which injunctive relief or other conduct remedies may be sought, an injunction prohibiting the Company from selling one or more products at all or in particular ways. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on the Company’s business, results of operations, financial position and overall trends. The outcomes in these matters are not reasonably estimable.
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Grant Disbursement Agreement (GDA) with the State of New York
The Company currently has a GDA with the State of New York Urban Development Corporation (doing business as Empire State Development). The GDA provides a potential total grant amount of $500.0 million to partially and fully reimburse the Company for certain property, plant and equipment costs related to the Company's construction of a new silicon carbide fabrication facility in Marcy, New York.
The GDA was signed in the fourth quarter of fiscal 2020 and requires the Company to satisfy a number of objectives for the Company to receive reimbursements through the span of the 13-year agreement. These objectives include maintaining a certain level of local employment, investing a certain amount in locally administered research and development activities and the payment of an annual commitment fee for the first six years. Additionally, the Company has agreed, under a separate agreement (the SUNY Agreement), to sponsor the creation of two endowed faculty chairs and fund a scholarship program at SUNY Polytechnic Institute.
The annual cost of satisfying the objectives of the GDA and the SUNY Agreement, excluding the direct and indirect costs associated with employment, varies from $1.0 million to $5.2 million per year through fiscal 2031.
Note 14 – Reportable Segments
Reportable segments are components of the Company that the Chief Operating Decision Maker (CODM) regularly reviews when allocating resources and assessing performance. The Company’s CODM reviews segment performance and allocates resources based upon segment revenue and segment gross profit. The Company's identified CODM is the Chief Executive Officer.
The Company’s operating and reportable segments are:
•Wolfspeed
•LED Products
The Wolfspeed segment includes silicon carbide materials, power devices and RF devices and the LED Products segment includes LED chips and LED components.
Financial Results by Reportable Segment
The tables below reflect the results of the Company's reportable segments as reviewed by the CODM for the three month periods ended September 27, 2020 and September 29, 2019. The Company used the same accounting policies to derive the segment results reported below as those used in the Company’s consolidated financial statements.
The Company’s CODM does not review inter-segment transactions when evaluating segment performance and allocating resources to each segment, and inter-segment transactions are not included in the segment revenue presented in the table below. As such, total segment revenue in the table below is equal to the Company’s consolidated revenue.
The Company’s CODM reviews gross profit as the lowest and only level of segment profit. As such, all items below gross profit in the consolidated statements of operations must be included to reconcile the consolidated gross profit presented in the table below to the Company’s consolidated loss before income taxes.
In order to determine gross profit for each reportable segment, the Company allocates direct costs and indirect costs to each segment’s cost of revenue. The Company allocates indirect costs, such as employee benefits for manufacturing employees, shared facilities services, information technology, purchasing, and customer service, when the costs are identifiable and beneficial to the reportable segment. The Company allocates these indirect costs based on a reasonable measure of utilization that considers the specific facts and circumstances of the costs being allocated.
Unallocated costs in the table below consisted primarily of manufacturing employees’ stock-based compensation, expenses for quarterly or annual incentive plans, and matching contributions under the Company’s 401(k) plan. These costs were not allocated to the reportable segments' gross profit because the Company’s CODM does not review them regularly when evaluating segment performance and allocating resources.
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For the first quarter of fiscal 2021, unallocated costs include incremental costs relating to operating manufacturing operations during the COVID-19 pandemic. These incremental costs are primarily comprised of increased cleaning costs, cleaning supplies and protective equipment, as well as the costs from implementing preventative safety measures, including increased wellness checks and time off policies. Additionally, unallocated costs for the first quarter of fiscal 2021 included underutilization charges related to transitioning certain LED Products operations to Wolfspeed operations.
Revenue, gross profit and gross margin for each of the Company's segments were as follows:
| Three months ended | |||||||||||
| September 27, 2020 | September 29, 2019 | ||||||||||
| Revenue: | |||||||||||
| Wolfspeed revenue | $115.5 | $127.7 | |||||||||
| LED Products revenue | 101.1 | 115.1 | |||||||||
| Total revenue | $216.6 | $242.8 | |||||||||
| Gross Profit and Gross Margin: | |||||||||||
| Wolfspeed gross profit | $42.3 | $59.0 | |||||||||
| Wolfspeed gross margin | 36.6 | % | 46.2 | % | |||||||
| LED Products gross profit | 22.4 | 22.1 | |||||||||
| LED Products gross margin | 22.2 | % | 19.2 | % | |||||||
| Total segment gross profit | 64.7 | 81.1 | |||||||||
Unallocated costs (1) | (10.7) | (6.9) | |||||||||
| Consolidated gross profit | $54.0 | $74.2 | |||||||||
| Consolidated gross margin | 24.9 | % | 30.6 | % | |||||||
(1) Unallocated costs for the three months ended September 27, 2020 include $0.9 million in incremental manufacturing costs relating to COVID-19.
Geographic Information
The Company conducts business in several geographic areas. Revenue is attributed to a particular geographic region based on the shipping address for the products. Disaggregated revenue from external customers by geographic area is as follows:
| Three months ended | |||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | ||||||||||||||||||||||
| (in millions of U.S. Dollars) | Revenue | % of Revenue | Revenue | % of Revenue | |||||||||||||||||||
| United States | $56.7 | 26.2 | % | $55.4 | 22.8 | % | |||||||||||||||||
| China | 64.4 | 29.7 | % | 73.2 | 30.1 | % | |||||||||||||||||
| Europe | 51.0 | 23.5 | % | 63.0 | 25.9 | % | |||||||||||||||||
| Other | 44.5 | 20.6 | % | 51.2 | 21.2 | % | |||||||||||||||||
| Total | $216.6 | $242.8 | |||||||||||||||||||||
Assets by Reportable Segment
Inventories are the only assets reviewed by the Company’s CODM when evaluating segment performance and allocating resources to the segments. The CODM reviews all of the Company's assets other than inventories on a consolidated basis.
Unallocated inventories in the table below were not allocated to the reportable segments because the Company’s CODM does not review them when evaluating performance and allocating resources to each segment. Unallocated inventories consisted primarily of manufacturing employees’ stock-based compensation, profit sharing and quarterly or annual incentive compensation, matching contributions under the Company’s 401(k) plan, and acquisition related costs.
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Inventories for each of the Company's segments were as follows:
| September 27, 2020 | June 28, 2020 | ||||||||||
| Wolfspeed | $106.7 | $97.3 | |||||||||
| LED Products | 71.7 | 76.2 | |||||||||
| Total segment inventories | 178.4 | 173.5 | |||||||||
| Unallocated inventories | 8.9 | 5.6 | |||||||||
| Consolidated inventories | $187.3 | $179.1 | |||||||||
Note 15 - Restructuring
The Company has approved various operational plans that include restructuring costs. All restructuring costs are recorded in other operating expense on the consolidated statement of operations.
Factory Optimization Restructuring
In May 2019, the Company started a significant, multi-year factory optimization plan anchored by a state-of-the-art, automated 200mm capable silicon carbide and GaN fabrication facility and a large materials factory at its U.S. campus headquarters in Durham, North Carolina. As part of the plan, the Company will incur restructuring charges associated with the movement of equipment as well as disposals on certain long-lived assets.
In September 2019, the Company announced its intent to build the new fabrication facility in Marcy, New York to complement the factory expansion underway at its U.S. campus headquarters in Durham, North Carolina. The Company has commenced the building of the New York facility and is currently evaluating the impact of this decision on future restructuring charges.
The Company expects approximately $70.0 million in restructuring charges related to the factory optimization plan to be incurred through 2024. For the three months ended September 27, 2020 and September 29, 2019, the Company expensed $1.6 million and $1.2 million of restructuring charges related to the factory optimization plan, respectively, of which $0.2 million is accrued for as of September 27, 2020.
Corporate Restructuring
In September 2020, the Company realigned certain resources to further focus on areas vital to our growth while driving efficiencies. As a result, the Company recorded $3.2 million in severance-related costs during the three months ended September 27, 2020, of which $1.5 million is accrued for as of September 27, 2020.
Sales Representatives Restructuring
In July 2019, the Company realigned its sales resources as part of the Company's transition to a more focused semiconductor company. As a result, the Company recorded $0.8 million in contract termination costs during the three months ended September 29, 2019, all of which has been paid as of September 27, 2020.
Note 16 - Subsequent Events
On October 18, 2020, the Company entered into an Asset Purchase Agreement (the Purchase Agreement) with SMART with respect to the LED Business Divestiture. The transaction is targeted to close in the first calendar quarter of 2021, subject to customary closing conditions and governmental approvals.
Pursuant to the Purchase Agreement, the Company will sell to SMART, and SMART will (i) purchase from the Company, (a) certain equipment, inventory, intellectual property rights, contracts, and real estate comprising the Company’s LED Products segment, (b) all of the issued and outstanding equity interests of Cree Huizhou Solid State Lighting Company Limited, a limited liability company organized under the laws of the People’s Republic of China and an indirect wholly owned subsidiary of the Company, and (c) the Company’s ownership interest in Cree Venture LED Company Limited, the Company’s joint venture with San’an Optoelectronics Co., Ltd. (collectively, the LED Business); and (ii) assume certain liabilities related to the LED Business. The Company will retain certain assets used in and pre-closing liabilities associated with the LED Products segment.
The purchase price for the LED Business consists of (i) a payment of $50 million in cash, subject to customary adjustments, (ii) an unsecured promissory note issued to the Company by SGH in the amount of $125 million (the Purchase Price Note), (iii) the
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potential to receive an earn-out payment of up to $125 million based on the revenue and gross profit performance of the LED Business in the first four full fiscal quarters following the closing (the Earnout Period), also payable in the form of a unsecured promissory note of SGH (the Earnout Note), and (iv) the assumption of certain liabilities. The Purchase Price Note and the Earnout Note, if earned, will accrue interest at a rate of three-month LIBOR plus 3.0% with interest paid every three months and one bullet payment of principal and all accrued and unpaid interest will be payable on each note’s maturity date. The Purchase Price Note will mature on August 15, 2023, and the Earnout Note, if issued, will mature on the third anniversary of the completion of the Earnout Period.
In connection with the closing of the LED Business Divestiture, the Company and SMART will also enter into certain ancillary and related agreements, including (i) an Intellectual Property Assignment and License Agreement, which will assign to SMART certain intellectual property owned by the Company and its affiliates and license to SMART certain additional intellectual property owned by the Company, (ii) a Transition Services Agreement, which is designed to ensure a smooth transition of the LED Business to SMART, (iii) a Wafer Supply and Fabrication Services Agreement, pursuant to which the Company will supply SMART with certain silicon carbide materials and fabrication services for four years, and (iv) a Real Estate License Agreement, which will allow SMART to use certain premises owned by the Company to conduct the LED Business for a period of up to 24 months after closing.
The completion of the LED Business Divestiture is subject to the satisfaction or waiver of a number of conditions set forth in the Purchase Agreement, including the receipt of governmental and regulatory consents and approvals and expiration of any mandatory waiting period related thereto, and other customary closing conditions. The Purchase Agreement provides for customary termination rights of the parties and also provides that, in the event the Purchase Agreement is terminated in connection with certain specified regulatory-related circumstances, SMART may be required to pay the Company a termination fee of $4 million.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Information set forth in this Quarterly Report on Form 10-Q contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). All information contained in this report relative to future markets for our products and trends in and anticipated levels of revenue, gross margins and expenses, as well as other statements containing words such as “believe,” “project,” “may,” “will,” “anticipate,” “target,” “plan,” “estimate,” “expect” and “intend” and other similar expressions constitute forward-looking statements. These forward-looking statements are subject to business, economic and other risks and uncertainties, both known and unknown, and actual results may differ materially from those contained in the forward-looking statements. Any forward-looking statements we make are as of the date made, and except as required under the U.S. federal securities laws and the rules and regulations of the Securities and Exchange Commission (the SEC), we have no duty to update them if our views later change. These forward-looking statements should not be relied upon as representing our views as of any date subsequent to the date of this Quarterly Report. Examples of risks and uncertainties that could cause actual results to differ materially from historical performance and any forward-looking statements include, but are not limited to, those described in “Risk Factors” in Part II, Item 1A of this Quarterly Report.
Executive Summary
The following discussion is designed to provide a better understanding of our unaudited consolidated financial statements, including a brief discussion of our business and products, key factors that impacted our performance and a summary of our operating results. The following discussion should be read in conjunction with the unaudited consolidated financial statements and the notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q, and the consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended June 28, 2020. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.
Overview
Cree, Inc. (Cree, we, our, or us) is an innovator of wide bandgap semiconductors, focused on silicon carbide and gallium nitride materials, devices for power and radio-frequency (RF) applications and specialty lighting-class light emitting diode (LED) products. Our silicon carbide and gallium nitride (GaN) materials and devices are targeted for applications such as transportation, power supplies, inverters and wireless systems. Our LEDs are targeted for use in indoor and outdoor lighting, electronic signs and signals and video displays.
We operate in two reportable segments:
•Wolfspeed, which consists of silicon carbide and GaN materials, power devices and RF devices based on wide bandgap semiconductor materials and silicon. Our materials products and power devices are used in electric vehicles, motor drives, power supplies, solar and transportation applications. Our materials products and RF devices are used in military communications, radar, satellite and telecommunication applications.
•LED Products, which consists of LED chips and LED components. Our LED products enable our customers to develop and market LED-based products for lighting, video screens, automotive and specialty lighting applications.
The majority of our products are manufactured at our production facilities located in North Carolina, California, Arkansas and China. We also use contract manufacturers for certain products and aspects of product fabrication, assembly and packaging. Additionally, we are in the process of building a silicon carbide fabrication facility in New York. We operate research and development facilities in North Carolina, Arizona, Arkansas, New York, California and China (including Hong Kong).
Cree, Inc. is a North Carolina corporation established in 1987, and our headquarters are in Durham, North Carolina. For further information about our consolidated revenue and earnings, please see our consolidated financial statements included in Item 1 of this Quarterly Report.
As discussed more fully in "Business Outlook", on October 18, 2020, we entered into a definitive agreement to sell certain assets and subsidiaries comprising our LED Products segment (the LED Business) to SMART Global Holdings, Inc. (SGH) and its wholly owned subsidiary Chili Acquisition, Inc. (collectively with SGH, SMART) for up to $300 million, including fixed upfront and deferred payments and contingent consideration (the LED Business Divestiture). We will retain certain assets used in and pre-closing liabilities associated with the LED Products segment. Following the LED Business Divestiture, we will operate solely in our Wolfspeed segment.
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Industry Dynamics and Trends
There are a number of industry factors that affect our business which include, among others:
•COVID-19 Outbreak. COVID-19 has continued to spread globally, including locations where we do business. While the financial impact of COVID-19 on our results is difficult to measure, we believe it has had an unfavorable impact on our operating income. The full extent of the outbreak, related business and travel restrictions and changes to behavior intended to reduce its spread are uncertain as of the date of this Quarterly Report as the pandemic continues to evolve globally. The potential effects of COVID-19 could affect us in a number of ways including, but not limited to, the impact on employees becoming ill, quarantined, or otherwise unable to work or travel due to illness or governmental restriction, the impact on customers and their related demand and/or purchases, the impact on our suppliers' ability to fulfill our orders, and the overall impact of the aforementioned items that could cause output challenges and increased costs. Additionally, COVID-19 could have a number of additional adverse effects, including additional laws and regulations affecting our business, fluctuations in foreign currency markets and the credit risks of our customers.
•Overall Demand for Products and Applications using silicon carbide power devices, GaN and silicon RF devices, and LEDs. Our potential for growth depends significantly on the adoption of silicon carbide and GaN materials and device products in the power and RF markets, the continued use of silicon devices in the RF telecommunications market, the continued adoption of LEDs and LED lighting, and our ability to win new designs for these applications. Demand also fluctuates based on various market cycles, continuously evolving industry supply chains, trade and tariff terms, as well as evolving competitive dynamics in each of the respective markets. These uncertainties make demand difficult to forecast for us and our customers.
•Governmental Trade and Regulatory Conditions. Our potential for growth, as with most multi-national companies, depends on a balanced and stable trade, political, economic and regulatory environment among the countries where we do business. Changes in trade policy such as the imposition or extension of tariffs or export bans to specific customers or countries could reduce or limit demand for our products in certain markets.
•Intense and Constantly Evolving Competitive Environment. Competition in the industries we serve is intense. Many companies have made significant investments in product development and production equipment. Product pricing pressures exist as market participants often undertake pricing strategies to gain or protect market share, increase the utilization of their production capacity and open new applications in the power, RF and LED markets we serve. To remain competitive, market participants must continuously increase product performance, reduce costs and develop improved ways to serve their customers. To address these competitive pressures, we have invested in research and development activities to support new product development, lower product costs and deliver higher levels of performance to differentiate our products in the market. In addition, we invest in systems, people and new processes to improve our ability to deliver a better overall experience for our customers.
•Technological Innovation and Advancement. Innovations and advancements in materials, power, RF, and LED technologies continue to expand the potential commercial application for our products. However, new technologies or standards could emerge or improvements could be made in existing technologies that could reduce or limit the demand for our products in certain markets.
•Intellectual Property Issues. Market participants rely on patented and non-patented proprietary information relating to product development, manufacturing capabilities and other core competencies of their business. Protection of intellectual property is critical. Therefore, steps such as additional patent applications, confidentiality and non-disclosure agreements, as well as other security measures are generally taken. To enforce or protect intellectual property rights, litigation or threatened litigation is common.
Overview of the three months ended September 27, 2020
Financial results for the three months ended September 27, 2020 include the impacts of a $105.7 million goodwill impairment charge associated with our determination as of September 27, 2020 that it was more likely than not that we would sell all or a portion of the assets comprising the LED Products segment below carrying value.
The following is a summary of our financial results for the three months ended September 27, 2020:
•Revenue decreased to $216.6 million for the three months ended September 27, 2020 from $242.8 million for the three months ended September 29, 2019.
•Gross profit decreased to $54.0 million for the three months ended September 27, 2020 from $74.2 million for the three months ended September 29, 2019. Gross margin was 24.9% for the three months ended September 27, 2020 and 30.6% for the three months ended September 29, 2019.
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•Operating loss was $170.0 million for the three months ended September 27, 2020 compared to $38.9 million for the three months ended September 29, 2019.
•Diluted loss per share was $1.68 for the three months ended September 27, 2020 compared to $0.35 for the three months ended September 29, 2019.
•Combined cash, cash equivalents and short-term investments was $1,138.5 million at September 27, 2020 and $1,251.7 million at June 28, 2020.
•Cash provided by operating activities was $0.4 million for the three months ended September 27, 2020 compared to cash used in operating activities of $20.0 million for the three months ended September 29, 2019.
•Purchases of property and equipment were $114.0 million for the three months ended September 27, 2020 compared to $42.0 million for the three months ended September 29, 2019.
Business Outlook
We believe we are uniquely positioned as an innovator in the global semiconductor industry. The strength of our balance sheet and ability to generate cash provides us the ability to invest in our business, as indicated by our planned construction of a state-of-the-art, automated 200mm capable silicon carbide fabrication facility and a large materials factory to expand our silicon carbide capacity, each of which was announced in May 2019. In September 2019, we announced our intention to build the new fabrication facility in Marcy, New York to complement the factory expansion already underway at our U.S. campus headquarters in Durham, North Carolina. Construction on the new fabrication facility commenced in the fourth quarter of fiscal 2020.
When completed, the LED Business Divestiture will represent a key milestone in our transformation to be a global semiconductor powerhouse focused on disruptive technology solutions for high-growth applications. This transaction positions us with a sharpened strategic focus to lead the semiconductor industry transition from silicon to silicon carbide and further strengthens our financial position, which we target to support continued investments to capitalize on multi-decade growth opportunities across electrical vehicles (EVs), 5G and industrial applications.
We are focused on investing in the Wolfspeed business to expand the scale, further develop the technologies, and accelerate the growth opportunities of silicon carbide materials, silicon carbide power devices and modules, and GaN and silicon RF devices. We believe these efforts will support our goals of delivering higher revenue and shareholder returns over time.
In addition, we are focused on improving the number of usable items in a production cycle (yield) as our manufacturing technologies become more complex. Despite increased complexities in our manufacturing process, we believe we are in a position to improve yield levels to support our future growth.
In regards to COVID-19, our manufacturing facilities in the United States are currently operating as essential businesses. We have instituted strict measures designed to balance employee safety with meeting the needs of business operations. These measures include increased employee sick days, robust health screening, social distancing policies and cleaning protocols to ensure the safety of our employees and the protection of our customers, suppliers, and partners. Our manufacturing facilities in China briefly closed mid-third quarter of fiscal 2020 and have remained open since that time. Our manufacturing facilities in China mostly support the LED Products segment and will transfer to SMART in connection with the LED Business Divestiture through the sale of our ownership interest in Cree Huizhou Solid State Lighting Company Limited.
We believe the strength of our balance sheet and our ability to continue operations allow us to navigate the current environment while maintaining our capital expenditure plans to support future growth, including the construction of new facilities in New York and additional production capacity in North Carolina. Even so, our short-term impacts from COVID-19 to our financial position, results of operations and cash flows are uncertain.
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Results of Operations
Selected consolidated statements of operations data for the three months ended September 27, 2020 and September 29, 2019 is as follows:
| Three months ended | |||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | ||||||||||||||||||||||
| (in millions of U.S. Dollars, except share data) | Amount | % of Revenue | Amount | % of Revenue | |||||||||||||||||||
| Revenue, net | $216.6 | 100.0 | % | $242.8 | 100.0 | % | |||||||||||||||||
| Cost of revenue, net | 162.6 | 75.1 | 168.6 | 69.4 | |||||||||||||||||||
| Gross profit | 54.0 | 24.9 | 74.2 | 30.6 | |||||||||||||||||||
| Research and development | 49.6 | 22.9 | 43.7 | 18.0 | |||||||||||||||||||
| Sales, general and administrative | 51.9 | 24.0 | 57.6 | 23.7 | |||||||||||||||||||
| Amortization or impairment of acquisition-related intangibles | 3.6 | 1.7 | 3.6 | 1.5 | |||||||||||||||||||
| (Gain) loss on disposal or impairment of other assets | (0.2) | (0.1) | 1.0 | 0.4 | |||||||||||||||||||
| Goodwill impairment | 105.7 | 48.8 | — | — | |||||||||||||||||||
| Other operating expense | 13.4 | 6.2 | 7.2 | 3.0 | |||||||||||||||||||
| Operating (loss) income | (170.0) | (78.5) | (38.9) | (16.0) | |||||||||||||||||||
| Non-operating expense (income), net | 14.0 | 6.5 | (1.6) | (0.7) | |||||||||||||||||||
| Loss before income taxes | (184.0) | (84.9) | (37.3) | (15.4) | |||||||||||||||||||
| Income tax expense | 0.1 | — | 0.5 | 0.2 | |||||||||||||||||||
| Net loss | (184.1) | (85.0) | (37.8) | (15.6) | |||||||||||||||||||
| Net income attributable to non-controlling interest | 0.3 | 0.1 | — | — | |||||||||||||||||||
| Net loss attributable to controlling interest | ($184.4) | (85.1) | ($37.8) | (15.6) | |||||||||||||||||||
| Basic and diluted loss per share | |||||||||||||||||||||||
| Net loss attributable to controlling interest | ($1.68) | ($0.35) | |||||||||||||||||||||
Revenue
Revenue was comprised of the following:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Wolfspeed revenue | $115.5 | $127.7 | ($12.2) | (10) | % | ||||||||||||||||||
| Percent of revenue | 53 | % | 53 | % | |||||||||||||||||||
| LED Products revenue | 101.1 | 115.1 | (14.0) | (12) | % | ||||||||||||||||||
| Percent of revenue | 47 | % | 47 | % | |||||||||||||||||||
| Total revenue | $216.6 | $242.8 | ($26.2) | (11) | % | ||||||||||||||||||
Wolfspeed Segment Revenue
The decrease in Wolfspeed segment revenue was primarily due to supply and demand factors relating to the COVID-19 pandemic, the ongoing trade dispute between the United States and China, which has led some customers to adjust their materials-related supply chain to other suppliers and the timing of shipments to certain customers.
LED Products Segment Revenue
The decrease in LED Products segment revenue was primarily due to decreases in demand related to COVID-19 and factory capacity restrictions.
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Gross Profit and Gross Margin
Gross profit and gross margin were as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Wolfspeed gross profit | $42.3 | $59.0 | ($16.7) | (28) | % | ||||||||||||||||||
| Wolfspeed gross margin | 36.6 | % | 46.2 | % | |||||||||||||||||||
| LED Products gross profit | 22.4 | 22.1 | 0.3 | 1 | % | ||||||||||||||||||
| LED Products gross margin | 22.2 | % | 19.2 | % | |||||||||||||||||||
Unallocated costs (1) | (10.7) | (6.9) | (3.8) | (55) | % | ||||||||||||||||||
| Consolidated gross profit | $54.0 | $74.2 | ($20.2) | (27) | % | ||||||||||||||||||
| Consolidated gross margin | 24.9 | % | 30.6 | % | |||||||||||||||||||
(1) Unallocated costs for the three months ended September 27, 2020 include $0.9 million in incremental manufacturing costs relating to COVID-19.
Wolfspeed Segment Gross Profit and Gross Margin
The decreases in Wolfspeed segment gross profit and gross margin are primarily due to higher costs, customer mix and impacts from decreased revenue.
LED Products Segment Gross Profit and Gross Margin
The increases in LED Products segment gross profit and gross margin are primarily due to more favorable product and customer mix, offset by impacts from decreased revenue.
Unallocated Costs
Unallocated costs primarily consist of manufacturing employees' stock-based compensation, expenses for annual incentive plans, and matching contributions under our 401(k) plan. These costs were not allocated to the reportable segments' gross profit because our CODM does not review them regularly when evaluating segment performance and allocating resources.
For the first quarter of fiscal 2021, unallocated costs also include incremental costs relating to operating our manufacturing operations during the COVID-19 pandemic. These incremental costs are primarily comprised of increased cleaning costs, cleaning supplies and protective equipment, as well as the costs from implementing preventative safety measures, including increased wellness checks and time off policies.
Unallocated costs increased primarily due to incremental operational costs as a result of operating our manufacturing operations during the COVID-19 pandemic and underutilization charges related to transitioning certain LED Products operations to Wolfspeed operations as part of our factory optimization efforts. Additionally, increased stock based compensation was offset by a decrease in annual incentive expense.
Research and Development
Research and development expenses include costs associated with the development of new products, enhancements of existing products and general technology research. These costs consisted primarily of employee salaries and related compensation costs, occupancy costs, consulting costs and the cost of development equipment and supplies.
Research and development expenses were as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Research and development | $49.6 | $43.7 | $5.9 | 14 | % | ||||||||||||||||||
| Percent of revenue | 23 | % | 18 | % | |||||||||||||||||||
The increase in research and development expenses is primarily due to our continued investment in our silicon carbide and GaN technologies, including the development of existing silicon carbide materials and fabrication technology for next generation platforms and expansion of our Power and RF product portfolio.
Our research and development expenses vary significantly from year to year based on a number of factors, including the timing of new product introductions and the number and nature of our ongoing research and development activities.
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Sales, General and Administrative
Sales, general and administrative expenses are comprised primarily of costs associated with our sales and marketing personnel and our executive and administrative personnel (for example, finance, human resources, information technology and legal) and consists of salaries and related compensation costs; consulting and other professional services (such as litigation and other outside legal counsel fees, audit and other compliance costs); marketing and advertising expenses; facilities and insurance costs; and travel and other costs.
Sales, general and administrative expenses were as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Sales, general and administrative | $51.9 | $57.6 | ($5.7) | (10) | % | ||||||||||||||||||
| Percent of revenue | 24 | % | 24 | % | |||||||||||||||||||
The decrease in sales, general and administrative expenses is primarily due to decreases in stock based compensation, as stock based compensation expense for the three months ended September 29, 2019 included certain adjustments relating to former executives’ awards. Additionally, our travel costs decreased as a result of the COVID-19 pandemic and we incurred lower legal fees in the current quarter, partially offset by increased information technology costs.
Amortization or Impairment of Acquisition-Related Intangibles
As a result of our acquisitions, we have recognized various amortizable intangible assets, including customer relationships, developed technology, non-compete agreements and trade names.
Amortization of intangible assets related to our acquisitions was as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Customer relationships | $1.5 | $1.5 | $— | — | % | ||||||||||||||||||
| Developed technology | 1.4 | 1.4 | — | — | % | ||||||||||||||||||
| Non-compete agreements | 0.7 | 0.7 | — | — | % | ||||||||||||||||||
| Total amortization | $3.6 | $3.6 | $— | — | % | ||||||||||||||||||
Amortization of acquisition-related intangible assets stayed consistent due to the absence of acquisition-related intangible activity between the periods, as well as no impairments. Amortization of acquisition-related intangibles relate to operations under our Wolfspeed segment.
Loss on Disposal and Impairment of Other Assets
We operate a capital-intensive business. As such, we dispose of a certain level of our equipment in the normal course of business as our production processes change due to production improvement initiatives or product mix changes. Due to the risk of technological obsolescence or changes in our production process, we regularly review our long-lived assets and capitalized patent costs for possible impairment.
Loss on disposal or impairment of other assets were as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| (Gain) loss on disposal or impairment of other assets | ($0.2) | $1.0 | ($1.2) | (120) | % | ||||||||||||||||||
Gain on disposal or impairment of other assets for the three months ended September 27, 2020 primarily relates to proceeds from asset sales offset by write-offs of impaired or abandoned patents.
Loss on disposal or impairment of other assets for the three months ended September 29, 2019 primarily relates to write-offs of impaired or abandoned patents.
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Goodwill Impairment
We review goodwill for impairment whenever events or circumstances indicate potential impairment. In the first quarter of fiscal 2021, we determined we would more likely than not sell all or a portion of the assets comprising the LED Products segment below carrying value. As a result of this triggering event, we recorded an impairment to goodwill of $105.7 million as of September 27, 2020. As of September 27, 2020, we had not met the held-for-sale criteria.
No goodwill impairment was made as of September 29, 2019.
Other Operating Expense
Other operating expense was as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Factory optimization restructuring | $1.6 | $1.2 | $0.4 | 33 | % | ||||||||||||||||||
| Severance and other restructuring | 3.2 | 0.8 | 2.4 | 300 | % | ||||||||||||||||||
| Total restructuring costs | 4.8 | 2.0 | 2.8 | 140 | % | ||||||||||||||||||
| Project, transformation and transaction costs | 5.6 | 2.6 | 3.0 | 115 | % | ||||||||||||||||||
| Factory optimization start-up costs | 3.0 | 1.4 | 1.6 | 114 | % | ||||||||||||||||||
| Non-restructuring related executive severance | — | 1.2 | (1.2) | (100) | % | ||||||||||||||||||
| Other operating expense | $13.4 | $7.2 | $6.2 | 86 | % | ||||||||||||||||||
Factory optimization restructuring costs relate to facility consolidations as well as disposals on certain long-lived assets. Severance and other restructuring costs relate to corporate restructuring plans. See Note 15, "Restructuring," to our unaudited consolidated financial statements in Part I, Item 1 of this Quarterly Report for additional information on our restructuring costs.
Project, transformation and transaction costs primarily relate to professional services fees associated with completed and potential acquisitions and divestitures, as well as internal transformation programs focused on optimizing our administrative processes and upgrading our enterprise resource planning (ERP) system to support our expected future growth.
Factory optimization start-up costs are additional start-up costs as part of our factory optimization efforts, which began in the fourth quarter of fiscal 2019. These efforts are focused on expanding our production footprint to support expected growth in the Wolfspeed segment.
Other operating expense increased primarily from increased project costs related to the LED Business Divestiture and a corporate restructuring event in the first quarter of fiscal 2021.
Non-Operating Expense (Income), net
Non-operating expense (income), net was comprised of the following:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Loss (gain) on equity investment, net | $3.4 | ($3.5) | $6.9 | (197) | % | ||||||||||||||||||
| Foreign currency loss, net | — | 0.1 | (0.1) | (100) | % | ||||||||||||||||||
| Interest income | (2.7) | (5.5) | 2.8 | (51) | % | ||||||||||||||||||
| Interest expense, net of capitalized interest | 13.1 | 7.4 | 5.7 | (77) | % | ||||||||||||||||||
| Other, net | 0.2 | (0.1) | 0.3 | (300) | % | ||||||||||||||||||
| Non-operating expense (income), net | $14.0 | ($1.6) | $15.6 | (975) | % | ||||||||||||||||||
Loss (gain) on equity investment, net. The loss on equity investment for the three months ended September 27, 2020 was due to the decrease in fair value of our Lextar Electronics Corporation (Lextar) investment. Lextar’s stock is publicly traded on the Taiwan Stock Exchange and its share price decreased from 19.90 New Taiwanese Dollars (TWD) per share at June 28, 2020 to 18.70 TWD at September 27, 2020.
The gain on equity investment for the three months ended September 29, 2019 was due to Lextar’s share price increasing from 14.75 TWD per share at June 30, 2019 to 16.05 TWD at September 29, 2019.
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This volatile stock price trend may continue in the future given the risks inherent in Lextar’s business and trends affecting the Taiwan and global equity markets. We have a 16% common stock ownership interest in Lextar and utilize the fair value option in accounting for the ownership interest. In June 2020, Lextar announced a plan to restructure under a holding company with EPISTAR Corporation (EPISTAR) via a share swap. As approved by the shareholders of Lextar and EPISTAR at the meetings held on August 7, 2020, we will receive 0.275 shares of common stock of the holding company, to be named ENNOSTAR Inc. (ENNOSTAR), for each share for Lextar common stock once the share swap is effected (currently scheduled for January 6, 2021), representing in the aggregate an approximately 3.3% common stock ownership interest in ENNOSTAR. The shares of ENNOSTAR will be listed on the Taiwan Stock Exchange. Any future stock price changes will be recorded as further gains or losses on equity investment based on the increase or decrease, respectively, in the fair value of the investment during the applicable fiscal period. Further losses could have a material adverse effect on our results of operations.
Foreign currency loss, net. Foreign currency loss (gain), net, primarily consists of remeasurement adjustments resulting from our Lextar investment and from our international subsidiaries.
Interest income. The decrease in interest income was due to significant reductions in investment returns on our short-term investment securities.
Interest expense, net of capitalized interest. The increase in interest expense was primarily due to the addition of our 1.75% convertible senior notes due May 1, 2026 (2026 Notes), which were sold on April 21, 2020.
Income tax expense
Income tax expense and our effective tax rate was as follows:
| Three months ended | |||||||||||||||||||||||
| (in millions of U.S. Dollars) | September 27, 2020 | September 29, 2019 | Change | ||||||||||||||||||||
| Income tax expense | $0.1 | $0.5 | ($0.4) | (80) | % | ||||||||||||||||||
| Effective tax rate | — | % | (1) | % | |||||||||||||||||||
Our effective tax rate remained steady due to relatively consistent year-to-date income in jurisdictions where we do not recognize a full valuation allowance.
In general, the variation between our effective income tax rate and the U.S. statutory rate of 21% is primarily due to: (i) changes in our valuation allowances against deferred tax assets in the U.S. and Luxembourg, (ii) projected income for the full year derived from international locations with differing tax rates than the U.S., and (iii) projected tax credits generated.
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Liquidity and Capital Resources
Overview
We require cash to fund our operating expenses and working capital requirements, including outlays for research and development, capital expenditures, strategic acquisitions and investments. Our principal sources of liquidity are cash on hand, marketable securities, cash generated from operations and availability under our line of credit. We have a $125 million line of credit as discussed in Note 9, “Long-term Debt,” in our consolidated financial statements included in Part I, Item 1 of this Quarterly Report. The purpose of this facility is to provide short term flexibility to optimize returns on our cash and investment portfolio while funding capital expenditures and other general business needs. Additionally, on April 21, 2020, we issued and sold a total of $575.0 million aggregate principal amount of 2026 Notes, as discussed in Note 9, “Long-term Debt,” in our consolidated financial statements included in Part I, Item 1 of this Quarterly Report. The total net proceeds of the 2026 Notes was $561.4 million, of which we used $144.3 million to repurchase $150.2 million aggregate principal amount of our 0.875% convertible senior notes due September 1, 2023 (the 2023 Notes). We expect to use the remainder of the net proceeds for general corporate purposes.
Based on past performance and current expectations, we believe our current working capital, availability under our line of credit and anticipated cash flows from operations will be adequate to meet our cash needs for our daily operations and capital expenditures for at least the next 12 months. With the strength of our working capital position, we believe that we have the ability to continue to invest in further development of our products and, when necessary or appropriate, make selective acquisitions or other strategic investments to strengthen our product portfolio, secure key intellectual properties and/or expand our production capacity.
From time to time, we evaluate strategic opportunities, including potential acquisitions, joint ventures, divestitures, spin-offs or investments in complementary businesses, and we have continued to make such evaluations. For example, we recently entered into a definitive agreement with SMART regarding the LED Business Divestiture, which, when completed, will provide us with $50 million in up front payments, a $125 million unsecured promissory note due in August 2023 and the potential of up to $125 million in contingent consideration. We may also access capital markets through the issuance of debt or additional shares of common stock, which we may use in connection with the acquisition of complementary businesses or other significant assets or for other strategic opportunities or general corporate purposes.
We are currently building a new silicon carbide fabrication facility in Marcy, New York, to expand capacity for our silicon carbide device business. We expect to invest approximately $1.0 billion in construction, equipment and other related costs for the new facility through fiscal 2024, of which approximately $500 million is expected to be reimbursed in future fiscal years by the State of New York through a grant program administered by the State of New York Urban Development Corporation (doing business as Empire State Development). Given our current cash position, we believe we are positioned to adequately fund the construction of the facility.
The full extent to which COVID-19 may impact our results of operations or liquidity is uncertain. Currently, the local governments in the locations in which we operate have designated our Company as an essential business, but our operations have, and likely will continue, to experience supply, labor, demand and output challenges. We continue to monitor the impact that the COVID-19 pandemic is having on our business, the semiconductor and LED industries, and the economies in which we operate. We anticipate our future results of operations, including the results for fiscal 2021, will be materially impacted by COVID-19, but at this time we do not expect the impact from the COVID-19 outbreak will have a material effect on our liquidity or financial position. However, given the speed and frequency of continuously evolving developments with respect to this pandemic, we cannot reasonably estimate the magnitude of the impact to our results of operations, and, if the outbreak continues on its current trajectory, such impacts could grow and become material to our liquidity or financial position. To the extent our suppliers continue to be materially and adversely impacted by COVID-19, this could reduce the availability, or result in delays, of materials or supplies to or from us, which in turn could materially interrupt our business operations.
Liquidity
Our liquidity and capital resources primarily depend on our cash flows from operations and our working capital. The significant components of our working capital are liquid assets such as cash and cash equivalents, short-term investments, accounts receivable and inventories reduced by trade accounts payable.
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The following table presents the components of our cash conversion cycle:
| Three months ended | |||||||||||||||||
| September 27, 2020 | June 28, 2020 | Change | |||||||||||||||
Days of sales outstanding (a) | 33 | 37 | (4) | ||||||||||||||
Days of supply in inventory (b) | 104 | 104 | — | ||||||||||||||
Days in accounts payable (c) | (112) | (103) | (9) | ||||||||||||||
| Cash conversion cycle | 25 | 38 | (13) | ||||||||||||||
a)Days of sales outstanding (DSO) measures the average collection period of our receivables. DSO is based on the ending net trade receivables less receivable related accrued contract liabilities and the revenue, net for the quarter then ended. DSO is calculated by dividing ending accounts receivable, less receivable related accrued contract liabilities, by the average net revenue per day for the respective 90-day period.
b)Days of supply in inventory (DSI) measures the average number of days from procurement to sale of our product. DSI is based on ending inventory and cost of revenue, net for the quarter then ended. DSI is calculated by dividing ending inventory by average cost of revenue, net per day for the respective 90-day period.
c)Days in accounts payable (DPO) measures the average number of days our payables remain outstanding before payment. DPO is based on ending accounts payable and cost of revenue, net for the quarter then ended. DPO is calculated by dividing ending accounts payable and accrued expenses (less accrued salaries and wages) by the average cost of revenue, net per day for the respective 90-day period.
The decrease in our cash conversion cycle was primarily driven by increased accounts payable balances relating to investment at our future silicon carbide fabrication facility in New York.
As of September 27, 2020, we had unrealized losses on our short-term investments of $0.1 million. All of our short-term investments had investment grade ratings, and any such investments that were in an unrealized loss position at September 27, 2020 were in such position due to interest rate changes, sector credit rating changes, company-specific rating changes or negative market conditions surrounding the COVID-19 outbreak. We evaluate our short-term investments for expected credit losses. We believe we are able to and we intend to hold each of the investments held with an unrealized loss as of September 27, 2020 until the investments fully recover in market value. No allowance for credit losses was recorded as of September 27, 2020.
Cash Flows
In summary, our cash flows were as follows:
| Three months ended | |||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | Change | |||||||||||||||||||||
| Cash provided by (used in) operating activities | $0.4 | ($20.0) | $20.4 | (102) | % | ||||||||||||||||||
| Cash used in investing activities | (16.0) | (52.3) | 36.3 | 69 | % | ||||||||||||||||||
| Cash provided by financing activities | 3.1 | 5.4 | (2.3) | (43) | % | ||||||||||||||||||
| Effect of foreign exchange changes | 0.1 | (0.3) | 0.4 | (133) | % | ||||||||||||||||||
| Net change in cash and cash equivalents | ($12.4) | ($67.2) | $54.8 | (82) | % | ||||||||||||||||||
Cash Flows from Operating Activities
Net cash provided by operating activities increased primarily due to improved working capital.
Cash Flows from Investing Activities
Our investing activities primarily relate to short-term investment transactions, purchases of property and equipment and payments for patents and licensing rights.
Cash used in investing activities decreased primarily due to increased net proceeds from short-term investments of $108.5 million offset by an increase in property and equipment purchases of $72.0 million.
For fiscal 2021, we target approximately $400.0 million of net capital investment, which is primarily related to capacity and infrastructure projects to support our Wolfspeed segment longer-term growth and strategic priorities. This target is highly dependent on the timing and overall progress on the construction of our new silicon carbide fabrication facility in New York and is net of expected reimbursements from Empire State Development under a Grant Disbursement Agreement (GDA). For more details on the GDA, see Note 13, "Commitments and Contingencies," to our unaudited consolidated financial statements in Part I, Item 1 of this Quarterly Report.
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Cash Flows from Financing Activities
For the three months ended September 27, 2020, our financing activities primarily consisted of net proceeds of $3.7 million from issuances of common stock pursuant to the exercise of employee stock options.
For the three months ended September 29, 2019, our financing activities consisted of net proceeds of $5.4 million from issuances of common stock pursuant to the exercise of employee stock options.
Off-Balance Sheet Arrangements
We do not use off-balance sheet arrangements with unconsolidated entities or related parties, nor do we use any other forms of off-balance sheet arrangements. Accordingly, our liquidity and capital resources are not subject to off-balance sheet risks from unconsolidated entities. As of September 27, 2020, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Critical Accounting Policies and Estimates
Allowance for Available-for-sale Debt Securities (new for fiscal 2021 due to ASC 326 Adoption)
Available-for-sale debt securities in an unrealized loss position at each measurement date are individually evaluated for expected credit losses. First, we determine our intent and ability to hold the security in an unrealized loss position until it recovers its fair value. If we do not have the intent or ability to hold the security until recovery, we recognize an expected credit loss equal to the decrease in fair value. If we have the intent and ability to hold the security until recovery, we evaluate if the unrealized loss is the result of credit related factors, primarily using qualitative data. If we determine the security has an unrealized loss as a result of credit related factors, we use a discounted cash flow model to determine the present value of expected cash flows. If the security has a present value of expected cash flows less than its amortized cost, we record an allowance and an expense equal to the amount of the unrealized loss. If the investment recovers its fair value, the allowance is reversed and a recovery is recognized in earnings.
We record any unrealized loss related to market interest rate changes or other non-credit related factors as an adjustment to other comprehensive income.
We do not include accrued interest in our assessment of credit losses for available-for-sale debt securities. We record losses related to noncollectable interest receivable as an adjustment to interest income in the period the losses are realized.
Allowance for Doubtful Accounts (updated for fiscal 2021 due to ASC 326 Adoption)
Receivables are evaluated for expected credit losses on a collective (pool) basis and aggregated on the basis of similar risk characteristics, including customers' financial strength, credit standing, payment history and historical defaults, as well as geographical and industry conditions. Pooling criteria is evaluated each period to ensure the risk profile for each pool is consistent with the prior period. If a receivable does not fit into defined risk pool, it is evaluated for expected credit losses on an individual basis.
Each risk pool is assigned an expected credit loss rate (if any), which is calculated by considering historical write offs, current market conditions, forecast data and other qualitative data. Expected credit losses are recorded each period by applying the expected credit loss rates to the total balance of each defined risk pool.
For information our other critical accounting policies and estimates, see the “Critical Accounting Policies and Estimates” section of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended June 28, 2020.
Recent Accounting Pronouncements
For a description of recent accounting pronouncements, including the expected dates of adoption and the estimated effects, if any, on our consolidated financial statements, see Note 1, “Basis of Presentation and New Accounting Standards,” to our unaudited consolidated financial statements in Part I, Item 1 of this Quarterly Report.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
For quantitative and qualitative disclosures about our market risks, see “Part II. Item 7A. Quantitative and Qualitative Disclosures About Market Risk” of our Annual Report on Form 10-K for the fiscal year ended June 28, 2020. There have been no material changes to the amounts presented therein.
Item 4. Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures are effective in that they provide reasonable assurances that the information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and will take action as appropriate. There have been no changes to our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, during the first quarter of fiscal 2021 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II – OTHER INFORMATION
Item 1. Legal Proceedings
The information required by this item is set forth under Note 13, “Commitments and Contingencies,” to our unaudited financial statements in Part I, Item 1 of this Quarterly Report and is incorporated herein by reference.
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Item 1A. Risk Factors
Described below are various risks and uncertainties that may affect our business. The descriptions below include any material changes to and supersede the description of the risk factors affecting our business previously disclosed in "Part I, Item 1A. Risk Factors" of our Annual Report on Form 10-K for the fiscal year ended June 28, 2020. If any of the risks described below actually occurs, our business, financial condition or results of operations could be materially and adversely affected.
Our financial condition and results of operations for fiscal 2021 and future periods may be adversely affected by the recent COVID-19 outbreak or other outbreak of infectious disease or similar public health threat.
COVID-19 continues to spread globally and has resulted in authorities implementing numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter in place orders, and shutdowns. These measures have impacted and may continue to impact our workforce and operations, the operations of our customers, and those of our respective vendors and suppliers. We have significant manufacturing operations in the United States and China, and each of these countries has been affected by the outbreak and taken measures to try to contain it. We have experienced some limited disruptions in supply from some of our suppliers, although the disruptions to date have not been significant. Additionally, we have experienced a shift in customer demand. There is considerable uncertainty regarding such measures and potential future measures. Restrictions on access to our manufacturing facilities or on our support operations or workforce, or similar limitations for our vendors and suppliers, and restrictions or disruptions of transportation, such as reduced availability of air transport, port closures, and increased border controls or closures, could limit our capacity to meet customer demand, lead to increased costs and have a material adverse effect on our financial condition and results of operations.
The outbreak has significantly increased economic and demand uncertainty. These uncertainties also make it more difficult for us to assess the quality of our product order backlog and to estimate future financial results. The current outbreak of COVID-19 has caused an economic slowdown, and it is increasingly likely that its continued spread will lead to a global recession, which could have a material adverse effect on demand for our products and on our financial condition and results of operations.
The spread of COVID-19 has caused us to modify our business practices (including employee travel, employee work locations, and cancellation of physical participation in meetings, events, and conferences), and we may take further actions as may be required by government authorities or that we determine are in the best interests of our employees, customers, partners, and suppliers. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus, and our ability to perform critical functions could be harmed. In addition, in light of concerns about the spread of COVID-19, our workforce has at times been operating at reduced levels at our manufacturing facilities, which may continue to have an adverse impact on our ability to timely meet future customer orders.
The duration of the business disruption and related financial impact cannot be reasonably estimated at this time. However, it may materially affect our ability to obtain raw materials, manage customer credit risk, manufacture products or deliver inventory in a timely manner, and it also may impair our ability to meet customer demand for products, result in lost sales, additional costs, or penalties, or damage our reputation. The extent to which COVID-19 or any other health epidemic will further impact our results will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact, among others.
Our operating results are substantially dependent on the acceptance of new products.
Our future success may depend on our ability to deliver new, higher performing and/or lower cost solutions for existing and new markets and for customers to accept those solutions. The development of new products is a highly complex process, and we have in some instances experienced delays in completing the development, introduction and qualification of new products which has impacted our results in the past. Our research and development efforts are aimed at solving increasingly complex problems, and we do not expect that all our projects will be successful. The successful development, introduction and acceptance of new products depend on a number of factors, including the following:
•our ability to introduce new products in a timely and cost-effective manner;
•our ability to secure volume purchase orders related to new products;
•qualification and acceptance of our new product and systems designs, specifically entering into automotive applications which require even more stringent levels of qualification and standards;
•achievement of technology breakthroughs required to make commercially viable products;
•the accuracy of our predictions for market requirements;
•our ability to predict, influence and/or react to evolving standards;
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•acceptance of new technology in certain markets;
•our ability to protect intellectual property developed in new products;
•the availability of qualified research and development personnel;
•our timely completion of product designs and development;
•our ability to develop repeatable processes to manufacture new products in sufficient quantities, with the desired specifications and at competitive costs;
•our ability to effectively transfer increasingly complex products and technology from development to manufacturing;
•our customers’ ability to develop competitive products incorporating our products; and
•market acceptance of our products and our customers’ products.
If any of these or other similar factors becomes problematic, we may not be able to deliver and introduce new products in a timely or cost-effective manner.
We face significant challenges managing our growth strategy.
Our potential for growth depends significantly on the adoption of our products within the markets we serve and for other applications, and our ability to affect this rate of adoption. In order to manage our growth and business strategy effectively relative to the uncertain pace of adoption, we must continue to:
•maintain, expand, construct and purchase adequate manufacturing facilities and equipment, as well as secure sufficient third-party manufacturing resources, to meet customer demand, including specifically the expansion of our silicon carbide capacity with the construction of a state-of-the-art, automated 150mm and 200mm capable silicon carbide fabrication facility and a large materials factory;
•manage an increasingly complex supply chain that has the ability to supply an increasing number of raw materials, subsystems and finished products with the required specifications and quality, and deliver on time to our manufacturing facilities, our third-party manufacturing facilities, or our logistics operations;
•expand the capability of our information systems to support a more complex business, such as our current initiative to upgrade our company-wide ERP system;
•be successful in the qualification and acceptance of our new product and systems designs, including those entering into automotive applications which require even more stringent levels of qualification and standards;
•expand research and development, sales and marketing, technical support, distribution capabilities, manufacturing planning and administrative functions;
•safeguard confidential information and protect our intellectual property;
•manage organizational complexity and communication;
•expand the skills and capabilities of our current management team;
•add experienced senior level managers and executives;
•attract and retain qualified employees; and
•execute, maintain and adjust the operational and financial controls that support our business.
While we intend to continue to focus on managing our costs and expenses, we expect to invest to support our growth and may have additional unexpected costs. Such investments take time to become fully operational, and we may not be able to expand quickly enough to exploit targeted market opportunities. For example, we continue converting the majority of our Wolfspeed power production from 100mm to 150mm substrates. If we are unable to complete this transition in a timely or cost-effective manner, our results could be negatively impacted. In connection with our efforts to cost-effectively manage our growth, we have increasingly relied on contractors for production capacity, logistics support and certain administrative functions including hosting of certain information technology software applications. If our contract manufacturers, original design manufacturers (ODMs) or other service providers do not perform effectively, we may not be able to achieve the expected cost savings and may incur additional costs to correct errors or fulfill customer demand. Depending on the function involved, such errors may also lead to business disruption, processing inefficiencies, the loss of or damage to intellectual property through security breach, or an impact on employee morale. Our operations may also be negatively impacted if any of these contract manufacturers, ODMs or other service providers do not have the financial capability to meet our growing needs.
There are also inherent execution risks in starting up a new factory or expanding production capacity, whether one of our own factories or that of our contract manufacturers or ODMs, or moving production to different contract manufacturers or ODMs, that could increase costs and reduce our operating results. In September 2019, we announced the intent to build the new fabrication facility in Marcy, New York to complement the factory expansion underway at our United States campus
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headquarters in Durham, North Carolina. The establishment and operation of a new manufacturing facility or expansion of an existing facility involves significant risks and challenges, including, but not limited to, the following:
•design and construction delays and cost overruns;
•issues in installing and qualifying new equipment and ramping production;
•poor production process yields and reduced quality control; and
•insufficient personnel with requisite expertise and experience to operate a fabrication facility.
We are also increasingly dependent on information technology to enable us to improve the effectiveness of our operations and to maintain financial accuracy and efficiency. Allocation and effective management of the resources necessary to successfully implement, integrate, train personnel and sustain our information technology platforms will remain critical to ensure that we are not subject to transaction errors, processing inefficiencies, loss of customers, business disruptions or loss of or damage to intellectual property through a security breach in the near term. Additionally, we face these same risks if we fail to allocate and effectively manage the resources necessary to build, implement, upgrade, integrate and sustain appropriate technology infrastructure over the longer term.
If we fail to evaluate and execute strategic opportunities successfully, our business may suffer.
From time to time, including the present, we evaluate strategic opportunities available to us for product, technology or business transactions, such as business acquisitions, investments, joint ventures, divestitures, or spin-offs. For example, in the fourth quarter of fiscal 2019, we completed the sale of our Lighting Products business unit to IDEAL Industries, Inc. (IDEAL) and in the second quarter of fiscal 2021 we entered into an Asset Purchase Agreement (the Purchase Agreement) with SMART with respect to the LED Business Divestiture. If we choose to enter into such transactions, we face certain risks including:
•the failure of an acquired business, investee or joint venture to meet our performance and financial expectations;
•identification of additional liabilities relating to an acquired business;
•loss of existing customers of our current and acquired businesses due to concerns that new product lines may be in competition with the customers’ existing product lines or due to regulatory actions taken by governmental agencies;
•that we are not able to enter into acceptable contractual arrangements with the significant customers of an acquired business;
•difficulty integrating an acquired business's operations, personnel and financial and operating systems into our current business;
•that we are not able to develop and expand customer bases and accurately anticipate demand from end customers, which can result in increased inventory and reduced orders as we experience wide fluctuations in supply and demand;
•diversion of management attention;
•difficulty separating the operations, personnel and financial and operating systems of a spin-off or divestiture from our current business;
•the possibility we are unable to complete the transaction and expend substantial resources without achieving the desired benefit;
•the inability to obtain required regulatory agency approvals;
•reliance on a transaction counterparty for transition services for an extended period of time, which may result in additional expenses and delay the integration of the acquired business and realization of the desired benefit of the transaction;
•uncertainty of the financial markets or circumstances that cause conditions that are less favorable and/or different than expected; and
•expenses incurred to complete a transaction may be significantly higher than anticipated.
We may not be able to adequately address these risks or any other problems that arise from our prior or future acquisitions, investments, joint ventures, divestitures or spin-offs. Any failure to successfully evaluate strategic opportunities and address risks or other problems that arise related to any such business transaction could adversely affect our business, results of operations or financial condition.
We are subject to a number of risks associated with the sale of our LED Products segment, and these risks could adversely impact our operations, financial condition and business.
On October 18, 2020, we executed the Purchase Agreement with SMART with respect to the LED Business Divestiture. We are subject to a number of risks associated with this transaction, including risks associated with:
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•the failure to satisfy, on a timely basis or at all, the closing conditions set forth in the Purchase Agreement, including the receipt of governmental and regulatory consents and approvals;
•the separation of the LED Business, and related information technology, from the businesses we are retaining and the operation of our retained business without the LED Business;
•issues, delays or complications in completing required transition activities to allow the LED Business to operate under the SMART portfolio of businesses after the closing, including incurring unanticipated costs to complete such activities;
•unfavorable reaction to the sale by customers, competitors, suppliers and employees;
•the disruption to and uncertainty in our business and our relationships with our customers, including attempts by our customers to terminate or renegotiate their relationships with us or decisions by our customers to defer or delay purchases from us;
•difficulties in hiring, retaining and motivating key personnel during this process or as a result of uncertainties generated by this process or any developments or actions relating to it;
•the diversion of our management’s attention away from the operation of the business we are retaining;
•the need to incur significant transaction costs in connection with the transaction, regardless of whether it is completed;
•the restrictions on and obligations with respect to our business set forth in the Purchase Agreement and, following closing, the transition services agreement and a wafer supply and fabrication agreement, in each case between us and SMART;
•the need to provide transition services in connection with the transaction, which may result in the diversion of resources and focus;
•our failure to realize the full purchase price anticipated under the Purchase Agreement, including the ability of the LED Business to generate revenue and gross profit in the first four full fiscal quarters following the closing sufficient to result in payment of the targeted earnout payment or any earnout payment; and
•the ability of SMART to pay the unsecured promissory note to be issued to us at the closing of the transaction and any additional unsecured promissory notes issued upon achievement of the general revenue and gross profit targets.
As a result of these risks, we may be unable to realize the anticipated benefits of the transaction, including the total amount of cash we expect to realize. Our failure to realize the anticipated benefits of the transaction would adversely impact our operations, financial condition and business and could limit our ability to pursue additional strategic transactions.
Variations in our production could impact our ability to reduce costs and could cause our margins to decline and our operating results to suffer.
All of our products are manufactured using technologies that are highly complex. The number of usable items, or yield, from our production processes may fluctuate as a result of many factors, including but not limited to the following:
•variability in our process repeatability and control;
•contamination of the manufacturing environment;
•equipment failure, power outages, fires, flooding, information or other system failures or variations in the manufacturing process;
•lack of consistency and adequate quality and quantity of piece parts, other raw materials and other bill of materials items;
•inventory shrinkage or human errors;
•defects in production processes (including system assembly) either within our facilities or at our suppliers; and
•any transitions or changes in our production process, planned or unplanned.
In the past, we have experienced difficulties in achieving acceptable yields on certain products, which has adversely affected our operating results. We may experience similar problems in the future, and we cannot predict when they may occur or their severity.
In some instances, we may offer products for future delivery at prices based on planned yield improvements or increased cost efficiencies from other production advances. Failure to achieve these planned improvements or advances could have a significant impact on our margins and operating results.
In addition, our ability to convert volume manufacturing to larger diameter substrates can be an important factor in providing a more cost-effective manufacturing process. We continue converting the majority of our Wolfspeed power production from
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100mm to 150mm substrates. If we are unable to make this transition in a timely or cost-effective manner, our results could be negatively impacted.
Global economic conditions could materially adversely impact demand for our products and services.
Our operations and performance depend significantly on worldwide economic conditions. Uncertainty about global economic conditions could result in customers postponing purchases of our products and services in response to tighter credit, unemployment, negative financial news and/or declines in income or asset values and other macroeconomic factors, which could have a material negative effect on demand for our products and services and, accordingly, on our business, results of operations or financial condition. For example, any economic and political uncertainty caused by the United States tariffs imposed on goods from China, among other potential countries, and any corresponding tariffs or currency devaluations from China or such other countries in response, has negatively impacted, and may in the future, negatively impact, demand and/or increase the cost for our products.
Additionally, our international sales are subject to variability as our selling prices become less competitive in countries with currencies that are declining in value against the U.S. Dollar and more competitive in countries with currencies that are increasing in value against the U.S. Dollar. In addition, our international purchases can become more expensive if the U.S. Dollar weakens against the foreign currencies in which we are billed.
Our results of operations, financial condition and business could be harmed if we are unable to balance customer demand and capacity.
As customer demand for our products changes, we must be able to adjust our production capacity to meet demand. We are continually taking steps to address our manufacturing capacity needs for our products. If we are not able to increase or decrease our production capacity at our targeted rate or if there are unforeseen costs associated with adjusting our capacity levels, we may not be able to achieve our financial targets when our factories are underutilized. We may be unable to build or qualify new capacity on a timely basis to meet customer demand and customers may fulfill their orders with one of our competitors instead. In addition, as we introduce new products and change product generations, we must balance the production and inventory of prior generation products with the production and inventory of new generation products, whether manufactured by us or our contract manufacturers, to maintain a product mix that will satisfy customer demand and mitigate the risk of incurring cost write-downs on the previous generation products, related raw materials and tooling.
Due to the proportionately high fixed cost nature of our business (such as facility costs), if demand does not materialize at the rate forecasted, we may not be able to scale back our manufacturing expenses or overhead costs to correspond to the demand. This could result in lower margins and adversely impact our business and results of operations. Additionally, if product demand decreases or we fail to forecast demand accurately, our results may be adversely impacted due to higher costs resulting from lower factory utilization, causing higher fixed costs per unit produced. Further, we may be required to recognize impairments on our long-lived assets or recognize excess inventory write-off charges, or excess capacity charges, which would have a negative impact on our results of operations.
In addition, our efforts to improve quoted delivery lead-time performance may result in corresponding reductions in order backlog. A decline in backlog levels could result in more variability and less predictability in our quarter-to-quarter net revenue and operating results.
We are subject to risks related to international sales and purchases.
We expect that revenue from international sales will continue to represent a significant portion of our total revenue. As such, a significant slowdown or instability in relevant foreign economies or lower investments in new infrastructure, could have a negative impact on our sales. We also purchase a portion of the materials included in our products from overseas sources.
Our international sales and purchases are subject to numerous United States and foreign laws and regulations, including, without limitation, tariffs, trade sanctions, trade barriers, trade embargoes, regulations relating to import-export control, technology transfer restrictions, the International Traffic in Arms Regulation promulgated under the Arms Export Control Act, the Foreign Corrupt Practices Act and the anti-boycott provisions of the U.S. Export Administration Act. For example, on May 15, 2019, the Bureau of Industry and Security (BIS) of the U.S. Department of Commerce added Huawei Technologies Co., Ltd. and numerous more of its affiliates since then (collectively, “Huawei”) to the “Entity List” maintained by the U.S. Department of Commerce, which imposes limitations on the supply of certain United States items and product support to Huawei. To comply with the Entity List restrictions, we suspended shipments of all products to Huawei and cannot predict when we will be able to resume such shipments, which has reduced our revenue and profit in at least the near term and increased our inventories of product intended for Huawei. If the U.S. Government maintains the restrictions on Huawei or
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imposes restrictions on sales to other foreign customers, as it did in October 2019 with the addition of 28 new companies to the Entity List and has continued to do so through several Entity Listings and other sanctions since then, it will reduce company revenue and profit related to those customers at least in the short term and could have a potential longer-term impact. In the second quarter of fiscal 2020, we recorded an $8.3 million reserve on inventory manufactured for Huawei. Additionally, like many global manufacturers, we continue to evaluate and address the short-term and potential long-term impact of the recent change to the United States foreign direct product rule, military end-use restrictions, changes in export licensing policies, and tariffs imposed on Chinese goods and any corresponding Chinese regulations or tariffs in response. If we fail to comply with these laws and regulations, we could be liable for administrative, civil or criminal liabilities, and, in the extreme case, we could be suspended or debarred from government contracts or have our export privileges suspended, which could have a material adverse effect on our business.
International sales and purchases are also subject to a variety of other risks, including risks arising from currency fluctuations, collection issues and taxes. We have entered into and may in the future enter into foreign currency derivative financial instruments in an effort to manage or hedge some of our foreign exchange rate risk. We may not be able to engage in hedging transactions in the future, and, even if we do, foreign currency fluctuations may still have a material adverse effect on our results of operations.
Our operations in foreign countries expose us to certain risks inherent in doing business internationally, which may adversely affect our business, results of operations or financial condition.
We have revenue, operations, manufacturing facilities and contract manufacturing arrangements in foreign countries that expose us to certain risks. For example, fluctuations in exchange rates may affect our revenue, expenses and results of operations as well as the value of our assets and liabilities as reflected in our financial statements. We are also subject to other types of risks, including the following:
•protection of intellectual property and trade secrets;
•tariffs, customs, trade sanctions, trade embargoes and other barriers to importing/exporting materials and products in a cost-effective and timely manner, or changes in applicable tariffs or custom rules;
•the burden of complying with and changes in United States or international taxation policies;
•timing and availability of export licenses;
•rising labor costs;
•disruptions in or inadequate infrastructure of the countries where we operate;
•the impact of public health epidemics on employees and the global economy, such as COVID-19;
•difficulties in collecting accounts receivable;
•difficulties in staffing and managing international operations; and
•the burden of complying with foreign and international laws and treaties.
For example, the United States tariffs imposed on Chinese goods, among other potential countries and any corresponding tariffs from China or such other countries in response has, and may in the future, negatively impact demand and/or increase the costs for our products. In some instances, we have received and may continue to receive incentives from foreign governments to encourage our investment in certain countries, regions or areas outside of the United States. In particular, we have received and may continue to receive such incentives in connection with our operations in Asia, as Asian national and local governments seek to encourage the development of the technology industry. Government incentives may include tax rebates, reduced tax rates, favorable lending policies and other measures, some or all of which may be available to us due to our foreign operations. Any of these incentives could be reduced or eliminated by governmental authorities at any time or as a result of our inability to maintain minimum operations necessary to earn the incentives. Any reduction or elimination of incentives currently provided for our operations could adversely affect our business and results of operations. These same governments also may provide increased incentives to or require production processes that favor local companies, which could further negatively impact our business and results of operations.
Changes in regulatory, geopolitical, social, economic, or monetary policies and other factors, including those which may result from the outcome of the 2020 U.S. Presidential election, if any, may have a material adverse effect on our business in the future, or may require us to exit a particular market or significantly modify our current business practices. Abrupt political change, terrorist activity and armed conflict pose a risk of general economic disruption in affected countries, which could also result in an adverse effect on our business and results of operations.
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We operate in industries that are subject to significant fluctuation in supply and demand and ultimately pricing that affects our revenue and profitability.
The industries we serve are in different stages of adoption and are characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving standards, short product life-cycles in the case of the LED industry and fluctuations in product supply and demand. The power, RF, and LED industries have experienced, and may in the future experience, significant fluctuations, often in connection with, or in anticipation of, product cycles and changes in general economic conditions. The semiconductor industry is characterized by rapid technological change, high capital expenditures, short product life cycles and continuous advancements in process technologies and manufacturing facilities. As the markets for our products mature, additional fluctuations may result from variability and consolidations within the industry’s customer base. These fluctuations have been characterized by lower product demand, production overcapacity, higher inventory levels and increased pricing pressure as currently seen in the LED market. These fluctuations have also been characterized by higher demand for key components and equipment used in, or in the manufacture of, our products resulting in longer lead times, supply delays and production disruptions. We have experienced these conditions in our business and may experience such conditions in the future, which could have a material negative impact on our business, results of operations or financial condition.
In addition, as we diversify our product offerings and as pricing differences in the average selling prices among our product lines widen, a change in the mix of sales among our product lines may increase volatility in our revenue and gross margin from period to period.
If we are unable to effectively develop, manage and expand our sales channels for our products, our operating results may suffer.
We sell a substantial portion of our products to distributors. We rely on distributors to develop and expand their customer base as well as anticipate demand from their customers. If they are not successful, our growth and profitability may be adversely impacted. Distributors must balance the need to have enough products in stock in order to meet their customers’ needs against their internal target inventory levels and the risk of potential inventory obsolescence. The risks of inventory obsolescence are especially relevant to technological products. The distributors’ internal target inventory levels vary depending on market cycles and a number of factors within each distributor over which we have very little, if any, control. Distributors also have the ability to shift business to different manufacturers within their product portfolio based on a number of factors, including new product availability and performance. Similarly, we have the ability to add, consolidate, or remove distributors.
We typically recognize revenue on products sold to distributors when the item is shipped and title passes to the distributor (sell-in method). Certain distributors have limited rights to return inventory under stock rotation programs and have limited price protection rights for which we make estimates. We evaluate inventory levels in the distribution channel, current economic trends and other related factors in order to account for these factors in our judgments and estimates. As inventory levels and product return trends change or we make changes to our distributor roster, we may have to revise our estimates and incur additional costs, and our gross margins and operating results could be adversely impacted.
Additionally, our distributors have in the past and may in the future choose to drop our product lines from their portfolio to avoid losing access to our competitors’ products, resulting in a disruption in the project pipeline and lower than targeted sales for our products. Our distributors have the ability to shift business to different suppliers within their product portfolio based on a number of factors, including customer service and new product availability. If we are unable to effectively penetrate these channels or develop alternate channels to ensure our products are reaching the intended customer base, our financial results may be adversely impacted. In addition, if we successfully penetrate or develop these channels, we cannot guarantee that customers will accept our products or that we will be able to manufacture and deliver them in the timeline established by our customers.
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We may be subject to confidential information theft or misuse, which could harm our business and results of operations.
We face attempts by others to gain unauthorized access to our information technology systems on which we maintain proprietary and other confidential information. Our security measures may be breached as the result of industrial or other espionage actions of outside parties, employees, employee error, malfeasance or otherwise, and as a result, an unauthorized party may obtain access to our systems. The risk of a security breach or disruption, particularly through cyber-attacks, or cyber intrusion, including by computer hackers, foreign governments, and cyber terrorists, has generally increased as cyber-attacks have become more prevalent and harder to detect and fight against. Additionally, outside parties may attempt to access our confidential information through other means, for example by fraudulently inducing our employees to disclose confidential information. We actively seek to prevent, detect and investigate any unauthorized access, which sometimes occurs. To date, we do not believe that such unauthorized access has caused us any material damage. We might be unaware of any such access or unable to determine its magnitude and effects. In addition, these threats are constantly evolving, thereby increasing the difficulty of successfully defending against them or implementing adequate preventative measures. The theft and/or unauthorized use or publication of our trade secrets and other confidential business information as a result of such an incident could adversely affect our competitive position and the value of our investment in research and development could be reduced. Our business could be subject to significant disruption and we could suffer monetary or other losses.
Our disclosure controls and procedures address cybersecurity and include elements intended to ensure that there is an analysis of potential disclosure obligations arising from security breaches. In addition, we are subject to data privacy, protection and security laws and regulations, including the European General Data Protection Act (GDPR) that governs personal information of European persons. We also maintain compliance programs to address the potential applicability of restrictions against trading while in possession of material, nonpublic information generally and in connection with a cyber-security breach. However, a breakdown in existing controls and procedures around our cyber-security environment may prevent us from detecting, reporting or responding to cyber incidents in a timely manner and could have a material adverse effect on our financial position and value of our stock.
There are limitations on our ability to protect our intellectual property.
Our intellectual property position is based in part on patents owned by us and patents licensed to us. We intend to continue to file patent applications in the future, where appropriate, and to pursue such applications with U.S. and certain foreign patent authorities.
Our existing patents are subject to expiration and re-examination and we cannot be sure that additional patents will be issued on any new applications around the covered technology or that our existing or future patents will not be successfully contested by third parties. Also, since issuance of a valid patent does not prevent other companies from using alternative, non-infringing technology, we cannot be sure that any of our patents, or patents issued to others and licensed to us, will provide significant commercial protection, especially as new competitors enter the market.
We periodically discover products that are counterfeit reproductions of our products or that otherwise infringe on our intellectual property rights. The actions we take to establish and protect trademarks, patents and other intellectual property rights may not be adequate to prevent imitation of our products by others, and therefore, may adversely affect our sales and our brand and result in the shift of customer preference away from our products. Further, the actions we take to establish and protect trademarks, patents and other intellectual property rights could result in significant legal expense and divert the efforts of our technical personnel and management, even if the litigation or other action results in a determination favorable to us.
We also rely on trade secrets and other non-patented proprietary information relating to our product development and manufacturing activities. We try to protect this information through appropriate efforts to maintain its secrecy, including requiring employees and third parties to sign confidentiality agreements. We cannot be sure that these efforts will be successful or that the confidentiality agreements will not be breached. We also cannot be sure that we would have adequate remedies for any breach of such agreements or other misappropriation of our trade secrets, or that our trade secrets and proprietary know-how will not otherwise become known or be independently discovered by others.
The markets in which we operate are highly competitive and have evolving technical requirements.
The markets for our products are highly competitive. In the semiconductor market, we compete with companies that have greater market share, name recognition, distribution and sales channels, and/or technical resources than we do. Competitors continue to offer new products with aggressive pricing, additional features and improved performance. Competitive pricing pressures remain a challenge and continue to accelerate the rate of decline in our sales prices. Aggressive pricing actions by our competitors in our businesses could reduce margins if we are not able to reduce costs at an equal or greater rate than the sales price decline.
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As competition increases, we need to continue to develop new products that meet or exceed the needs of our customers. Therefore, our ability to continually produce more efficient and lower cost power, RF and LED products that meet the evolving needs of our customers will be critical to our success. Competitors may also try to align with some of our strategic customers. This could lead to lower prices for our products, reduced demand for our products and a corresponding reduction in our ability to recover development, engineering and manufacturing costs. Any of these developments could have an adverse effect on our business, results of operations or financial condition.
We will continue to face increased competition in the future across our businesses. If the investment in capacity exceeds the growth in demand, such as exists in the current LED market, the LED market is likely to become more competitive with additional pricing pressures. Additionally, new technologies could emerge or improvements could be made in existing technologies that may also reduce the demand for LEDs in certain markets.
We depend on a limited number of customers, including distributors, for a substantial portion of our revenue, and the loss of, or a significant reduction in purchases by, one or more of these customers could adversely affect our operating results.
We receive a significant amount of our revenue from a limited number of customers, including distributors, one of which represented 15% of our consolidated revenue in fiscal 2020. Many of our customer orders are made on a purchase order basis, which does not generally require any long-term customer commitments. Therefore, these customers may alter their purchasing behavior with little or no notice to us for various reasons, including developing, or, in the case of our distributors, their customers developing, their own product solutions; choosing to purchase or distribute product from our competitors; incorrectly forecasting end market demand for their products; or experiencing a reduction in their market share in the markets for which they purchase our products. If our customers alter their purchasing behavior, if our customers’ purchasing behavior does not match our expectations or if we encounter any problems collecting amounts due from them, our financial condition and results of operations could be negatively impacted.
We face risks relating to our suppliers, including that we rely on a number of key sole source and limited source suppliers, are subject to high price volatility on certain commodity inputs, variations in parts quality, and raw material consistency and availability, and rely on independent shipping companies for delivery of our products.
We depend on a number of sole source and limited source suppliers for certain raw materials, components, services and equipment used in manufacturing our products, including key materials and equipment used in critical stages of our manufacturing processes. Although alternative sources generally exist for these items, qualification of many of these alternative sources could take up to six months or longer. Where possible, we attempt to identify and qualify alternative sources for our sole and limited source suppliers.
We generally purchase these sole or limited source items with purchase orders, and we have limited guaranteed supply arrangements with such suppliers. Some of our sources can have variations in attributes and availability which can affect our ability to produce products in sufficient volume or quality. We do not control the time and resources that these suppliers devote to our business, and we cannot be sure that these suppliers will perform their obligations to us. Additionally, general shortages in the marketplace of certain raw materials or key components may adversely impact our business. In the past, we have experienced decreases in our production yields when suppliers have varied from previously agreed upon specifications or made other modifications we do not specify, which impacted our cost of revenue.
Additionally, the inability of our suppliers to access capital efficiently could cause disruptions in their businesses, thereby negatively impacting ours. This risk may increase if an economic downturn negatively affects key suppliers or a significant number of our other suppliers. Any delay in product delivery or other interruption or variation in supply from these suppliers could prevent us from meeting commercial demand for our products. If we were to lose key suppliers, if our key suppliers were unable to support our demand for any reason or if we were unable to identify and qualify alternative suppliers, our manufacturing operations could be interrupted or hampered significantly.
We rely on arrangements with independent shipping companies for the delivery of our products from vendors and to customers both in the United States and abroad. The failure or inability of these shipping companies to deliver products or the unavailability of shipping or port services, even temporarily, could have a material adverse effect on our business. We may also be adversely affected by an increase in freight surcharges due to rising fuel costs and added security.
The risks mentioned above, including our sole source or limited source suppliers' ability to produce products and adequately access capital, and our ability to arrange effective shipping arrangements, may further increase due to the COVID-19 pandemic.
In our fabrication process, we consume a number of precious metals and other commodities, which are subject to high price volatility. Our operating margins could be significantly affected if we are not able to pass along price increases to our
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customers. In addition, production could be disrupted by the unavailability of the resources used in production such as water, silicon, electricity and gases. Future environmental regulations could restrict supply or increase the cost of certain of those materials.
Our revenue is highly dependent on our customers’ ability to produce, market and sell more integrated products.
Our revenue depends on getting our products designed into a larger number of our customers’ products and in turn, our customers’ ability to produce, market and sell their products. For example, we have current and prospective customers that create, or plan to create, power, and RF products or systems using our substrates, die, components or modules. Even if our customers are able to develop and produce products or systems that incorporate our substrates, die, components or modules, there can be no assurance that our customers will be successful in marketing and selling these products or systems in the marketplace.
We may be required to recognize a significant charge to earnings if our goodwill or other intangible assets become impaired.
Goodwill is reviewed for impairment annually and when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We assess the recoverability of the unamortized balance of our finite-lived intangible assets when indicators of potential impairment are present. Factors that may indicate that the carrying value of our goodwill or other intangible assets may not be recoverable include a decline in our stock price and market capitalization and slower growth rates in our industry. The recognition of a significant charge to earnings in our consolidated financial statements resulting from any impairment of our goodwill or other intangible assets could adversely impact our results of operations.
We review goodwill for impairment whenever events or circumstances indicate potential impairment. In the first quarter of fiscal 2021, we determined we would more likely than not sell all or a portion of the assets comprising the LED Products segment below carrying value. As a result of this triggering event, we recorded an impairment to goodwill of $105.7 million as of September 27, 2020. As of September 27, 2020, we had not met the held-for-sale criteria.
In order to compete, we must attract, motivate and retain key employees, and our failure to do so could harm our results of operations.
Hiring and retaining qualified executives, scientists, engineers, technical staff, sales personnel and production personnel is critical to our business, and competition for experienced employees in our industry can be intense. As a global company, this issue is not limited to the United States, but includes our other locations such as Europe and Asia. For example, there is substantial competition for qualified and capable personnel, particularly experienced engineers and technical personnel, which may make it difficult for us to recruit and retain qualified employees. If we are unable to staff sufficient and adequate personnel at our facilities, we may experience lower revenue or increased manufacturing costs, which would adversely affect our results of operations.
To help attract, motivate and retain key employees, we use benefits such as stock-based compensation awards. If the value of such awards does not appreciate, as measured by the performance of the price of our common stock or if our stock-based compensation otherwise ceases to be viewed as a valuable benefit, our ability to attract, retain and motivate employees could be weakened, which could harm our business and results of operations.
Our results may be negatively impacted if customers do not maintain their favorable perception of our brands and products.
Maintaining and continually enhancing the value of our brands is critical to the success of our business. Brand value is based in large part on customer perceptions. Success in promoting and enhancing brand value depends in large part on our ability to provide high-quality products. Brand value could diminish significantly due to a number of factors, including adverse publicity about our products (whether valid or not), a failure to maintain the quality of our products (whether perceived or real), the failure of our products to deliver consistently positive consumer experiences, the products becoming unavailable to consumers or consumer perception that we have acted in an irresponsible manner. Damage to our brand, reputation or loss of customer confidence in our brand or products could result in decreased demand for our products and have a negative impact on our business, results of operations or financial condition.
If our products fail to perform or fail to meet customer requirements or expectations, we could incur significant additional costs, including costs associated with the recall of those items.
The manufacture of our products involves highly complex processes. Our customers specify quality, performance and reliability standards that we must meet. If our products do not meet these standards, we may be required to replace or rework the products.
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In some cases, our products may contain undetected defects or flaws that only become evident after shipment and installation. Even if our products meet standard specifications, our customers may attempt to use our products in applications for which they were not designed or in products that were not designed or manufactured properly, resulting in product failures and creating customer satisfaction issues.
We have experienced product quality, performance or reliability problems from time to time and defects or failures may occur in the future. If failures or defects occur, they could result in significant losses or product recalls due to:
•costs associated with the removal, collection and destruction of the product;
•payments made to replace product;
•costs associated with repairing the product;
•the write-down or destruction of existing inventory;
•insurance recoveries that fail to cover the full costs associated with product recalls;
•lost sales due to the unavailability of product for a period of time;
•delays, cancellations or rescheduling of orders for our products; or
•increased product returns.
A significant product recall could also result in adverse publicity, damage to our reputation and a loss of customer or consumer confidence in our products. We also may be the target of product liability lawsuits or regulatory proceedings by the Consumer Product Safety Commission (CPSC) and could suffer losses from a significant product liability judgment or adverse CPSC finding against us if the use of our products at issue is determined to have caused injury or contained a substantial product hazard.
We provide warranty periods ranging from 90 days to 5.5 years on our products. Although we believe our reserves are appropriate, we are making projections about the future reliability of new products and technologies, and we may experience increased variability in warranty claims. Increased warranty claims could result in significant losses due to a rise in warranty expense and costs associated with customer support.
Litigation could adversely affect our operating results and financial condition.
We are often involved in litigation, primarily patent litigation. Defending against existing and potential litigation will likely require significant attention and resources and, regardless of the outcome, result in significant legal expenses, which could adversely affect our results unless covered by insurance or recovered from third parties. If our defenses are ultimately unsuccessful or if we are unable to achieve a favorable resolution, we could be liable for damage awards that could materially affect our results of operations and financial condition.
Where necessary, we may initiate litigation to enforce our patent or other intellectual property rights, which could adversely impact our relationship with certain customers. Any such litigation may require us to spend a substantial amount of time and money and could distract management from our day-to-day operations. Moreover, there is no assurance that we will be successful in any such litigation.
Our business may be impaired by claims that we, or our customers, infringe the intellectual property rights of others.
Vigorous protection and pursuit of intellectual property rights characterize our industry. These traits have resulted in significant and often protracted and expensive litigation. Litigation to determine the validity of patents or claims by third parties of infringement of patents or other intellectual property rights could result in significant legal expense and divert the efforts of our technical personnel and management, even if the litigation results in a determination favorable to us. In the event of an adverse result in such litigation, we could be required to:
•pay substantial damages;
•indemnify our customers;
•stop the manufacture, use and sale of products found to be infringing;
•incur asset impairment charges;
•discontinue the use of processes found to be infringing;
•expend significant resources to develop non-infringing products or processes; or
•obtain a license to use third party technology.
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There can be no assurance that third parties will not attempt to assert infringement claims against us, or our customers, with respect to our products. In addition, our customers may face infringement claims directed to the customer’s products that incorporate our products, and an adverse result could impair the customer’s demand for our products. We have also promised certain of our customers that we will indemnify them in the event they are sued by our competitors for infringement claims directed to the products we supply. Under these indemnification obligations, we may be responsible for future payments to resolve infringement claims against them.
From time to time, we receive correspondence asserting that our products or processes are or may be infringing patents or other intellectual property rights of others. If we believe the assertions may have merit or in other appropriate circumstances, we may take steps to seek to obtain a license or to avoid the infringement. We cannot predict, however, whether a license will be available; that we would find the terms of any license offered acceptable; or that we would be able to develop an alternative solution. Failure to obtain a necessary license or develop an alternative solution could cause us to incur substantial liabilities and costs and to suspend the manufacture of affected products.
We are subject to a number of risks associated with the sale of the Lighting Products business unit, and these risks could adversely impact our operations, financial condition and business.
On May 13, 2019, we closed the sale of our former Lighting Products business unit to IDEAL. We are subject to a number of risks associated with this transaction, including risks associated with:
•the restrictions on and obligations with respect to our remaining businesses following closing set forth in the transition services agreement and the LED supply agreement, in each case between us and IDEAL, including the need to provide transition services in connection with the transaction, which may result in the diversion of resources and focus from our remaining businesses;
•issues, delays, complications and/or additional costs associated with the transition of the operations, systems, technology infrastructure and data, third-party contracts, and personnel of the Lighting Products business unit and provision of transition services, each, as applicable, within the term of the transition services agreement;
•any required payments of indemnification obligations under the Purchase Agreement with IDEAL for retained liabilities and breaches of representations, warranties or covenants; and
•our failure to realize the full purchase price anticipated under the Purchase Agreement, including the ability of the Lighting Products business unit to generate adjusted EBITDA in the third year post-closing sufficient to result in payment of the targeted earnout or any earnout payment.
As a result of these risks, we may be unable to realize the anticipated benefits of the transaction, including the total amount of cash we expect to realize. Our failure to realize the anticipated benefits of the transaction would adversely impact our operations, financial condition and business and could limit our ability to pursue additional strategic transactions.
As a result of our continued expansion into new markets, we may compete with existing customers who may reduce their orders.
Through acquisitions and organic growth, we continue to expand into new markets and new market segments. Many of our existing customers who purchase our Wolfspeed substrate materials develop and manufacture products using those wafers, die and components that are offered into the same power and RF markets. As a result, some of our current customers perceive us as a competitor in these market segments. In response, our customers may reduce or discontinue their orders for our Wolfspeed substrate materials. This reduction in or discontinuation of orders could occur faster than our sales growth in these new markets, which could adversely affect our business, results of operations or financial condition.
The adoption of or changes in government and/or industry policies, standards or regulations relating to the efficiency, performance, use or other aspects of our products could impact the demand for our products.
The adoption of or changes in government and/or industry policies, standards or regulations relating to the efficiency, performance or other aspects of our products may impact the demand for our products. Demand for our products may also be impacted by changes in government and/or industry policies, standards or regulations that encourage energy efficiency or vehicle range. For example, efforts to change, eliminate or reduce industry or regulatory standards could negatively impact our business. These constraints may be eliminated or delayed by legislative action, which could have a negative impact on demand for our products. Our ability and the ability of our competitors to meet these new requirements could impact competitive dynamics in the market.
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We are exposed to fluctuations in the market value of our investment portfolio and in interest rates, and therefore, impairment of our investments or lower investment income could harm our earnings.
We are exposed to market value and inherent interest rate risk related to our investment portfolio. We have historically invested portions of our available cash in fixed interest rate securities such as high-grade corporate debt, commercial paper, municipal bonds, certificates of deposit, government securities and other fixed interest rate investments. The primary objective of our cash investment policy is preservation of principal. However, these investments are generally not Federal Deposit Insurance Corporation insured and may lose value and/or become illiquid regardless of their credit rating.
From time to time, we have also made investments in public and private companies that engage in complementary businesses. For example, during fiscal 2015 we made an investment in Lextar, a publicly traded company based in Taiwan. An investment in another company is subject to the risks inherent in the business of that company and to trends affecting the equity markets as a whole. Investments in publicly held companies are subject to market risks and, like our investment in Lextar, may not be liquidated easily. As a result, we may not be able to reduce the size of our position or liquidate our investments when we deem appropriate to limit our downside risk. Should the value of any such investments we hold decline, the related write-down in value could have a material adverse effect on our financial condition and results of operations. For example, the value of our Lextar investment declined from the date of our investment in December 2014 through the end of the first quarter of fiscal 2021 with variability between quarters, and may continue to decline in the future.
Our business may be adversely affected by uncertainties in the global financial markets and our or our customers’ or suppliers’ ability to access the capital markets.
Global financial markets continue to reflect uncertainty, which has been heightened by the COVID-19 pandemic. Given these uncertainties, there could be future disruptions in the global economy, financial markets and consumer confidence. If economic conditions deteriorate unexpectedly, our business and results of operations could be materially and adversely affected. For example, our customers, including our distributors and their customers, may experience difficulty obtaining the working capital and other financing necessary to support historical or projected purchasing patterns, which could negatively affect our results of operations.
Although we believe we have adequate liquidity and capital resources to fund our operations internally and under our existing line of credit, our inability to access the capital markets on favorable terms in the future, or at all, may adversely affect our financial performance. The inability to obtain adequate financing from debt or capital sources in the future could force us to self-fund strategic initiatives or even forego certain opportunities, which in turn could potentially harm our performance.
Changes in our effective tax rate may affect our results.
Our future effective tax rates may be affected by a number of factors including:
•the jurisdiction in which profits are determined to be earned and taxed;
•changes in tax laws or interpretation of such tax laws and changes in generally accepted accounting principles, for example interpretations and U.S. regulations issued as a result of the significant changes to the U.S. tax law included within the Tax Cuts and Jobs Act of 2017 ("TCJA") and the Coronavirus Aid, Relief and Economic Security Act of 2020;
•the outcome of the upcoming U.S. Presidential election on November 3, 2020;
•the resolution of issues arising from tax audits with various authorities;
•changes in the valuation of our deferred tax assets and liabilities;
•adjustments to estimated taxes upon finalization of various tax returns;
•increases in expenses not deductible for tax purposes, including impairment of goodwill in connection with acquisitions;
•changes in available tax credits;
•the recognition and measurement of uncertain tax positions;
•variations in realized tax deductions for certain stock-based compensation awards (such as non-qualified stock options and restricted stock) from those originally anticipated; and
•the repatriation of non-U.S. earnings for which we have not previously provided for taxes or any changes in legislation that may result in these earnings being taxed, regardless of our decision regarding repatriation of funds. For example, the TCJA included a one-time tax on deemed repatriated earnings of non-U.S. subsidiaries.
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Any significant increase or decrease in our future effective tax rates could impact net (loss) income for future periods. In addition, the determination of our income tax provision requires complex estimations, significant judgments and significant knowledge and experience concerning the applicable tax laws. To the extent our income tax liability materially differs from our income tax provisions due to factors, including the above, which were not anticipated at the time we estimated our tax provision, our net (loss) income or cash flows could be affected.
Failure to comply with applicable environmental laws and regulations worldwide could harm our business and results of operations.
The manufacturing, assembling and testing of our products require the use of hazardous materials that are subject to a broad array of environmental, health and safety laws and regulations. Our failure to comply with any of these applicable laws or regulations could result in:
•regulatory penalties, fines, legal liabilities and the forfeiture of certain tax benefits;
•suspension of production;
•alteration of our fabrication, assembly and test processes; and
•curtailment of our operations or sales.
In addition, our failure to manage the use, transportation, emission, discharge, storage, recycling or disposal of hazardous materials could subject us to increased costs or future liabilities. Existing and future environmental laws and regulations could also require us to acquire pollution abatement or remediation equipment, modify our product designs or incur other expenses, such as permit costs, associated with such laws and regulations. Many new materials that we are evaluating for use in our operations may be subject to regulation under existing or future environmental laws and regulations that may restrict our use of one or more of such materials in our manufacturing, assembly and test processes or products. Any of these restrictions could harm our business and results of operations by increasing our expenses or requiring us to alter our manufacturing processes.
Our results could vary as a result of the methods, estimates and judgments that we use in applying our accounting policies, including changes in the accounting standards to be applied.
The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on our results (see “Critical Accounting Policies and Estimates” in Item 7, "Management’s Discussion and Analysis of Financial Condition and Results of Operations"). Such methods, estimates and judgments are, by their nature, subject to substantial risks, uncertainties and assumptions, and factors may arise over time that lead us to change our methods, estimates and judgments. Changes in those methods, estimates and judgments could significantly affect our results of operations or financial condition.
Likewise, our results may be impacted due to changes in the accounting standards to be applied, such as the increased use of fair value measurement standards and changes in revenue recognition requirements.
Catastrophic events may disrupt our business.
A disruption or failure of our systems or operations in the event of a natural disaster, health pandemic, such as an influenza outbreak within our workforce, or man-made catastrophic event could cause delays in completing sales, continuing production or performing other critical functions of our business, particularly if a catastrophic event occurred at our primary manufacturing locations or our subcontractors' locations. Any of these events could severely affect our ability to conduct normal business operations and, as a result, our operating results could be adversely affected. There may also be secondary impacts that are unforeseeable as well, such as impacts to our customers, which could cause delays in new orders, delays in completing sales or even order cancellations.
Our stock price may be volatile.
Historically, our common stock has experienced substantial price volatility, particularly as a result of significant fluctuations in our revenue, earnings and margins over the past few years, and variations between our actual financial results and the published expectations of analysts. For example, the closing price per share of our common stock on the Nasdaq Global Select Market ranged from a low of $29.15 to a high of $73.69 during the twelve months ended September 27, 2020. If our future operating results or margins are below the expectations of stock market analysts or our investors, our stock price will likely decline.
Speculation and opinions in the press or investment community about our strategic position, financial condition, results of operations or significant transactions can also cause changes in our stock price. In particular, speculation on our go-forward strategy, competition in some of the markets we address such as electric vehicles, the ramp up of our Wolfspeed business, and the effect of tariffs or COVID-19 on our business, may have a dramatic effect on our stock price.
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We have outstanding debt which could materially restrict our business and adversely affect our financial condition, liquidity and results of operations.
As of September 27, 2020, our indebtedness consisted of $424.8 million aggregate principal amount of our 2023 Notes and $575.0 million aggregate principal amount of our 2026 Notes (collectively with the 2023 Notes, the Notes) and potential borrowings from our revolving line of credit. Our ability to pay interest and repay the principal for any outstanding indebtedness under our line of credit and the Notes is dependent upon our ability to manage our business operations and generate sufficient cash flows to service such debt. There can be no assurance that we will be able to manage any of these risks successfully.
The level of our outstanding debt may adversely affect our operating results and financial condition by, among other things:
•increasing our vulnerability to downturns in our business, to competitive pressures and to adverse general economic and industry conditions;
•requiring the dedication of an increased portion of our expected cash flows from operations to service our indebtedness, thereby reducing the amount of expected cash flow available for other purposes, including capital expenditures, research and development and stock repurchases;
•limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
•placing us at a competitive disadvantage compared to our peers that may have less indebtedness than we have by limiting our ability to borrow additional funds needed to operate and grow our business; and
•increasing our interest expense if interest rates increase.
Our line of credit requires us to maintain compliance with an asset coverage ratio. In addition, our line of credit contains certain restrictions that could limit our ability to, among other things: incur additional indebtedness, dispose of assets, create liens on assets, make acquisitions or engage in mergers or consolidations, and engage in certain transactions with our subsidiaries and affiliates. The Indentures governing the Notes require us to repurchase the Notes upon certain fundamental changes relating to our common stock, and also prohibit our consolidation, merger, or sale of all or substantially all of our assets except with or to a successor entity assuming our obligations under the Indentures. The restrictions imposed by our line of credit and by the Indentures governing our Notes could limit our ability to plan for or react to changing business conditions, or could otherwise restrict our business activities and plans.
Our ability to comply with our loan covenants and the provisions of the Indentures governing our Notes may also be affected by events beyond our control and if any of these restrictions or terms is breached, it could lead to an event of default under our line of credit or the Notes. A default, if not cured or waived, may permit acceleration of our indebtedness. In addition, our lenders could terminate their commitments to make further extensions of credit under our line of credit. If our indebtedness is accelerated, we cannot be certain that we will have sufficient funds to pay the accelerated indebtedness or that we will have the ability to refinance accelerated indebtedness on terms favorable to us or at all.
Regulations related to conflict-free minerals may force us to incur additional expenses.
The Dodd-Frank Wall Street Reform and Consumer Protection Act contains provisions to improve transparency and accountability concerning the supply of minerals originating from the conflict zones of the Democratic Republic of Congo (DRC) and adjoining countries. As a result, in August 2012 the SEC established new annual disclosure and reporting requirements for those companies who may use “conflict” minerals mined from the DRC and adjoining countries in their products. Our most recent disclosure regarding our due diligence was filed in May 2020 for calendar year 2019. These requirements could affect the sourcing and availability of certain minerals used in the manufacture of our products. As a result, we may not be able to obtain the relevant minerals at competitive prices and there will likely be additional costs associated with complying with the due diligence procedures as required by the SEC. In addition, because our supply chain is complex, we may face reputational challenges with our customers and other stakeholders if we are unable to sufficiently verify the origins of all minerals used in our products through the due diligence procedures, and we may incur additional costs as a result of changes to product, processes or sources of supply as a consequence of these requirements.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
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Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
Not applicable.
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Item 6. Exhibits
The following exhibits are being filed herewith and are numbered in accordance with Item 601 of Regulation S-K:
| Incorporated by Reference | |||||||||||||||||
| Exhibit No. | Description | Filed Herewith | Form | Exhibit | Filing Date | ||||||||||||
2.1^ | Asset Purchase Agreement, dated October 18, 2020, between Cree, Inc., SMART Global Holdings, Inc. and Chili Acquisition, Inc. | X | |||||||||||||||
| Notice of Grant to Gregg A. Lowe, dated August 24, 2020 | 8-K | 10.1 | 8/28/2020 | ||||||||||||||
| Notice of Grant to Neill P. Reynolds, dated August 24, 2020 | 8-K | 10.2 | 8/28/2020 | ||||||||||||||
| Form of Performance Share Award Agreement for Gregg A. Lowe | 8-K | 10.1 | 9/8/2020 | ||||||||||||||
| Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | X | ||||||||||||||||
| Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | X | ||||||||||||||||
| Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | X | ||||||||||||||||
| Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | X | ||||||||||||||||
| 101 | The following materials from Cree, Inc.’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2020 formatted in Inline XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Operations; (iii) Consolidated Statements of Comprehensive Loss; (iv) Consolidated Statement of Shareholders' Equity; (v) Consolidated Statements of Cash Flows; and (vi) Notes to Consolidated Financial Statements | X | |||||||||||||||
| 104 | The cover page from Cree Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 27, 2020 formatted in Inline XBRL (included in Exhibit 101) | X | |||||||||||||||
^ Portions of this exhibit have been omitted pursuant to Rule 601(b)(2) of Regulation S-K. The omitted information is not material and would likely cause competitive harm to the registrant if publicly disclosed.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| CREE, INC. | |||||
| October 29, 2020 | |||||
| /s/ Neill P. Reynolds | |||||
| Neill P. Reynolds | |||||
| Executive Vice President and Chief Financial Officer | |||||
| (Authorized Officer and Principal Financial and Chief Accounting Officer) | |||||
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