You should read the following discussion in conjunction with our accompanying consolidated financial statements, including the related notes. This discussion generally refers to elements within our accompanying consolidated financial statements on a pre-tax basis unless otherwise stated. Except for historical information, the discussions in this section contain forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those discussed below. For further information regarding risks and uncertainties, see Item 1A. "Risk Factors" in this Annual Report on Form 10-K.
We design and develop innovative power management and precision analog integrated circuits (ICs). We were formed in
August 1999when we acquired the semiconductor business of Harris Corporation and began operating as Intersil Corporation. That semiconductor business included product portfolios and intellectual property dating back to 1967 when semiconductor companies were just emerging in Silicon Valley. We are now an established supplier of power management and precision analog technology for many of the most rigorous applications in the computing, consumer and industrial markets. We supply a full range of power IC solutions including battery management, computing power, display power, regulators and controllers and power modules; as well as precision analog components such as amplifiers and buffers, proximity and light sensors, data converters, optoelectronics and interface products. As a major supplier to the military and aerospace industries, our product development methodologies reflect experience designing products to meet the highest standards for reliability and performance in challenging environments. 19
TABLE OF CONTENTS We utilize a 52/53 week fiscal year, ending on the nearest Friday to
December 31. Fiscal year 2013 is a 53 week period with an extra week included in our second quarter. All other years presented are fiscal years and contain 52 weeks. Quarterly or annual periods vary from exact calendar quarters or years.
Statement of Operations ($ in thousands and % of revenue):
2013 2012 2011 Revenue
$ 575,195100.0 % $ 607,864100.0 % $ 760,490100.0 % Cost of revenue 258,588 45.0 277,698 45.7 323,165 42.5 Gross profit 316,607 55.0 330,166 54.3 437,325 57.5 Operating costs and expenses: Research and development 130,541 22.7 166,884 27.5 185,458 24.4 Selling, general and administrative 113,333 19.7 134,314 22.1 140,314 18.5 Amortization of purchased intangibles 24,579 4.3 29,185 4.8 26,830 3.5 Income from IP agreements - - (14,412) (2.4) - - Provision for export compliance settlement 6,000 1.0 - - - - Restructuring and related costs 28,694 5.0 10,490 1.7 4,059 0.5 Operating income 13,460 2.3 3,705 0.6 80,664 10.6 Interest income 190 0.0 538 0.1 2,667 0.4 Interest expense and fees (2,091) (0.4) (12,829) (2.1) (14,499) (1.9) Loss on extinguishment of debt - - - - (8,399) (1.1) Gain (loss) on deferred compensation investments, net 1,452 0.3 920 0.1 (457) (0.1) Gain (loss) on investments 866 0.2 - - (6,547) (0.9) Income (loss) before income taxes 13,877 2.4 (7,666) (1.3) 53,429 7.0 Income tax expense (benefit) 11,022 1.9 29,983 4.9 (13,735) (1.8) Net income (loss) $ 2,8550.5 % $ (37,649)(6.2) % $ 67,1648.8 %
Revenue, Cost of Revenue and Gross Margin
Our three end markets are industrial & infrastructure, personal computing and consumer. Our revenue by end market was as follows ($ in thousands and % of revenue)
2013 2012 2011
Industrial & infrastructure
$ 402,43952.9 % Personal computing 118,222 20.6 141,345 23.2 191,472 25.2 Consumer 117,555 20.4 119,675 19.7 166,579 21.9 Total $ 575,195100.0 % $ 607,864100.0 % $ 760,490100.0 % Our revenue for fiscal 2013 was $575.2 million, a decrease of $32.7 millionor 5.4% from 2012. Revenue in the industrial & infrastructure market and consumer market decreased slightly from fiscal 2012 by 2.1% and 1.8% respectively while revenue in the personal computing market decreased 16.4%. In the industrial & infrastructure market, growth in products targeted at the automotive market was offset by decline in revenue from products targeted at the security market. The decrease in revenue from the personal computing market was due to unfavorable PC trends and our reduced market share in the next generation Intel-based PC platforms. In aggregate, lower overall unit demand in 2013 decreased revenue by $12.5 millionfrom 2012 levels and a decrease in average selling price ("ASPs") for the related product mix decreased revenue from 2012 levels by $20.2 million. Of this revenue decrease, $39.0 millioncame from our sales to customers in the Asia/Pacificregion, offset by an increase of $5.4 millionfrom sales to customers in North Americaand $1.0 millionfrom sales to customers in Europeand other countries. 20
TABLE OF CONTENTS Our revenue for fiscal 2012 was
$607.9 million, a decrease of $152.6 millionor 20.1% from fiscal 2011. The fiscal 2012 revenue decrease was primarily due to broad-based declines across all end markets. Revenue in the industrial & infrastructure market decreased 13.8% from fiscal 2011 levels, revenue in the personal computing market decreased 26.2% and revenue in the consumer market decreased 28.2% from fiscal 2011 levels. In aggregate, lower overall unit demand in 2012 decreased revenue by approximately $138.3 millionfrom 2011 levels and a decrease in ASPs decreased revenue from 2011 levels by approximately $14.3 million. Of this revenue decrease, $117.0 millioncame from our sales to customers in the Asia/Pacificregion, $20.6 millioncame from sales to customers in North Americaand $15.0 millioncame from sales to customers in Europeand other countries.
Geographical revenue ($ in thousands and % of revenue)
2013 2012 2011 Asia/Pacific
$ 435,38375.7 % $ 474,40978.0 % $ 591,36377.8 % North America 95,703 16.6 90,332 14.9 110,971 14.6 Europe and other 44,109 7.7 43,123 7.1 58,156 7.6 Total $ 575,195100.0 % $ 607,864100.0 % $ 760,490100.0 %
Cost of Revenue and Gross Margin
Cost of revenue consists primarily of purchased materials and services, labor, overhead and depreciation associated with manufacturing pertaining to products sold.
Our gross margin increased by 70 basis points in fiscal 2013 from fiscal 2012. The increase was primarily due to product sales mix changes at the product family level.
Our gross margin decreased by 320 basis points in fiscal 2012 from fiscal 2011. The decrease was primarily due to product sales mix changes at the product family level along with lower production volume when compared to fixed overhead costs charged to cost of revenue. Generally, our personal computing and consumer products have lower gross margins than our industrial and infrastructure products. We strive to improve gross margins from their present levels by introducing new high-margin products and cost saving opportunities in our manufacturing chain.
Operating Costs and Expenses
Research and Development
R&D expenses consist primarily of salaries and expenses of employees engaged in product/process research, design and development activities, as well as related subcontracting activities, masks, design automation software, engineering wafers, and technology license agreement expenses. Our R&D expenses decreased by 21.8% or
$36.3 millionto $130.5 millionin 2013 compared to $166.9 millionfor 2012. In the first and third quarters of fiscal 2013, we implemented efforts to refocus our investments in target areas that we believe can sustain high quality revenue growth, reducing our exposure to areas with low returns. The lower R&D expenses in 2013 are primarily the result of reduced headcount and other cost reductions related to our restructuring actions. Our R&D expenses decreased by 10.0% or $18.6 millionto $166.9 millionin 2012 compared to $185.5 millionfor 2011. During the last two quarters of 2011 and throughout 2012, we implemented substantial cost saving initiatives to optimize and integrate acquired companies and to reduce R&D spending. We realigned our resources to focus on our primary future growth drivers while continuing to invest in products aimed at the broad industrial market. 21
TABLE OF CONTENTS We believe that a continued commitment to R&D is essential to maintain product leadership and provide innovative new product offerings, and therefore we expect to continue to make significant future investments in R&D. As we continue to move to more advanced process technologies, our mask and engineering wafer costs are becoming more complex and expensive, and will therefore increasingly represent a greater proportion of total R&D expenses.
Selling, General and Administrative ("SG&A")
SG&A expenses consist primarily of salaries and expenses of employees engaged in selling and marketing our products as well as the salaries and expenses required to perform our human resources, finance, legal, executive and other administrative functions. Our SG&A expenses decreased by 15.6% or
$21.0 millionto $113.3 millionin 2013 compared to $134.3 millionfor 2012. The decrease in 2013 was primarily due to lower labor costs related to our restructuring activities in fiscal 2013 and stricter spending controls. Our SG&A expenses decreased by 4.3% or $6.0 millionto $134.3 millionin 2012 compared to $140.3 millionfor 2011. The decrease in 2012 was primarily due to lower labor costs.
Amortization of Purchased Intangibles
Our amortization of purchased intangibles was
$24.6 millionin 2013, $29.2 millionin 2012 and $26.8 millionin 2011. The decrease in 2013 was primarily due to certain intangibles that became fully amortized during 2012 and 2013 and the write-off of certain intangible assets to restructuring and related cost during the second quarter of fiscal 2013. The increase in fiscal 2012 from fiscal 2011 was primarily due to additional amortization on in-process R&D projects acquired from Techwell, Inc.("Techwell") and completed during the first quarter of 2012.
Income from Intellectual Property Agreements
Income from intellectual property agreements was
Provision for Export Compliance Settlement
We recorded a provision of
$6.0 millionduring fiscal 2013 related to alleged violations associated with ITARproceedings. See Note 18 to our consolidated financial statements.Restructuring and Related Costs Our restructuring and related costs were $28.7 millionin fiscal year 2013, $10.5 millionin fiscal year 2012, and $4.1 millionin fiscal year 2011 The 2013 restructuring charges consisted primarily of severance costs and lease exit costs and were part of efforts to better align our operating expenses with strategic growth areas for the purpose of improving competitiveness and execution across our business, realign our internal fabrication operations with existing requirements, prioritize our sales and development efforts, strengthen financial performance and improve cash flow. The 2012 and 2011 restructuring charges consisted primarily of severance costs and were part of our ongoing efforts to optimize operations and conclude the integrations of certain acquired companies. Other Income and Expenses Interest Income Our interest income decreased to $0.2 millionin fiscal 2013 compared to $0.5 millionin fiscal 2012 and $2.7 millionin fiscal 2011. Interest income decreased in fiscal years 2013 and 2012 due to decreased average cash and investment balances and continued low interest rates. During the fourth quarter of fiscal 2011, we sold our remaining auction rate securities ("ARS"). 22
TABLE OF CONTENTS Interest Expense and Fees Our interest expense and fees decreased to
$2.1 millionin 2013 compared to $12.8 millionin 2012 and $14.5 millionin 2011. Included in 2012 interest expense is approximately $5.8 millionreclassification of losses on settlement of our interest rate swaps, previously recorded as unrealized loss in other comprehensive income. Excluding these losses, interest expense and fees in 2013 and 2012 decreased from 2011 levels due to lower long-term debt balances.
Loss on Extinguishment of Debt
During the year ended
December 30, 2011, we extinguished the remaining portion of our $300.0 millionsix-year term loan facility and wrote-off $8.4 millionin unamortized loan fees.
Gain (Loss) on Deferred Compensation Investments, net
We have a liability for a non-qualified deferred compensation plan. We maintain a portfolio of
$11.6 millionin mutual fund investments and corporate owned life insurance under the plan. Changes in the fair value of the asset are recorded as a gain (loss) on deferred compensation investments and changes in the fair value of the liability are recorded as a component of compensation expense. In general, the compensation expense (benefit) is substantially offset by the gains and losses on the investment. During fiscal years 2013 and 2012, we recorded gains on deferred compensation investments of $1.5 millionand $0.9 millionrespectively and compensation expense of $1.7 millionand $1.1 millionrespectively. During fiscal 2011, we recorded a loss on deferred compensation investments of $0.5 millionand a decrease in compensation expense of $0.1 million.
Gain (Loss) on Investments
We recognized a gain of
$0.9 millionin fiscal 2013 related to the recovery of previously recognized losses on ARS. During fiscal 2011, we sold our remaining portfolio of ARS for a net loss of $6.5 million.
Income Tax Expense (Benefit)
Our income tax expense was
$11.0 millionfor 2013 compared to an income tax expense of $30.0 millionin 2012. Income tax for fiscal 2013 included a $2.1 millionnon-deductible charge related to alleged export violations from 2005 to 2010 with ITAR. Income tax for fiscal 2013 also included benefit of $5.7 millionrelating to the 2012 federal R&D tax credit which was retroactively reinstated on January 2, 2013, with the enactment of the American Taxpayer Relief ACT of 2012 as well as tax expense of $3.3 millionrelated to tax deficiencies in share based compensation. Excluding these items, the effective tax rate differs from the 35% statutory corporate tax rate primary due to losses in foreign jurisdictions with lower statutory tax rates and permanent non-deductible items, such as stock based compensation associated with our cost sharing arrangement. Our income tax expense was $30.0 millionfor fiscal 2012 compared to an income tax benefit of $13.7 millionin fiscal 2011. Income tax expense for fiscal 2012 included a $16.8 millioncharge related to a transfer pricing tax election to repatriate cash in connection with the IRSaudit of tax years 2005-2007 and 2008-2009. Excluding these unusual items, the effective tax rate was further increased due to the expiration of the federal R&D tax credit and a greater portion of income in higher tax jurisdictions. Income tax expense (benefit) for fiscal 2011 included a benefit of $10.9 millionprimarily related to the re-measurement of our unrecognized tax benefits and a tax benefit of $9.7 millionrelated to incremental prior year federal and state R&D credits net of a valuation allowance on the state portion of these credits. 23
TABLE OF CONTENTS During fiscal year 2013, we reached final settlement with the
IRSin connection with the 2008 - 2009 examination periods. The settlement primarily related to transfer pricing adjustments on the outbound pricing of tangible goods and our cost share arrangement with our Malaysiasubsidiary. The settlement resulted in a $23.4 millionreduction in unrecognized tax benefits ("UTBs"), which was a component of income taxes payable, comprised of a cash payment of $7.5 millionto the IRSand a $15.9 milliondecrease in deferred tax assets related federal R&D tax credits, federal alternative minimum tax ("AMT") tax credits, and federal net operating loss ("NOL") tax attributes. The $7.5 millioncash payment consisted of $6.7 millionof additional tax due and $0.8 millionof interest. We further reduced the UTB balance by $1.2 millionfor amended returns filed with the state authorities related to the IRSexamination settlement. The sum of these items reduced our UTBs by $24.6 million. In connection with the transfer pricing adjustments for the 2008 - 2009 exam periods, we made an election under Section 4 of Revenue Procedure 99-32, 199-2 C.B. 296. This election will allow us to repatriate cash to the U.S. group to the extent of the transfer pricing adjustments agreed to in the settlement, through the establishment of a deemed account receivable from the controlled foreign corporations ("CFCs"). We estimate this election will provide an additional $125.0 millionof cash to repatriate to the U.S., of which we repatriated $12.5 millionduring the quarter ended January 3, 2014. During fiscal year 2012, we reached a settlement with the IRSin connection with the 2005 - 2007 examination periods. The settlement primarily related to transfer pricing adjustments on the outbound pricing of tangible goods and the valuation of intangible property sold to our CFC. The settlement resulted in a $57.6 millionreduction in UTBs, which was a component of income taxes payable, comprised of a cash payment of $46.6 millionto the IRSand an $11.0 milliondecrease in deferred tax assets related federal R&D tax credits. The $46.6 millioncash payment consisted of $34.2 millionof additional tax due, $11.8 millionof interest and $0.6 millionof penalties. We further reduced the UTB balance with a $6.0 millionpayment to the state authorities related to the IRSexamination settlement. The sum of these items reduced our UTBs by $63.6 million. In connection with the transfer pricing adjustments for the 2005 - 2007 exam periods, we made an election under Section 4 of Revenue Procedure 99-32, 199-2 C.B. 296. This election allowed us to repatriate cash to the U.S. group to the extent of the transfer pricing adjustments agreed to in the settlement, through the establishment of a deemed account receivable from the CFCs. We recorded an $11.7 milliondiscrete tax charge to income tax expense and increased income taxes payable, of which $7.4 millionwas a component of our UTBs, for interest based on the election. We repatriated $162.3 millionof cash during fiscal 2012 related to the settlement. As a global company, our effective tax rate is highly dependent upon the geographic composition of worldwide earnings and tax regulations. We are subject to income taxes in the United Statesand many foreign jurisdictions and significant judgment is required to determine worldwide tax liabilities. Our effective tax rate, as well as our actual taxes payable, could be adversely affected by changes in the mix of earnings between countries with differing tax rates. Our primary foreign operations are in Malaysiawhere we currently have a tax holiday resulting in a tax rate of 0%. This tax holiday began on July 1, 2009and terminates on July 1, 2019. In order to retain this holiday in Malaysia, we must meet certain operating conditions, including compliance with warehouse and shipping quotas and specified manufacturing activities in Malaysia. Absent such tax incentives, the corporate income tax rate in Malaysiathat would otherwise apply to us would be 25%. If we cannot or elect not to comply with these conditions, we could lose the related tax benefits. In such event, we may be required to modify our operational structure and tax strategy. Any such modified structure or strategy may not be as beneficial as the benefits provided under the present tax concession arrangement. The impact of income earned in foreign jurisdictions being taxed at rates different than the United Statesfederal statutory rate was an expense of $3.5 millionand an increase on the effective tax rate of 25.3% for the year ended January 3, 2014, compared to an expense of $7.3 millionand an increase on the effective tax rate of 97.0% for the year ended December 28, 2012, and a benefit of $16.5 millionand decrease on the effective tax rate of 30.9% for the year ended December 30, 2011.In determining net (loss) income, we estimate and exercise judgment in the calculation of tax expense and tax liabilities and in assessing the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of assets and liabilities.Temporary differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, establish a valuation allowance. As of January 3, 2014, our net deferred tax asset amounted to $95.3 millioncompared to $105.5 millionas of December 28, 2012.Applicable guidance requires us to record our tax expense based on various estimates of probabilities of sustaining certain tax positions. As a result of this and other factors, our tax expense could be volatile, which contributes to volatility in reported financial results. As of January 3, 2014and December 28, 2012, our UTBs related to uncertain tax positions were $99.3 millionand $112.9 million, respectively. 24
TABLE OF CONTENTS
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual Obligations and Commitments
The following table sets forth our future contractual obligations as of
January 3, 2014(in thousands): 2014 2015 2016 2017 2018 Thereafter Total Future minimum lease commitments $ 8,244 $ 11,549 $ 6,112 $ 5,482 $ 5,042 $ 5,743 $ 42,172
Open capital asset purchase commitments 1,246 - - - - - 1,246 Open raw material purchase commitments 17,363 - - - - - 17,363 Tax liability arising from UTBs 9,240 86,836 2,116 1,151 - - 99,343 Other purchase commitments 4,875 4,679 2,304 - - - 11,858 Total
$ 40,968 $ 103,064 $ 10,532$
$ 5,042 $ 5,743 $ 171,982Our future minimum lease commitments consist primarily of leases for buildings and other real property. Open capital asset purchase commitments primarily include leasehold improvements, production equipment for the expansion of our Palm Bayfacility, and other equipment. Open raw material purchase commitments are for externally produced wafers and includes minimum purchase requirements as part of a guaranteed capacity agreement with one of our wafer suppliers. The UTBs relate primarily to the intercompany pricing of goods and services between different tax jurisdictions and are recorded within income taxes payable on our consolidated financial statements.
Off-Balance Sheet Arrangements
Liquidity and Capital Resources
Our capital requirements depend on a variety of factors, including but not limited to, the rate of increase or decrease in our existing business base; the success, timing and amount of investment required to bring new products to market; revenue growth or decline; and potential acquisitions. We believe cash flows from operations together with our cash and investment balances and available credit facility will provide the financial resources necessary to meet business requirements for the next 12 months for both our domestic and foreign operations. These requirements include our dividend program, the requisite capital expenditures for the maintenance of worldwide manufacturing capacity, working capital requirements and potential acquisitions or strategic investments. As of
January 3, 2014, approximately $141.4 millionof our cash and cash equivalents and short-term investments was held by our foreign subsidiaries. We have provided for federal and state taxation at approximately 37.5% in connection with the Revenue Procedure 99-32 election related to the 2008-2009 IRSexamination periods which allows for the repatriation of $125.0 million. During fiscal 2013, we repatriated $12.5 millionof this amount. Therefore, $112.5 millionof our cash and cash equivalents held by our foreign subsidiaries as of January 3, 2014would not be subject to further taxation upon repatriation. As of January 3, 2014, we have $325.0 millionof borrowing capacity under our five-year revolving credit facility (the "Facility"). The Facility matures on September 1, 2016and is payable in full upon maturity. Under the Facility, $25.0 millionis available for the issuance of standby letters of credit, $10.0 millionis available as swing line loans and $50.0 millionis available for multicurrency borrowings. Amounts repaid under the Facility may be re-borrowed. The Facility currently bears interest at 1.75% over one-month LIBORbut is variable based on our leverage ratio as described in the credit agreement in Exhibit 10.1. As of January 3, 2014, we were in compliance with all applicable covenants of the above mentioned credit agreement.
Cash provided by operating activities consists of net income (loss) adjusted for certain non-cash items and changes in certain assets and liabilities.
TABLE OF CONTENTS In fiscal year 2013, our net cash flows from operations were
$106.7 millioncompared to $35.6 millionin 2012, an increase of $71.1 million. This increase was mainly due to an increase in net income of $40.5 millionand net inflow from changes in operating assets and liabilities of $36.6 million. Trade receivables, net, decreased by $5.2 million, or 9.5%, to $49.5 millionas of January 3, 2014from $54.7 millionas of December 28, 2012primarily due to more linear shipments in the fourth quarter of fiscal 2013 compared to the fourth quarter of fiscal 2012. Inventories decreased by $12.5 million, or 16.6%, to $62.4 millionas of January 3, 2014from $74.9 millionas of December 28, 2012as a result of concerted effort to reduce inventory. In addition, the net increase in trade payables and accrued liabilities of $17.3 millionduring fiscal 2013 was driven by the timing of payments. Investing activities
Investing cash flows consist primarily of capital expenditures and net investment purchases and maturities.
Net cash used in investing activities was
$13.0 millionin fiscal 2013 compared to net cash provided by investing activities of $14.3 millionin fiscal 2012. Capital expenditures, net of sales proceeds, were $18.6 millionfor 2013, $12.2 millionfor 2012, and $9.8 millionfor 2011. Capital expenditures have been focused primarily on planned expansion of our Palm Bayfacility and increases to test capacity for new product lines. We expect capital expenditures in fiscal 2014 to be $12.0 millionto $15.0 millionas we upgrade our internal production capability to achieve lower internal production costs. Net proceeds from investment balances were $5.6 millionin fiscal 2013 and $26.5 millionin fiscal 2012. Investment balances declined in fiscal 2013 due to the maturity of bank time deposits. Financing activities
Financing cash flows consist primarily of payment of dividends to stockholders, proceeds from issuance of stock under our employee stock purchase plan, repurchases of common stock, and issuance and repayment of long-term debt.
Net cash used in financing activities was
$57.6 millionin fiscal 2013 compared to $274.4 millionin fiscal 2012. We paid dividends of $61.9 million, $62.1 millionand $61.5 millionduring fiscal 2013, 2012 and 2011respectively. We repaid debt of $200.0 millionand $376.7 millionin fiscal years 2012 and 2011, respectively. Our Board of Directors previously authorized the repurchase of up to $50.0 millionof our common stock through August 6, 2013. During fiscal 2012, we purchased and retired 1.9 million shares under the program at an average price per share of $8.03. We did not repurchase any of our common stock in fiscal 2013. The plan expired on August 6, 2013and no further shares may be purchased under the plan. Dividends on Common Stock In October 2013, our Board of Directors declared a dividend of $0.12per share of common stock. We paid dividends of $15.3 millionon November 29, 2013to shareholders of record as of the close of business on November 19, 2013. In January 2014, our Board of Directors declared a dividend of $0.12per share of common stock. The dividend will be paid on February 28, 2014to shareholders of record as of the close of business on February 18, 2014.
Transactions with Related and Certain Other Parties
TABLE OF CONTENTS
Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of such statements requires us to make estimates and assumptions that affect the reported amounts of revenues and expenses during the reporting period and the reported amounts of assets and liabilities as of the date of the financial statements. Our estimates and assumptions are based on historical experience and other factors that we consider to be appropriate in the circumstances. However, actual future results may vary from our estimates and assumptions. Based on this definition, our most critical accounting policies include revenue recognition, which impact the recording of revenues; valuation of inventories, which impacts cost of goods sold and gross margins; assessment of recoverability of intangible assets and goodwill, which impacts write-offs of goodwill and intangible assets; accounting for equity-based compensation, which impacts cost of goods sold, gross margins and operating expenses; accounting for income taxes, which impacts the income tax provision; and assessment of litigation and contingencies, which impacts charges recorded in cost of goods sold, selling, general and administrative expenses and income taxes. These policies and the estimates and judgments involved are discussed further below. We have other significant accounting policies that either do not generally require estimates and judgments that are as difficult or subjective, or it is less likely that such accounting policies would have a material impact on our reported results of operations for a given period. Our significant accounting policies are described in Note 2 to the Consolidated Financial Statements included in this Annual Report.
Receivables allowance and other allowances
Shipments to distributors are made under agreements which provide for certain pricing adjustments (referred to as "ship and debit") and limited product return privileges, under a stock rotation provision. Many of our sales to distributors are invoiced at list price and the final price is set via ship and debit credits at the time of resale. The distributor may also receive certain price protection on a percentage of unsold inventories they hold. Accordingly, we make estimates of price adjustments based upon inventory held by distributors as of the balance sheet date and record this as a distributor allowance. We rely on historical distributor allowances to estimate these adjustments. Distributors may also receive allowances for certain parts returned under a stock rotation provision of the distributor agreement. We estimate the stock rotation provision based on the percentage of sales made to distributors and historical returns.
We record our inventories at standard costs, which approximates the lower of actual cost or market. As the ultimate market value that we will realize through sales on our inventory cannot be known with exact certainty, we rely on past sales experience and future sales forecasts to project it. In analyzing our inventory levels, we classify certain inventory as either excess or obsolete. These classifications are maintained for all classes of inventory, although raw materials are seldom deemed excess or obsolete. We classify inventory as obsolete if we have withdrawn it from the marketplace or if we have had no sales of the product for the past 18 months and no sales forecasted for the next 24 months. We provide an allowance for 100% of the standard cost of obsolete inventory. We conduct reviews of excess inventory on a quarterly basis and reserve a significant portion of the excess inventory. We classify inventory as excess if we have quantities of product greater than the amounts we have sold in the past 18 months or have forecasted to sell in the next 24 months. We typically retain excess inventory until the inventory is sold or reclassified as obsolete, at which time we may scrap. For all items identified as excess or obsolete, management reviews the individual facts and circumstances, i.e. competitive landscape, industry economic conditions, product lifecycles and product cannibalization, specific to that inventory. Inventory allowances totaled approximately
$46.9 millionon gross inventory of $109.3 millionas of January 3, 2014and $45.9 millionon gross inventory of $120.8 millionas of December 28, 2012. Product demand estimates are a key element in determining inventory allowances. Our estimate of product demand requires significant judgment and is based in part on historical revenue. Historical sales may not accurately predict future demand. If future demand is ultimately lower than our estimate, we could incur significant additional expenses to provide allowances for and scrap obsolete inventory. If demand is higher than expected, we may sell inventory that had previously been written down as was the case in fiscal years 2013, 2012, and 2011. Our gross margins were positively impacted by the utilization of previously reserved inventory of $2.4 million, $1.5 million, and $1.6 millionin fiscal 2013, 2012, and 2011, respectively. 27
TABLE OF CONTENTS
Assessment of recoverability of goodwill
We perform an annual assessment of goodwill in the fourth quarter of each year, or more frequently if indications of potential impairment exist. Goodwill is tested under a two-step method for impairment at a level of reporting referred to as a reporting unit. Step one is to identify potential impairment. We compare the calculated fair value of each reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, no impairment of the goodwill of the reporting unit is indicated and step two is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test will be performed to measure the amount of impairment loss, if any. The amount of impairment loss is the excess of carrying amount of goodwill over the implied fair value of the reporting unit goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill will be the new accounting basis. Significant judgment is involved in the determination of fair value for the above analysis. Our estimates of fair value are based on a combination of the income approach, which estimates the fair value of our reporting units based on the future discounted cash flows, and the market approach, which estimates the fair value of our reporting units based on comparable market prices. The use of future discounted cash flows is based on assumptions that are consistent with our estimates of future growth and the strategic plan used to manage the underlying business. Factors requiring significant judgment include assumptions related to future growth rates, discount factors, market multiples and tax rates, amongst other considerations. Changes in economic and operating conditions that occur after the annual impairment analysis or an interim impairment analysis, and that impact these assumptions, may result in a future goodwill impairment charge. Any such impairment charge could be significant and could have a material adverse effect on our financial position and results of operations. Accounting for income taxes As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. We are subject to income taxes in
the United Statesand various foreign jurisdictions. Significant judgment is required to determine worldwide income tax liabilities. This process involves estimating our actual current tax liability together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. Our effective tax rate and the actual taxes ultimately payable could be adversely affected by changes in the mix of earnings between countries with differing statutory tax rates, in the valuation of deferred tax assets, in tax laws or by material audit assessments, which could affect our profitability. Temporary differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, establish a valuation allowance. As of January 3, 2014, our net deferred tax asset amounted to $95.3 millioncompared to $105.5 millionas of December 28, 2012. Applicable guidance requires us to record our tax expense based on various estimates of probabilities of sustaining certain tax positions. As a result of this and other factors, our tax expense could be volatile, which contributes to volatility in reported financial results. As of January 3, 2014and December 28, 2012, our UTBs related to uncertain tax positions were $99.3 millionand $112.9 million, respectively
Fair value of equity-based compensation
We generally calculate the fair value of an equity-based compensation grant (compensation cost) on the date of grant. We use a lattice method for options or, for market-based grants, a Monte-Carlo simulation. The compensation cost is then amortized straight-line over the requisite service period. Calculating fair value requires us to estimate certain key assumptions in the valuation model, including expected stock price volatility, the risk-free interest rate in the market, the expected life of the Option granted, and annualized dividend yield. Volatility is one of the most significant determinants of fair value. We estimate our volatility using the actual historic volatility of our stock price. We estimate our expected risk-free interest rate by using the zero-coupon U.S. Treasury rate at the time of the grant related to the expected life of the grant. Expected forfeitures must be estimated to offset the compensation cost expected to be recorded in the financial statements. We estimate forfeitures based on historical information about turnover for each appropriate employee level. As vesting tiers within an Option are more frequent after the first year until fully vested, forfeitures on options are recorded as they actually occur. We estimate the annualized dividend yield by dividing the current annualized dividend by the closing stock price on the date of grant. 28
TABLE OF CONTENTS Loss Contingencies We use significant judgment and assumptions to estimate the likelihood of loss or impairment of an asset, or the incurrence of a liability, in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We record a charge equal to the minimum estimated liability for litigation costs or a loss contingency only when both of the following conditions are met: (i) information available prior to issuance of our consolidated financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated.
We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required.
Recent Accounting Pronouncements
For a description of accounting changes and recent accounting guidance, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note 2. "Summary of Significant Accounting Policies" to Consolidated Financial Statements of this Annual Report on Form 10-K.