Item 1. Business
Introduction
We are a leading designer, manufacturer and marketer of power management products and the leading worldwide supplier of a type of power semiconductor called a MOSFET (a metal oxide semiconductor field effect transistor). Power semiconductors process electricity into a form more usable by electrical products. The technology advancements of power semiconductors increase system efficiency, allow more compact end products, improve features and functionality and extend battery life. Our products are used in a range of end-markets, including information technology, automotive, consumer electronics, aerospace/defense and industrial.
International Rectifier Corporation ("IR"®) uses its technology, comprehensive experience in power management, and low-cost manufacturing platforms to offer what we believe is one of the industry's most advanced and competitive lines of power management products. Our products are divided among three broad product categories:
•Analog Integrated Circuits and Advanced Circuit Devices. Our Analog Integrated Circuits, or Analog ICs, are semiconductors that integrate logic and power management functions on the same chip to optimize system performance. Advanced Circuit Devices are chipsets, multichip modules and other advanced-performance devices that generally address power management requirements in demanding applications. These products are value-added or are provided under reduced competition due to their technological content or our customer relationship. Our Analog ICs and Advanced Circuit Devices provide application-specific power management solutions for computers, servers and routers, consumer electronics, automotive systems, home appliances and other motor-control appliances, aircraft and satellites, defense electronic systems, and wireless and wireline communication devices.
•Power Systems. Power Systems combine power semiconductors with other power management components in modules that improve power efficiency, provide a cost-effective alternative to custom analog designs and enable customers to introduce new products more quickly. We supply Power Systems for automotive electronics (including electric fan control, electric power steering and integrated starter/alternator motors), other motor control applications (including home appliances and industrial refrigeration and air conditioning), and commercial and military aircraft.
•Power Components. Power Components are discrete devices used in general power management applications. These include some power MOSFETs and insulated gate bipolar transistors (IGBTs), rectifiers, diodes and thyristors. Power MOSFETs and IGBTs rapidly and efficiently switch electricity on and off in order to supply power in a form that can be formatted to the specific requirements of a circuit. Our Power Components are used in virtually all our end markets.
As described more fully below, we use a business strategy that focuses on adding value in high growth markets, leveraging our leading edge technology, extending our leadership position in power components, and capitalize on our relationships with market leaders and our efforts to provide low cost manufacturing (see "Capitalize on Low-Cost Manufacturing" below for recent initiatives in further realigning our business to manufacture our proprietary products and for acquisition of epitaxial silicon substrates manufacturing).
Industry Overview
Power semiconductors convert power from an electrical outlet, a battery or an alternator running off an internal combustion engine into more efficient and useful power for a wide range of electrical and electronic systems and equipment. The more sophisticated the end product, the greater its need for specially-formatted, finely-regulated power. The need for power semiconductor technology rises with the increasing complexity of electronic products and the proliferation of electronic features in information technology, automotive, consumer electronics, defense/aerospace and industrial products. Within the power semiconductor market, MOSFETs and IGBTs are important components in power management. Based on statistics published by the Semiconductor Industry Association, industry-wide revenues from sales of power MOSFETs and IGBTs were $4.4 billion in calendar 2003 and are forecasted to total approximately $5.8 billion in calendar 2004. The semiconductor industry is demonstrating signs of recovery from a significant downturn in recent years. Overall economic conditions continue to be somewhat uncertain and difficult to predict.
Historically, demand for power semiconductors has displayed cyclical characteristics. Current demand is driven largely by the following:
•Increased Speed and Functionality in Information Technology ("IT"). Product development roadmaps for the IT industry call for continued increases in speed and functionality and improvements in computers, servers, consumer electronics and a variety of leading-edge electronic devices and equipment. The need for greater processing power drives up current levels and operating frequencies, and each new generation of IT relies more heavily on, and places a higher value on, efficient, precise power management technology.
•Demand for Energy-Efficient Motor Controls. Worldwide demand for household appliances and industrial motors continues to rise. Whether the end product will be sold to customers in a developing nation with a modest energy budget or an industrialized nation with stringent environmental standards, advanced power management technology provides products to fulfill the need for energy-efficient motor control.
•Applications in Automotive Electronics and Motor Controls. In the automotive market, the proliferation of power features and high-end electronics for entertainment, communications, navigation and diagnostics increases the load on the engine, reduces fuel efficiency and strains the capacity of 12V electrical systems. The need to meet conflicting demands for more features and less gas consumption is prompting a fundamental re-design of automotive electrical systems. That re-design is shaped in part by advancements in power management technology.
•Defense/Aerospace Demand for Advanced Power Management Technology. In the defense/aerospace industry, power management technology is critical to meeting the rigorous space, weight and reliability requirements of highly-demanding applications. A renewed commitment to security drives demand in this sector for advanced power management technology. In addition, aircraft designs are converting from hydraulic control systems to electronic control systems. Aerospace systems designers are constantly striving for higher efficiency power conversion solutions.
Strategy
We pioneered a core power management technology. We build on our industry leadership in components to develop certain key products based on our proprietary technology. To distinguish ourselves from the industry, we focus on the power management requirements of an application and bring our comprehensive portfolio of products and technologies to advance the power management performance of the application. Our products are diversified within the power management field and serve various applications in the information technology, automotive, consumer electronics, defense/aerospace and industrial markets. Our proprietary products form an increasing proportion of our business, and improve our growth and profit potentials. In the fiscal year ended June 30, 2004, our proprietary products revenues grew 32 percent. Our gross margins increased to 41.2 percent in the fourth quarter fiscal 2004, from 34.8 percent in the fourth quarter fiscal 2003. In support of this growth, we have increased the number of new proprietary products sales professionals and field application engineers worldwide. Our proprietary products refer to our Analog ICs, Advanced Circuit Devices and Power Systems. We include in our reference to proprietary products those products that are value-added or are provided under reduced competition due to their technological content or our customer relationship.
We focus on market sectors where our advancements can provide enabling technology in targeted applications for better, more competitive products: information technology, energy-efficient appliances and motor-driven equipment, automotive and defense/aerospace. We implement our strategy through the following initiatives:
Focus on Adding Value in High Growth Markets. We focus all of our efforts on power management products and believe that this focus has helped IR to develop the most advanced products for these markets. For example, our Analog ICs are used in power management for portable electronics, next-generation plasma HDTV displays and Intel's and Advanced Micro Devices' most advanced microprocessors. In Power Systems, we are working with major automotive suppliers in designing next generation systems to replace traditional hydraulic and belt-driven applications with more cost-effective electronic systems that improve performance and fuel efficiency. We are also targeting a wide range of applications that have not historically utilized power management technologies, including refrigerators, washing machines, air conditioners and other appliances from such market leaders as Sanyo, Maytag, GE and Miele.
Leverage Our Leading Edge Technology. Our leading edge technology enables us to set performance and architecture standards for power electronics in targeted applications. Our research and development program focuses on Analog ICs, Advanced Circuit Devices and Power Systems and the advancement and diversification of our HEXFET® power MOSFET and IGBT product lines. Over the three years ended June 30, 2004, we spent $240.1 million on research and development. Our broad worldwide patent portfolio consists of 499 issued patents and 773 patent applications pending, of which 149 are provisional applications (see "Intellectual Property"). We continue to commit to research and development to generate new patents. We believe our technology leadership and product innovation will be a source of product growth in the fastest growing sectors of the power semiconductor industry. In fiscal 2004, 2003 and 2002, licenses under our patents generated $41.9 million, $42.0 million and $47.6 million, respectively, in royalties. Our royalty income stream is currently dependent on the continued enforceability and validity of our patents, the ability of our competitors to design around our licensed MOSFET technology or develop competing technologies and general market conditions. The continuation of such royalties is subject to a number of risks (see Item 7, Management's Discussion and Analysis of Financial Condition-Factors that May Affect Future Results-Our ongoing protection and reliance on our intellectual property assets expose us to material risks). Our licensed MOSFET patents expire between 2004 and 2010, with the broadest remaining in effect until 2007 and 2008. For technologies other than our licensed MOSFET technologies, we are concentrating on incorporating our
technologies into proprietary products and exploring licensing opportunities as we believe meet our overall business strategies.
Extend Leadership in Power Components. We pioneered a fundamental technology for power MOSFETs and estimate that the majority of the world's power MOSFETs are produced by us or use our patented technology. Over the last two years, we have invested aggressively to advance trench, planar and other process technologies. These investments have produced what we believe are the most efficient power MOSFET components in the marketplace. Our leadership position in Power Components provides us with a platform for continued expansion in value-added growth markets.
Capitalize on Relationships with Market Leaders. Many industry leaders look to us for products and programs that address their most challenging power management needs. These relationships put us at the forefront of developing products for new trends in the marketplace. We have increased the number of proprietary product sales professionals and field application engineers worldwide, to offer technological design expertise and high quality customer service. This comprehensive sales and engineering support includes Internet service applications, electronic order entry and just-in-time delivery. Our market leading customers include Bosch, Cisco, DaimlerChrysler, Danfoss, Dell, Emerson, IBM, Intel, Lockheed-Martin, Maytag, Motorola, Nortel, Northrop-Grumman, Philips, Raytheon, Sanyo and Visteon.
Capitalize on Low Cost Manufacturing. We fabricate most of our chips in facilities designed to address the specific requirements of power semiconductors. We believe that our wafer fabrication costs are among the lowest in the industry. We have wafer fabrication and/or assembly production facilities in California, Massachusetts, Mexico, the United Kingdom, Germany, Italy, India and China. We also use third-party foundries and assemblers to supplement our internal manufacturing in a manner to provide capacity flexibility and efficiency.
We purchased the Newport, Wales (United Kingdom) facility in fiscal 2002 near the bottom of the last market cycle. One of the two fabrication lines there was idle at the time of acquisition. In the fourth quarter of fiscal 2004, we began recommissioning the idled line and expect first production wafers by July 2005. This facility provides our most cost-effective and advanced manufacturing capabilities and offers us significant capacity to support our growth over the next several years.
In the second quarter of fiscal 2003, we announced certain restructuring initiatives. Our goal was to position the Company to better-fit market conditions, de-emphasize our commodity business and accelerate the move to our proprietary products. The restructuring plan included consolidating and closing several older facilities and legacy operations. We also plan to lower overhead costs across our support organizations. We expect these initiatives to be significantly completed by calendar year-end December 2004. We expect to realize annualized savings of over $70 million by calendar year-end 2004 from our restructuring activities. Additionally, in the fourth quarter of fiscal 2004, we began executing our plan to discontinue and divest business totaling $100 million in annual revenues from certain slow-growth, low-margin commodity products. We plan to reallocate certain manufacturing resources to the production of our fast growing, high-margin proprietary products (see also Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations-Fiscal 2004 Compared with Fiscal 2003-Impairment of Assets, Restructuring and Severance Charges).
In July 2004 subsequent to fiscal year-end 2004, we completed the acquisition of the specialty silicon epitaxial services assets from Advanced Technology Materials, Inc. for approximately $41 million in cash, which may be reduced by $3 million, pending the qualification of certain processes as part of the transaction. We expect this acquisition to lower our production costs and provide certain key intellectual property for epitaxial silicon substrates manufacturing (see Note 14, Acquisitions of Notes to Consolidated Financial Statements).
Products and Applications
Our products process electrical power into a form that is more readily usable by electric products. We believe that our full complement of power management technology represents a competitive advantage, enabling us to provide customers with solutions that shorten their overall product development cycle time. Our products are broadly divided among three product categories: Analog ICs and Advanced Circuit Devices, Power Systems and Power Components.
Analog ICs and Advanced Circuit Devices
An Analog IC is a semiconductor that integrates logic and power management functions on the same chip. These devices optimize the performance of circuits that often include power MOSFETs and IGBTs and allow our customers to simplify circuit design and assembly, improve reliability, and reduce overall system size and cost. The ability of an Analog IC to sense and respond to circuit conditions makes its performance superior to discrete components. Our ICs often use our proprietary power MOSFET technology. We have obtained substantial patent protection for our ICs and have additional patent applications pending.
Advanced Circuit Devices are chipsets, multichip modules and other advanced performance devices that address power management requirements in demanding applications. These products are value-added or are provided under reduced competition due to their technological content or our customer relationship.
Increased complexity in computers, routers, servers and other devices require increased levels of power and more effective heat dissipation, making power management one of the most critical tasks. IT applications are trending to lower voltages and higher current levels, which require greater efficiency and more complex power management to meet speed and performance demands. Advanced consumer electronics such as PDP televisions and game consoles also require more efficient and complex power management. We continue to invest aggressively in Analog IC technology and key trench, planar and other process technologies. These investments have resulted in what we believe are the most efficient Analog ICs and Advance Circuit Devices. Among other attributes, we believe these product offerings set the industry standard for performance and cost-efficiency in high-volume consumer electronics applications.
Power Systems
Power Systems combine power semiconductors with other power management components in specialized modules that improve power efficiency and simplify circuit design. We focus our Power Systems on automotive electronics and motor control. Our products provide a cost-effective alternative to custom analog designs.
The proliferation of power features in automobiles and tougher standards for safety, fuel economy and emissions, are driving the adoption of more complex power electronics. Our Power Systems can help reconcile conflicting demands for more power features and better fuel mileage by replacing traditional hydraulic and belt-driven applications with electronic systems. In addition, electrically operated automotive systems improve reliability and maintenance. Our Power Systems are designed into integrated starter/alternator motors, electronic power steering systems, fuel and water pumps and fan controls.
Motors consume approximately half of the world's electricity. New variable-speed motors equipped with Power Systems increase energy efficiency and performance in a wide range of household, commercial and industrial applications. For example, most refrigerator motors can operate only at full speed, but a variable-speed motor can run at the lowest speed needed to maintain the required temperature. Our Power Systems designed for variable-speed motors reduce electricity consumption, simplify product design, improve product performance and reduce overall costs. Also, we have achieved
multiple sole-source design wins from leading worldwide manufacturers in high-end washers, refrigerators and other energy-efficient appliances. In fiscal 2004, we entered into a joint venture agreement with the Semiconductor Division of Sanyo Electric Company. The joint venture, named IR-SA Integrated Technologies Co., is focused on electronic motion control solutions in the appliance and light industrial markets. The joint venture brings together our mixed signal IC and discrete expertise and Sanyo's packaging expertise to pursue those markets.
Power Components
Switching Products. Power MOSFETs and IGBTs rapidly and efficiently switch electricity on and off in order to supply power in a form that can be formatted to the specific requirements of a circuit.
Through our HEXFET® product line, we believe that we are the market leader in power MOSFETs. Our emphasis on quality control and reliability has helped us maintain market acceptance and brand recognition of our HEXFET® line of products. We pioneered the fundamental planar technology that set the industry standard for power MOSFETs.
MOSFETs are critical in a wide variety of electric products. Communications applications include cellular phones, telephone networks and modems. Computer and peripheral applications include power supplies, disk drives and printers. Office equipment applications include copiers and facsimile machines. Consumer electronics applications include home entertainment, video cameras, household appliances and power tools. Automobile applications include anti-lock braking systems, fuel injection systems, power accessories and air bags. Industrial applications include automated production equipment, instrumentation and test equipment. Defense/aerospace applications include communications satellites and satellite command-and-control systems.
IGBTs typically perform the switch function in industrial applications that require higher current and voltage than power MOSFETs can handle efficiently. The performance and ruggedness of these devices enable them to replace bipolar transistors and thyristors in many high-voltage, high-current motor control and power conditioning applications. Energy-efficient, variable-speed motor controls are an emerging application, and we believe hybrid and electric vehicles may require large quantities of IGBTs for each vehicle. Our IGBT technology is closely related to our power MOSFET technology. We believe that our patents on fundamental power MOSFET technology also apply to IGBTs.
Rectifiers, Diodes and Thyristors. We manufacture a broad line of rectifiers, diodes and thyristors. These products, which also condition electrical power to make it more efficient and usable, are used in industrial end products that require power-handling capability from one amp to 5,000 amps and from 20 volts to 5,000 volts. Applications include motor and lighting controls, welding equipment, forklifts, machine tools, induction heating, locomotives, motor-driven production lines, smelting equipment and power supplies.
Our Schottky diodes and fast-recovery diodes serve the output rectification function of power conversion. A diode is a discrete device that conducts current in one direction. A Schottky diode is an ultra-fast diode used in high-frequency, low-voltage circuits. A fast-recovery diode is a diode suited to applications above 200 volts where high switching speed is desirable. Schottky diodes are used with power MOSFETs in high-frequency applications such as computers and peripherals. Our HEXFRED® fast-recovery diodes are used with IGBTs in higher-current, lower-frequency applications such as motor controls.
Manufacturing
Semiconductor manufacturing involves two phases of production: wafer fabrication and assembly. Wafer fabrication requires a sequence of process steps that expose silicon wafers to chemicals that change their electrical properties. The chemicals are applied in patterns that define cells or circuits
within numerous individual devices, termed "die" or "chips", on each wafer. Assembly is the sequence of production steps that divide the wafer into individual chips and enclose the chips in structures, termed "packages", that make them usable in a circuit. Power semiconductors generally use process technology and equipment already proven in the manufacturing of integrated circuits.
We have manufacturing and/or assembly facilities in California, Massachusetts, Mexico, the United Kingdom, Germany, Italy, India and China. In addition, we have equipment at, or manufacturing supply agreements with, subcontractors located in the Philippines, Thailand, Taiwan, Malaysia, the Czech Republic, Germany and the United States.
Our most advanced wafer fabrication facility, located in Newport, Wales, provides wafer fabrication capacity for mixed-signal and analog processes. We have a MOSFET wafer fabrication facility in Temecula, California, and a high-voltage Analog IC wafer fabrication facility in El Segundo, California. Assembly operations for products used in defense/aerospace applications are located in Leominster, Massachusetts and Santa Clara, California. We are transitioning certain assembly of government and space products to Tijuana, Mexico as part of our restructuring activities (see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations). We manufacture substantially all of our Schottky diodes, high-power rectifiers and thyristors at our Turin, Italy facility. Plants that assemble power MOSFETs and other products are located overseas in facilities we own or in subcontracted facilities. Our high-volume assembly lines for power MOSFETs, IGBTs and diodes are located in our facility in Tijuana, Mexico. We use production facilities in Swansea, Wales and Krefeld, Germany to manufacture and assemble automotive power systems. Also as part of our restructuring activities, we are moving most manufacturing activities at Krefeld, Germany to Swansea, Wales and Tijuana, Mexico facilities, and expect the move to be completed by fiscal second quarter 2005 (see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations). In a duty-free zone in India, we have an assembly facility for rectifiers and thyristors.
In July 2004, subsequent to fiscal 2004, we acquired the specialty silicon epitaxial services assets from Advanced Technology Materials, Inc. This new manufacturing facility is located in Mesa, Arizona.
Marketing, Sales and Distribution
We market our products through direct sales staff, representatives and distributors. In line with this strategy, we are adding a complement of field application engineers and technical sales support staff to better serve the needs of our customers for IR's proprietary products. For the fiscal year ended June 30, 2004, direct sales to original equipment manufacturers ("OEM"s) and our distributors accounted for 71 percent and 29 percent, respectively, of product sales. For the fiscal year ended June 30, 2003, direct sales to OEMs and our distributors accounted for 69 percent and 31 percent, respectively, of product sales. For the fiscal year ended June 30, 2002, direct sales to OEMs and our distributors accounted for 63 percent and 37 percent, respectively, of product sales.
In fiscal 2004, our product sales by region, based on the location of the customer, were approximately 28 percent from North America, 24 percent from Europe and 48 percent from Asia, which includes Japan and Asia Pacific. Our domestic direct sales force is organized into five regional sales zones. In Europe, our products are sold through our own sales force as well as through independent sales agents and distributors. Our European sales and representative offices are in the United Kingdom, Sweden, Finland, Denmark, Spain, France, Italy, Germany, Switzerland, Austria, Russia, the Czech Republic and Hungary. In Asia, we have sales representative or liaison offices in India, Japan, Singapore, China, Hong Kong, South Korea, Taiwan and the Philippines. We also have sales representative or liaison offices in Mexico, Australia and New Zealand.
For financial information about the results for our geographic areas for each of the last three fiscal years, refer to "Notes to the Consolidated Financial Statements ("Note") 8, Geographic Information and Foreign Operations."
Because many applications require products from several product groups, we have organized our product development and marketing efforts by sector and application, rather than product type. In addition, our staff of application engineers provides customers with technical advice and support regarding the use of our products. We have increased the number of engineering offices to help support our proprietary products. We believe the depth of our power management product line enhances our competitive position in the overall power semiconductor market.
Customers
Our devices are incorporated in subsystems and end products manufactured by other companies. No single OEM customer, distributor or contract manufacturers accounted for more than ten percent of our revenue for the fiscal year ended June 30, 2004. The following table lists some of our major customers by end-market for fiscal 2004:
Backlog
As of June 30, 2004, our backlog of orders was $403.3 million compared to $244.8 million as of June 30, 2003. Backlog is comprised of purchase orders and customer forecast commitments scheduled to be shipped within the following twelve months. Increasingly, major customers are operating their businesses with shorter lead-times and are placing their orders at shorter intervals, which tend to reduce backlog relative to future revenue. The increase in backlog at June 30, 2004 is largely attributable to the success with our proprietary products and the upturn in the semiconductor industry. Given adequate notice, we usually allow customers to cancel purchase orders without penalty. The amount of backlog to be shipped during any period is dependent on various factors and can vary significantly from month to month. Accordingly, backlog is not necessarily indicative of sales for any future period.
Research and Development
We conduct research and development activities to improve the performance and cost effectiveness of our product offerings in target applications. Our research and development program focuses on
Analog ICs, Advanced Circuit Devices and Power Systems and the advancement and diversification of our HEXFET® power MOSFET and IGBT product lines. We also direct our research and development toward reducing our customers' time-to-market and reducing the cost of their products. Our program places increasing emphasis on the development of chipsets and system-level solutions that improve overall system performance and cost, and helps customers to accelerate market introduction of their products.
In fiscal 2004, 2003 and 2002, we spent $92.2 million, $78.9 million and $69.8 million, respectively, on research and development activities.
Our design centers are located throughout the world, including the United States, Canada, the United Kingdom, Denmark, Italy, France, Germany and Singapore. During fiscal 2004, we achieved performance enhancements and cost reductions across our product line. A few of the more notable product introductions for fiscal 2004 included: a) new additions to the iPOWIR family of products that provide the industry's first dual-output, two-phase power building blocks for DC-DC converters inside advanced telecom, networking and server systems b) a broad expansion of our family of DirectFET Power MOSFETs which tackle the thermal limitations associated with high-end microprocessors c) new lighting ICs that set new standards in innovation in energy-efficient lighting applications d) a growing complement of iMOTION motor control products that now include a collection of driver ICs and power stage modules, aimed at improving energy efficiency in appliance and industrial applications, e) a new driver IC for Class D audio amplifiers, and f) a new integrated motor control IC for automotive applications.
Intellectual Property
We continue to make significant investments in developing and protecting our intellectual property. We have increased our research and development spending 127 percent over the last five years, a period that included the steepest downturn in the history of the semiconductor industry. We have 309 issued unexpired U.S. patents and 363 U.S. patent applications pending (including 149 provisional applications). Our power MOSFET patents expire between 2004 and 2010, with the broadest remaining in effect until 2007 and 2008. In addition, we have 190 issued foreign patents and 410 foreign patent applications pending in a number of countries (including applications filed under treaty). We are also licensed to use certain patents owned by others. We have several registered trademarks in the United States and abroad, including the trademark HEXFET. We believe that our intellectual property contributes to our competitive advantage.
We are committed to enforcing our patent rights, including through litigation, if necessary. Through successful enforcement of our patents, we have entered into more than 20 license agreements, generated royalty income, and received substantial payments in settlement of litigation. Consistent with this policy, we have settled patent infringement suits against Hitachi Ltd. and affiliated companies in March 2004, (see Note 13, "Litigation"). Our broadest power MOSFET patents were subject to, and have successfully emerged from, reexamination by the United States Patent and Trademark Office. We currently have license agreements with the majority of power MOSFET manufacturers in the United States and abroad. In fiscal 2004, 2003 and 2002, we derived $41.9 million, $42.0 million and $47.6 million of royalty revenues from license agreements, respectively. Our royalty income stream is dependent on the continued enforceability and validity of our patents, the ability of our competitors to design around our MOSFET technology or develop competing technologies, and general market conditions. The continuation of such royalties is subject to a number of risks (see "Item 7, Management's Discussion and Analysis of Financial Condition-Factors that May Affect Future Results-Our ongoing protection and reliance on our intellectual property assets expose us to risks").
Competition
We encounter differing degrees of competition for our various products, depending upon the nature of the product and the particular market served. Generally, the semiconductor industry is highly competitive and subject to rapid price changes and product design changes. Several of our competitors are larger companies with greater financial resources. We believe that we are distinguished from our competitors by our comprehensive line of power management products and ability to combine these products into compact, cost-effective packages and system-level solutions. Our products compete with products manufactured by others on the basis of enabling capability, performance, reliability, quality, price, delivery time to customer and service (including technical advice and support). Our major competitors in Analog ICs and Advanced Circuit Devices include Analog Devices, Intersil, Linear Technology, Maxim Integrated Products, Semtech and Texas Instruments. Our major competitors in Power Components include Fairchild Semiconductor, Hitachi, Infineon Technologies, Mitsubishi, NEC, ON Semiconductor, Phillips, STMicroelectronics, Toshiba and Vishay-Siliconix. Aside from typical industry competitors, our Power Systems products often offer our customers an improved alternative to manufacturing systems internally.
Environmental Matters
Federal, state and local laws and regulations impose various restrictions and controls on the storage, use and discharge of certain materials, chemicals, and gases used in semiconductor manufacturing processes. We do not believe that compliance with such laws and regulations as now in effect will have a material adverse effect on our results of operations, financial position or cash flows.
However, under some of these laws and regulations, we could be held financially responsible for remedial measures if properties are contaminated or if waste is sent to a landfill or recycling facility that becomes contaminated. Also, we may be subject to common law claims if we release substances that damage or harm third parties. We cannot make assurances that changes in environmental laws and regulations will not require additional investments in capital equipment and the implementation of additional compliance programs in the future, which could have a material adverse effect on our results of operations, financial position or cash flows, as could any failure by us to comply with environmental laws and regulations.
IR and Rachelle Laboratories, Inc. ("Rachelle"), a former operating subsidiary of ours that discontinued operations in 1986, were each named a potentially responsible party ("PRP") in connection with the investigation by the United States Environmental Protection Agency ("EPA") of the disposal of allegedly hazardous substances at a major superfund site in Monterey Park, California ("OII Site"). Certain PRPs who settled certain claims with the EPA under consent decrees filed suit in Federal Court in May 1992 against a number of other PRPs, including us, for cost recovery and contribution under the provisions of the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"). IR has settled all outstanding claims that have arisen against it out of the OII Site. No claims against Rachelle have been settled. The Company has taken the position that none of the wastes generated by Rachelle were hazardous.
Counsel for Rachelle received another letter, dated August 2001, from the U.S. Department of Justice, directed to all or substantially all PRPs for the OII Site, offering to settle claims against such parties for all work performed through and including the final remedy for the OII Site. The offer required a payment from Rachelle in the amount of approximately $9.3 million in order to take advantage of the settlement. Rachelle did not accept the offer.
In as much as Rachelle has not accepted the settlement, we cannot predict whether the EPA or others would attempt to assert an action for contribution or reimbursement for monies expended to perform remedial actions at the OII Site. We cannot predict the likelihood that the EPA or such others would prevail against Rachelle in any such action. We maintain the position of Rachelle that its wastes
were not hazardous. Our insurer has not accepted liability, although it has made payments for defense costs for the lawsuit against us. We have made no accrual for potential loss, if any; however, an adverse outcome could have a material adverse effect on our results of operations and our cash flows.
We received a letter in June 2001 from a law firm representing UDT Sensors, Inc. relating to environmental contamination (chlorinated solvents such as trichlorethene) assertedly found in UDT's properties in Hawthorne, California. The letter alleges that we operated a manufacturing business at that location in the 1970's and/or 1980's and that we may have liability in connection with the claimed contamination. We have made no accrual for any potential losses since there has been no assertion of specific facts on which to form the basis for determination of liability.
Employees
As of June 30, 2004, we employed approximately 5,800 people, of whom approximately 3,900 were employed in North America, 1,200 in Europe and 700 in Asia Pacific and Japan. The only collective bargaining agreements to which we are subject apply to our employees in Italy. We have approximately 300 employees in Italy. We consider our relations with our employees to be good.
Available Information
We file, with the Securities and Exchange Commission ("SEC") pursuant to Section 13(a) or 15(d) of the Exchange Act, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished. These reports may be accessed at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. Information on the operation of the Public Reference Room is available by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information about us. The SEC's Internet address is http://www.sec.gov.
Our Internet address is http://www.irf.com. We make available free of charge through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
Item 2.
Item 2. Properties
Our operations occupy a total of approximately 1.7 million square feet, of which approximately 0.7 million square feet are located within the United States. Of the worldwide total, approximately 0.4 million square feet are leased.
Our leases expire between 2004 and 2011. If we are unable to renew these leases upon expiration, we believe that we could find other suitable premises without any material adverse impact on our operations. Our major facilities, including the Meza, Arizona facility we acquired in July 2004, are in the following locations:
We believe that these facilities are adequate for our current and anticipated near-term operating needs. At fiscal year ended June 30, 2004, we operated at approximately 90 percent of our worldwide manufacturing capacity.
We have sales or technical support offices located throughout the United States, Mexico, Canada, the United Kingdom, Spain, France, Italy, Germany, Switzerland, Sweden, Denmark, Finland, Russia, Hungary, the Czech Republic, China, Hong Kong, Taiwan, Japan, South Korea, India, Singapore, the Philippines, Australia and New Zealand.
Item 3.
Item 3. Legal Proceedings
In June 2000, we filed suit in Federal District Court in Los Angeles, California, against IXYS Corporation, alleging infringement of our key U.S. patents 4,959,699; 5,008,725 and 5,130,767. The suit sought damages and other relief customary in such matters. In August 2000, IXYS filed an answer and counterclaim, and in February 2002, amended its answer and counterclaim, denying infringement and alleging patent invalidity and unenforceability. The Federal District Court entered a permanent injunction, effective on June 5, 2002, barring IXYS "and all persons in active concert or participation with them who receive actual notice" of the injunction from "making, using, offering to sell or selling in, or importing into, the United States, MOSFETs (including IGBTs) covered by" IR's U.S. patents 4,959,699; 5,008,725 and/or 5,130,767. In August 2002, the Court of Appeals for the Federal Circuit stayed that injunction, pending appeal on the merits. In the Federal District Court, in August 2002, following trial on damages issues, the jury awarded us $9.1 million in compensatory damages. The Federal District Court subsequently trebled the damages, increasing the award from $9.1 million to approximately $27.2 million, and ruled that the Company is entitled to an additional award of reasonable attorney's fees for a total monetary judgment of $29.5 million. In March 2004, the U.S. Court of Appeals for the Federal Circuit reversed the summary judgment granted us by the Federal District Court in Los Angeles of infringement by IXYS of the Company's U.S. patents 4,959,699; 5,008,725 and 5,130,767. The case was remanded for further proceedings and reexamination of a number of issues before the Los Angeles District Court where it originated. The Federal Circuit reversed in part and vacated in part infringement findings of the District Court, granted IXYS the right to present certain affirmative defenses, and vacated the injunction against IXYS entered by the District
Court. The ruling by the Federal Circuit will also have the effect of vacating the damages judgment obtained against IXYS. The Federal Circuit affirmed the District Court's rulings in the Company's favor regarding the validity and enforceability of the three Company patents. Upon remand, the Company plans to continue to vigorously pursue its claims for damages and other relief based on IXYS' infringement of the asserted patents.
Additionally in a related case, in July 2003, the District Court awarded the Company sanctions against Samsung Semiconductor, Inc., in an amount including attorney's fees of about $7.3 million, subject to certain credits of up to $4.5 million. In March 2004, the Court of Appeals for the Federal Circuit determined that Samsung did not violate the injunction, vacating the previous sanctions award.
In January 2002, we filed suit in the Federal District Court in Los Angeles, California, against Hitachi, Ltd. and affiliated companies alleging infringement of certain of IR's U.S. patents. We later brought additional claims alleging infringement of certain other of our patents. Hitachi denied infringement and validity of the patents and entered a counterclaim of patent misuse. During fiscal 2004, we added Renesas Technology Corp ("Renesas") and its U.S. affiliate to such suit as additional parties defendant. Renesas is a joint venture comprised of Hitachi (55 percent) and Mitsubishi Electric Corporation (45 percent). In January 2004, we entered into a patent cross-license agreement with Hitachi and Renesas. The agreement also settled the previously pending litigation among the parties. In the March quarter, we reported a one-time pretax gain, net of legal expenses and related costs, of approximately $5.9 million related to this matter. The agreement also provides for Hitachi and Renesas paying an on-going royalty on worldwide sales covered by certain of our power MOSFET/IGBT patents. We will pay an on-going royalty to Hitachi on our sales in Japan of certain power MOSFETs and to Renesas on our sales in Japan of certain other products. The agreement takes effect for payment of ongoing royalties on April 1, 2004 and will continue through the expiration of the applicable licensed patents.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Additional Item. Executive Officers of the Registrant
Our executive officers serve at the discretion of the Board of Directors. Mr. Eric Lidow's employment with IR is subject to the provisions of an executive employment agreement with IR dated May 15, 1991, and subsequently amended on April 12, 1995, June 22, 1998 and August 5, 1998.
The executive officers of IR are:
Eric Lidow, the founder of the Company, has been a director since our inception in 1947 and was Chief Executive Officer until March 1995. Mr. Lidow continues as Chairman of the Board.
Alexander Lidow, Ph.D., has been employed by us since 1977. He was elected a director in September 1994 and Chief Executive Officer in March 1995. Dr. Lidow serves on the Board of Trustees of the California Institute of Technology. Dr. Lidow is a son of Eric Lidow.
Michael P. McGee joined us in 1990. He became Vice President and Chief Financial Officer in 1993. In November 1998, Mr. McGee was elected Executive Vice President. Since June 2000, he was Chairman of the Board of Nihon Inter Electronics Corporation, a publicly-held Japanese corporation. Prior to June 2003, during that period he had also been Co-Chief Executive Officer of that company.
Robert Grant joined the Company in 1992 as Director, Worldwide Customer Operations. In October 1998, Mr. Grant became Senior Vice President, Customer Service and Sales Systems, and in October 1999 became Senior Vice President, Marketing Communications and eCommerce. In July 2000, Mr. Grant was elected Executive Vice President. He was promoted to Executive Vice President, Global Sales and Corporate Marketing in November 2001.
Walter Lifsey has been employed by us since 1999. His most recent assignment was as Senior Vice President, Corporate Development before being appointed Executive Vice President, Operations in April 2002. Prior to joining IR, he held senior management positions at AMP, Inc. and TRW Inc.
Donald R. Dancer joined IR in August 2002. He most recently was General Counsel for GE Industrial Systems Solutions and served 22 years in various senior legal positions with the General Electric Company.
PART II
Item 5.
Item 5. Market for the Registrants' Common Equity-Related Stockholder Matters and
Issuer Purchases of Equity Securities
Price Range of Common Stock
(Closing Prices in Dollars)
Our common stock is traded on The New York Stock Exchange and the Pacific Exchange under the symbol "IRF." On September 13, 2004, the closing sale price of the common stock on The New York Stock Exchange was $35.43. Shareholders are urged to obtain current market quotations for the common stock. There were approximately 1,999 holders of record of our common stock as of September 13, 2004. No cash dividends have been declared to stockholders during the past three years, and the Company does not expect to declare cash dividends in the foreseeable future. The payment of dividends is within the discretion of the Company's Board of Directors, and will depend upon, among other things, the Company's earnings, financial condition, capital requirements, and general business conditions. In addition, the Company's bank credit agreement currently includes covenants putting limitations on certain dividend payments.
The quoted market prices are as reported on The New York Stock Exchange Composite. Stockholders are urged to obtain current market quotations for the common stock.
Item 6.
Item 6. Selected Financial Data
The selected consolidated financial data as of June 30, 2004 and 2003 and for the fiscal years ended June 30, 2004, 2003 and 2002, are derived from our audited consolidated financial statements and should be read in conjunction with our audited consolidated financial statements and notes beginning on page 39. The selected consolidated financial data as of June 30, 2002, 2001 and 2000, and for the fiscal years ended June 30, 2001 and 2000, are derived from our audited consolidated financial statements which are not included in this document.
(1)Certain reclassifications have been made to previously reported amounts to conform to the current year presentation.
(2)Gross profit in fiscal years 2003 and 2001 includes pretax charges for inventory written down by $6.0 million and $38.4 million, respectively. Fiscal 2003 $6.0 million charge reflected certain raw material and work-in-process inventories that were impaired as a result of our restructuring initiatives, including products that could not be completed in other facilities, materials that were not compatible with the processes used in the alternative facilities, and materials such as gases and chemicals that could not readily be transferred. Fiscal 2001 $38.4 million charge reflected excess inventory written down to net realizable value as a result of semiconductor industry downturn and weak demand in our end markets.
(3)Impairment of assets, restructuring and severance charges include total pretax charges of $33.5 million, $187.9 million and $86.4 million for the fiscal years 2004, 2003 and 2001, respectively. These charges are comprised of severance-related charges of $18.3 million, $18.2 million and $2.8 million in fiscal years 2004, 2003 and 2001, respectively, and impairment of assets and other restructuring-related charges of $15.2 million, $169.6 million, and $45.2 million for fiscal years 2004, 2003 and 2001, respectively. Fiscal 2004 and 2003 charges included asset impairment, plant closure costs and other charges associated with our restructuring initiatives announced in fiscal 2003 second quarter ended December 31, 2002, and severance-related charges associated with the elimination of manufacturing, operating and company-wide administrative personnel as a result of plant consolidations and closures, and overhead cost reductions across our support organization. Fiscal 2001 charges included assets written down to their expected discounted future cash flow or to an amount deemed recoverable, and severance charges associated with the elimination of company-wide administrative and operating personnel at our facilities in the United Kingdom.
(4)Net income (loss) per common share, basic and diluted, for fiscal years 2004, 2003 and 2001, includes impairment of assets, restructuring and severance charges outlined in Notes (2) and (3) above of $(0.39), $(2.16) and $(1.03), respectively. Net income per common share, basic and diluted, for fiscal year 2004 also includes $0.07 from the one-time Hitachi settlement gain related to patent infringement.
(5)Working capital is defined as current assets less current liabilities.
(6)Cash flows used in investing activities primarily reflect net cash used to purchase cash investments and capital expenditures. Cash flows used in investing activities in fiscal 2002, 2001 and 2000, included acquisitions of certain business assets and businesses, net of cash of $169.6 million, $74.7 million and $28.5 million, respectively.
(7)Cash flows provided by financing activities in fiscal 2004 reflect $45.3 million for the issuance of common stock and options exercised. Cash flows provided by financing activities in fiscal 2001 included the issuance of $550 million of 4.25 percent Convertible Subordinated Notes due 2007. Cash flows provided by financing activities in fiscal 2000 included the net proceeds from the issuance of 9,250,000 shares of common stock of $360.7 million, offset by $192.3 million of extinguishment of debt under the syndicated Credit Agreement with Banque Nationale de Paris.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read together with the consolidated financial statements and notes to consolidated financial statements included elsewhere in this Form 10-K. Except for historic information contained herein, the matters addressed in this Item 7 constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements are subject to a variety of risks and uncertainties, including those discussed under the heading "Cautionary Statement for Purposes of the 'Safe Harbor' Provision of Private Securities Litigation Reform Act of 1995", "Factors That May Affect Future Results" and elsewhere in this Annual Report on From 10-K, that could cause actual results to differ materially from those anticipated by the Company. The Company undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the date of this Annual Report or to reflect actual outcomes.
Overview
This section presents summary information regarding our industry, markets, products and operating trends only. For further information regarding our financial condition and results of operation, please read our "Management's Discussion and Analysis of Financial Condition and Results of Operations" in its entirety, of which this is a part.
Company and Industry Overview
We are a leading designer, manufacturer and marketer of power management products and the leading worldwide supplier of a type of power semiconductor called a MOSFET (a metal oxide semiconductor field effect transistor). Power semiconductors process electricity into a form more usable by electrical products. Power semiconductors increase system efficiency, allow more compact end products, improve features and functionality and extend battery life. Our products are used in a range of end-markets, including information technology, automotive, consumer electronics, aerospace/defense and industrial.
Historically, demand for power semiconductors has displayed cyclical characteristics. Within the power semiconductor market, MOSFETs and other related products known as IGBTs are important components in power management. Based on statistics published by the Semiconductor Industry Association, a leading semiconductor industry group, industry-wide revenues from sales of power MOSFETs and IGBTs were $4.4 billion in calendar 2003 and are forecasted to total approximately $5.8 billion in calendar 2004. Based on this information and other publicly available surveys, the semiconductor industry appears to be demonstrating signs of recovery from a significant downturn in recent years. Overall economic conditions continue to be somewhat uncertain and difficult to predict.
We believe current demand for our products is driven largely by the following:
•Increased Speed and Functionality in Information Technology. Increases in speed and functionality and improvements in computers, servers, consumer electronics and a variety of leading-edge electronic devices and equipment.
•Demand for Energy-Efficient Motor Controls. Worldwide demand for household appliances and industrial motors with power management technology.
•Applications in Automotive Electronics and Motor Controls. In the automotive market, the proliferation of power features and high-end electronics and a desire for increased fuel efficiency.
•Defense/Aerospace Demand for Advanced Power Management Technology. In the defense/aerospace industry, power management technology is used to meet rigorous space,
weight and reliability requirements. Aerospace systems designers are constantly striving for higher efficiency power conversion solutions and there is a trend in aircraft designs of converting from hydraulic control systems to electronic control systems.
Company Products & Strategy
Our products are broadly divided among three general product categories: Analog ICs and Advanced Circuit Devices, Power Systems and Power Components. (See "Business" for a more detailed description of our products.) Our products serve a wide range of applications in the information technology, consumer electronics, automotive, defense/aerospace and industrial markets. However, we emphasize targeted applications where we can apply our more advanced and more competitive products. In doing so, we focus on what we call our proprietary products. Our proprietary products refer to our Analog ICs, Advanced Circuit Devices and Power Systems. We include in our reference to proprietary products those products that are value-added or are provided under reduced competition due to their technological content or our customer relationship. We periodically review products to determine their inclusion as proprietary products so as to help focus our efforts. In the fiscal year ended June 30, 2004, our proprietary products revenues grew 32 percent over the previous fiscal year's revenues.
We implement our strategy through initiatives that leverage our technology, develop products to meet application specific needs and lower costs.
Leverage Our Leading-Edge Technology and Extend our Leadership in Power Components. Our research and development program focuses on our proprietary products and the advancement and diversification of certain of our power MOSFET and IGBT product lines. Over the three years ended June 30, 2004, we spent $240.1 million on research and development.
Our worldwide patent portfolio consists of 499 issued patents and 773 patent applications pending, of which 149 are provisional applications (See "Business- Intellectual Property"). In fiscal 2004, 2003 and 2002, licenses under our patents, primarily our power MOSFET patents, generated $41.9 million, $42.0 million and $47.6 million, respectively, in royalties. Our royalty income stream is currently dependent on the continued enforceability and validity of our patents, the ability of our competitors to design around our licensed MOSFET technology or develop competing technologies, and general market conditions. The continuation of such royalties is subject to a number of risks (see "Item 7, Management's Discussion and Analysis of Financial Condition-Factors that May Affect Future Results-Our ongoing protection and reliance on our intellectual property assets expose us to risks"). Our licensed MOSFET patents expire between 2004 and 2010, with the broadest remaining in effect until 2007 and 2008. For technologies other than our licensed MOSFET technologies, we are concentrating on incorporating our technologies into proprietary products and exploring licensing opportunities we believe meet our overall business strategies.
Capitalize on Relationships with Market Leaders. Many industry leaders look to us for products and programs that address their most challenging power management needs. These relationships put us at the forefront of developing products for new trends in the marketplace. We have increased the number of proprietary product sales professionals and field application engineers worldwide, to offer technological design expertise and high quality customer service. This comprehensive sales and engineering support includes Internet service applications, electronic order entry and just-in-time delivery.
Capitalize on Low-Cost Manufacturing. We fabricate most of our chips in facilities designed to address the specific requirements of power semiconductors. We believe that our wafer fabrication costs are among the lowest in the industry. We have wafer fabrication and/or assembly production facilities in California, Massachusetts, Mexico, the United Kingdom, Germany, Italy, India and China. We also use
third-party foundries and assemblers to supplement our internal manufacturing in a manner to provide capacity flexibility and efficiency.
We purchased the Newport, Wales facility in fiscal 2002 near the bottom of the last market cycle. One of the two fabrication lines there was idle at the time of acquisition. In the fourth quarter of fiscal 2004, we began recommissioning the idled line and expect first production wafers by July 2005. This facility provides our most cost-effective and advanced manufacturing capabilities and offers us significant capacity to support our growth over the next several years.
In the second quarter of fiscal 2003, we announced certain restructuring initiatives. Our goal was to position the Company to better-fit market conditions, de-emphasize our commodity business and accelerate the move to our proprietary products. The restructuring plan included consolidating and closing several older facilities and legacy operations. We also plan to lower overhead costs across our support organizations. We expect these initiatives to be significantly completed by calendar year-end December 2004. We expect to realize annualized savings of over $70 million by calendar year-end 2004 from our restructuring activities. Additionally, in the fourth quarter of fiscal 2004, we began executing our plan to discontinue and divest business totaling $100 million in annual revenues from certain slow-growth, low-margin commodity products. We plan to reallocate certain manufacturing resources to the production of our fast growing, high-margin proprietary products.
In July 2004 subsequent to year-end 2004, we completed the acquisition of the specialty silicon epitaxial services assets from Advanced Technology Materials, Inc. for approximately $41 million in cash, which may be reduced by $3 million, pending the qualification of certain processes as part of the transaction. We expect this acquisition to lower our production costs and provide certain key intellectual property for epitaxial silicon substrate manufacturing.
We believe our strategies as outlined above have contributed to our overall margin growth. Our gross margins increased to 41.2 percent in the fourth quarter of fiscal 2004, from 34.8 percent in the fourth quarter of fiscal 2003.
We generated $163.0 million in cash flow from operations in fiscal 2004 compared to $129.5 million in the prior year period. Our cash, cash equivalents, cash investments in marketable debt securities and unused credit facilities of $133.7 million, totaled $969.9 million. Our financial position, in addition to our available credit facilities described below, enables IR to continue to invest for the future. We continue to invest in both personnel and facilities to support our growth, among other areas, in Asia/Pacific, our largest and fastest growing region, including breaking ground on a new assembly and test facility in X'ian, China. We invested $86.2 million in capital expenditures primarily related to upgrading wafer manufacturing capabilities and increasing assembly capacity. Additionally at June 30, 2004, we had purchase commitments for capital expenditures of approximately $11.3 million primarily at our Newport, Wales facility. We believe that our current cash and cash investment balances, cash flows from operations and borrowing capacity, including unused amounts under our credit facilities will be sufficient to meet our currently foreseeable operating cash requirements and to take advantage of strategic opportunities as they occur in the next twelve months. Although we believe that our current financial resources will be sufficient for normal operating activities, we may also consider the use of funds from other external sources, including, but not limited to, public or private offerings of debt or equity.
Results of Operations
The following table sets forth certain items included in selected financial data as a percentage of revenues.
Fiscal 2004 Compared with Fiscal 2003
Revenues
Revenues for fiscal 2004 were $1.06 billion compared to $864.4 million in fiscal 2003. Fiscal 2004 revenues reflected the growth in sales of what we categorize as our proprietary products and the upturn in the semiconductor industry. For the twelve months ended June 30, 2004, Semiconductor Industry Association data showed a 22 percent growth in semiconductor industry revenues for the business in which we operate, while IR's revenues increased by 23 percent during this period. Royalties contributed $41.9 million to revenues, compared to $42.0 million in fiscal 2003.
Revenues from our proprietary products increased by 32 percent compared to the prior fiscal year. These revenues comprised 61 percent of product revenues for the fourth quarter of fiscal 2004, compared to 58 percent in the comparable prior year period. Our proprietary products refer to our Analog ICs, Power Systems and Advanced Circuit Devices. In designating proprietary products, we periodically review products to characterize them as value-added or as provided under reduced competition due to their technological content or due to customer requirements.
Revenues as a percentage of total product revenues were 30 percent, 46 percent and 24 percent for North America, Asia and Europe, respectively, for the fiscal year ended June 30, 2004. Revenues as a percentage of total product revenues were 34 percent, 42 percent and 24 percent for North America, Asia and Europe, respectively, for the fiscal year ended June 30, 2003.
Fiscal 2004 revenues from sales to original equipment manufacturers ("OEMs") grew by 26 percent from fiscal 2003, accounting for 71 percent of fiscal 2004 product revenues, compared to 69 percent for fiscal 2003. We also classify revenues from sales to OEMs by end-market applications. Compared to the prior year, revenues from all end-market applications grew. Fiscal 2004 performance in end-market applications is as follows:
•The information technology sector comprised approximately 44 percent of sales to OEMs for fiscal 2004. Revenues from this sector grew 61 percent from fiscal 2003. This increase primarily reflected greater content and market share of our proprietary products for the latest desktops, notebooks and servers and a general upturn in the information technology market.
•The automotive sector comprised approximately 21 percent of sales to OEMs for fiscal 2004. Revenues from this sector grew by one percent from fiscal 2003. In the December 2003 quarter, we were awarded a significant automotive contract for which production on this program is expected to commence in calendar year 2005.
•The consumer sector comprised approximately 16 percent of sales to OEMs for fiscal 2004. Revenues from this sector increased by 20 percent from fiscal 2003, reflecting growth in plasma display panels ("PDPs"), liquid crystal displays ("LCDs"), digital televisions, recordable digital video discs ("DVDs"), digital music players and smart appliances.
•The defense/aerospace sector comprised approximately 12 percent of sales to OEMs for fiscal 2004. Revenues from this sector grew 11 percent from fiscal 2003, primarily as a result of increase in market share and new programs including advanced aircraft, global positioning satellites and smart weaponry.
•The industrial sector comprised approximately seven percent of sales to OEMs for fiscal 2004. Revenues from this sector grew 0.3 percent from fiscal 2003, reflecting conservative capital equipment spending patterns.
Our sales to distributors grew 18 percent from fiscal 2003, and our top fifteen distributors' sales of our products to the end customers increased 49 percent over the same period.
Gross Profit Margin
For the twelve months ended June 30, 2004 and 2003, gross profit was $411.1 million and $287.8 million (38.8 percent and 33.3 percent of revenues), respectively. The gross profit margin improvement reflected the sale of a higher margin mix of proprietary products and manufacturing cost savings, including reduced material costs, increased yield and labor and overhead efficiencies. Gross margin in the prior year ended June 30, 2003, included a $6.0 million inventory charge to write-down raw material and work-in-process inventories impaired as a result of planned plant closures, which negatively impacted gross margin by 0.7 percent for that period.
Selling and Administrative Expenses
For the twelve months ended June 30, 2004, selling and administrative expense was $164.7 million (15.5 percent of revenues), compared to $142.5 million (16.5 percent of revenues) in the twelve months ended June 30, 2003. The decline in the selling and administrative expense ratio primarily reflected a higher revenue base in the current year compared to the prior year and our cost containment efforts. The absolute selling and administrative expense increase primarily reflected sales commissions and other variable costs paid on a higher revenue base.
Research and Development Expenses
For the twelve months ended June 30, 2004 and 2003, research and development expense was $92.2 million and $78.9 million (8.7 percent and 9.1 percent of revenues, respectively). Research and development expenditures increased reflecting continued development focus on our proprietary products.
Impairment of Assets, Restructuring and Severance Charges
During fiscal 2003 second quarter ended December 31, 2002, we announced our restructuring initiatives. Under our restructuring initiatives, our goal was to reposition the Company to better fit the market conditions, de-emphasize the commodity business and accelerate the move to what we categorize as our proprietary products. Our restructuring plan included consolidating and closing certain manufacturing sites, upgrading equipment and processes in designated facilities and discontinuing production in a number of others that cannot support more advanced technology
platforms or products. We also planned to lower overhead costs across our support organizations. During fiscal 2004 second quarter ended December 31, 2003, we announced the divestiture or discontinuation of certain of our commodity products totaling approximately $100 million of annual revenues, to further focus our resources on value-added opportunities.
We estimate that charges associated with the restructuring will be approximately $234 million. These charges will consist of approximately $189 million for asset impairment, plant closure costs and other charges, $6 million of raw material and work-in-process inventory, and approximately $39 million for severance. Of the $234 million in total charges, we expect cash charges to be approximately $60 million. As of June 30, 2004, we have achieved approximately $65 million in annualized savings from the restructuring activities and expect to realize annualized savings of over $70 million by calendar year-end 2004, with approximately 70 percent of that savings affecting cost of goods sold.
For the fiscal year ended June 30, 2004, we recorded $33.5 million in total charges, consisting of: $15.2 million for asset impairment, plant closure costs and other charges and $18.3 million for severance-related costs. For the fiscal year ended June 30, 2003, we recorded $193.9 million in total restructuring-related charges, consisting of: $169.7 million for asset impairment, plant closure costs and other charges, $6.0 million for raw material and work-in-process inventory charges, and $18.2 million for severance-related costs. Restructuring-related costs were charged in accordance with SFAS No. 146, "Accounting for the Costs Associated with Exit or Disposal Activities". Asset impairments were calculated in accordance with SFAS No. 144. In determining the asset groups, we grouped assets at the lowest level for which independent identifiable cash flows information was available. In determining whether an asset was impaired we evaluated undiscounted future cash flows and other factors such as changes in strategy and technology. The undiscounted cash flows from our initial analyses were less than the carrying amount for certain of the asset groups, indicating impairment losses. Based on this, we determined the fair value of these asset groups using the present value technique, by applying a discount rate to the estimated future cash flows that is consistent with the rate used when analyzing potential acquisitions.
As of June 30, 2004, we had recorded $227.4 million in total charges, consisting of: $184.8 million for asset impairment, plant closure costs and other charges, $6.0 million for raw material and work-in-process inventory charges, and $36.6 million for severance-related costs. Components of the $184.8 million asset impairment, plant closure and other charges included the following items:
•As we emphasize more advanced generation planar products, we expect the future revenue stream from our less advanced facilities in Temecula, California to decrease significantly. These facilities had a net book value of $138.3 million and were written down by $77.7 million. It is expected that these facilities will continue in use until approximately December 2007 and the remaining basis is being depreciated over units of production during this period. It is assumed that salvage value will equal disposition costs.
•As we emphasize more advanced generation trench products, we expect the future revenue stream from our less advanced facility in El Segundo, California to decrease significantly. This facility had a net book value of $59.5 million and was written down by $57.2 million. This facility had significantly reduced production as of fiscal year-end 2003 and 2004, and is being used primarily for research and development activities.
•As we emphasize more advanced generation Schottky products, we expect the future revenue stream from our less advanced facility in Borgaro, Italy to decrease significantly. This facility had a net book value of $20.5 million and was written down by $13.5 million. It is expected that this facility will continue in use until approximately December 2007 and the remaining basis is being depreciated over units of production during this period. It is assumed that salvage value will equal disposition costs.
•We are in the process of restructuring our manufacturing activities in Europe, which included a review of our Swansea, Wales facility, a general-purpose module facility. Based on a review, we determined that this facility would be better suited to focus only on automotive applications. The general-purpose assembly assets in this facility, with a net book value of $13.6 million, were written down by $8.2 million. In addition, we are moving most manufacturing activities at our recently acquired automotive facility in Krefeld, Germany to our Swansea, Wales and Tijuana, Mexico facilities. We expect the move to be completed by fiscal second quarter 2005.
We have also moved the majority of the production from our Veneria, Italy facility to our Mumbai, India facility, which was completed as of December 31, 2003. We stopped manufacturing activities in our Oxted, England facility as of September 30, 2003, and the remaining inventory was transferred to our Tijuana, Mexico assembly facility.
•We have eliminated the manufacturing of our non-space products in our Santa Clara, California facility as of July 31, 2004. Going forward, subcontractors will handle our non-space qualified products formerly manufactured in this facility. We are also transitioning certain assembly of government and space products from our Leominster, Massachusetts facility to our Tijuana, Mexico facility. Associated with this reduction in manufacturing activities, certain assets with a net book value of $4.0 million were written down by $2.0 million.
•$26.2 million in other miscellaneous items were charged, including $19.3 million in relocation costs and other impaired asset charges and $6.9 million in contract termination and settlement costs.
As a result of the restructuring initiatives, certain raw material and work-in-process inventories were impaired, including products that could not be completed in other facilities, materials that were not compatible with the processes used in the alternative facilities, and materials such as gases and chemicals that could not readily be transferred. Based on these factors we wrote down these inventories, with a carrying value of $98.2 million, by $6.0 million. As of June 30, 2004 and 2003, we had disposed of $3.0 million and $2.6 million, respectively, of these inventories, which did not have a material impact on gross margin for the fiscal years then ended.
Our restructuring activities are expected to result in severance charges of approximately $39 million through December 2004. Below is a table of approximate severance charges by major activity and location:
To date, of the $39 million noted above, we have recorded $36.6 million in severance-related charges: $31.5 million in severance termination costs related to approximately 1,054 administrative, operating and manufacturing positions, and $5.1 million in pension termination costs at our manufacturing facility in Oxted, England. For the years ended June 30, 2004 and 2003, we recorded $15.5 million and $15.9 million, respectively, in severance termination costs and $2.8 million and $2.3 million, respectively, in pension termination costs. The severance charges associated with the elimination of positions, which included the 1,054 persons notified to date, had been and will continue to be recognized ratably over the future service period, as applicable, in accordance with SFAS No. 146,
"Accounting for the Costs Associated with Exit or Disposal Activities". We measured the total termination benefits at the communication date based on the fair value of the liability as of the termination date. A change resulting from a revision to either the timing or the amount of estimated cash over the future service period will be measured using the credit-adjusted risk-free rate that was used to initially measure the liability. The cumulative effect of the change will be recognized as an adjustment to the liability in the period of the change.
In fiscal 2003, we had recorded an estimated $5.1 million in severance costs associated with the acquisition of TechnoFusion GmbH in Krefeld, Germany. In fiscal 2004, we finalized our plan and determined that total severance would be approximately $10 million, and accordingly, we adjusted purchased goodwill by $4.8 million. We communicated the plan and the elimination of approximately 250 positions primarily in manufacturing to its affected employees at that time. The associated severance is expected be paid by fiscal second quarter 2005.
The following summarizes our severance accrued related to the TechnoFusion acquisition and the December 2002 restructuring plan for the fiscal years ended June 30, 2004 and 2003. Severance activity related to the elimination of 29 administrative and operating personnel as part of the previously reported restructuring in the fiscal quarter ended June 30, 2001, is also disclosed. The remaining June 2001 severance relates primarily to certain legal accruals associated with that restructuring, which will be paid or released as the outcome is determined (in thousand's):
Other Income and Expenses
Other income (expense) was $5.0 million and $(0.02) million for the twelve months ended June 30, 2004 and 2003, respectively. For the twelve months ended June 30, 2004, we recognized $5.9 million in one-time pretax gains from the Hitachi settlement, net of legal costs and related expenses, partially offset by $1.3 million in litigation accruals (see Note 13, "Litigation").
Interest Income and Expenses
Interest income was $14.2 million and $20.4 million for the twelve months ended June 30, 2004 and 2003, respectively. The decrease in income reflected lower prevailing interest rates in the current year.
Interest expense was $16.0 million and $19.7 million for the twelve months ended June 30, 2004 and 2003, respectively. The decrease in current period expense primarily reflected lower effective interest rate payable on our $550 million convertible debt (the "debt") outstanding. In December 2002 of fiscal 2003, we modified the fixed rate payable on the debt from 4.25 percent to a variable LIBOR rate for $412.5 million of the balance outstanding. In April 2004, we modified the fixed rate payable on the remaining $137.5 million to a variable LIBOR rate (see Note 3, "Derivative Financial Instruments").
Income Taxes
Our effective tax provision for the twelve months ended June 30, 2004 and 2003, was 24.1 percent and 24.0 percent, respectively, rather than the expected U.S. federal statutory tax provision of 35 percent, as a result of lower statutory tax rates in certain foreign jurisdictions, the benefit of foreign tax credits and research and development credits; partially offset by state taxes and certain foreign losses without foreign tax benefit.
Fiscal 2003 Compared with Fiscal 2002
Revenues
Revenues for fiscal 2003 were $864.4 million, versus $720.2 million in fiscal 2002. Fiscal 2003 revenues reflected the growth of what we categorize as our proprietary products and the upturn in the semiconductor industry. Royalties contributed $42.0 million to revenues, compared to $47.6 million in fiscal 2002. For the twelve months ended June 30, 2003, Semiconductor Industry Association data showed a 17 percent growth in semiconductor industry revenues for the business in which we operate, while IR's revenues increased by 20 percent during this period.
Revenues from our proprietary products increased by 37 percent compared to the prior fiscal year. These revenues comprised 58 percent of product revenues for the fourth quarter of fiscal 2003, compared to 50 percent in the comparable prior year period. Our proprietary products refer to our Analog ICs, Power Systems and Advanced Circuit Devices. These products are value-added or are provided under reduced competition due to their technological content or our customer relationship.
Revenues from sales to original equipment manufacturers ("OEMs") grew by 34 percent from fiscal 2002, accounting for 69 percent of fiscal 2003 product revenues, compared to 63 percent for fiscal 2002. We also classify revenues from sales to OEMs by end-market applications. Compared to the prior year, revenues from all end-market applications grew. Fiscal 2003 performance in end-market applications is as follows:
•The information technology sector comprised approximately 35 percent of sales to OEMs for fiscal 2003. Revenues from this sector grew 36 percent from fiscal 2002. This increase reflected greater content, the introduction of Intel's Centrino™ and Pentium M™ based products, and an increase in market share.
•The automotive sector comprised approximately 26 percent of sales to OEMs for fiscal 2003. Revenues from this sector grew by 69 percent from fiscal 2002. The revenue increase reflected new programs and the acquisition of TechnoFusion GmbH. TechnoFusion contributed $41.7 million and $7.5 million in automotive revenues for the twelve months ended June 30, 2003 and 2002, respectively.
•The consumer sector comprised approximately 17 percent of sales to OEMs for fiscal 2003. Revenues from this sector increased by 22 percent from fiscal 2002, reflecting the success of energy-efficient appliances and plasma HDTV.
•The defense/aerospace sector comprised approximately 13 percent of sales to OEMs for fiscal 2003. Revenues from this sector grew 13 percent from fiscal 2002, primarily as a result of new programs including advanced aircraft, global positioning satellites and smart weaponry.
•The industrial sector comprised approximately eight percent of sales to OEMs for fiscal 2003. Revenues from this sector increased 11 percent from fiscal 2002.
Our sales to distributors remained relatively unchanged from fiscal 2002, up two percent in fiscal 2003. However, distributors' sales of our products to their end customers increased 11 percent over the same period. Inventories at our distributors decreased by over 12 percent from fiscal 2002, and over 30 percent from the peak in fiscal 2001.
Orders for proprietary products increased 37 percent from fiscal 2002, and represented 57 percent of total bookings. We continue to secure new designs for our proprietary products and to expand proprietary product content in target applications.
Gross Profit Margin
For the twelve months ended June 30, 2003 and 2002, gross profit was $287.8 million and $256.9 million (33.3% and 35.7% of revenues), respectively. Compared to the prior year, the gross profit margin decline primarily reflected continued price pressure on multi-market components. For example, the average selling price of our HEXFET® products, which accounted for approximately 60 percent of our fiscal 2003 component product sales, decreased by approximately 10 percent compared to fiscal 2002. The decline in gross margin from the prior year was partially offset by more stable pricing of our proprietary products.
Selling and Administrative Expenses
For the twelve months ended June 30, 2003, selling and administrative expense was 16.5 percent of revenues, compared to 17.4 percent of revenues in the twelve months ended June 30, 2002. The decline in the selling and administrative expense ratio primarily reflected a higher revenue base in fiscal 2003 and efforts to keep selling and administrative expenses down in light of the growth in revenue base. Absolute selling and administrative expenditures were $142.5 million for the current fiscal year, compared to $125.6 million in the comparable prior-year period. The increase primarily reflected selling commissions paid on a higher revenue base.
Research and Development Expenses
For the twelve months ended June 30, 2003 and 2002, research and development expense was 9.1 percent and 9.7 percent of revenues, respectively. Absolute research and development expenditures were $78.9 million and $69.8 million for the twelve months ended June 30, 2003 and 2002, respectively, reflecting increased development activities focused primarily on proprietary products.
Amortization of Acquisition-Related Intangible Assets
For the twelve months ended June 30, 2003 and 2002, amortization of acquisition-related intangible assets was $5.4 million and $4.1 million, respectively. The increase reflected the acquisition of TechnoFusion at fiscal year-end 2002.
Other Income and Expenses
In fiscal 2002, we reached an insurance settlement for equipment that was damaged at one of our wafer fabrication lines (see Note 7, "Insurance Claim"). For the twelve months ended June 30, 2003 and 2002, we recognized a $2.4 million and $7.4 million net gain on the settlement, respectively, which had been included in other income and expenses.
Fiscal 2003's gain from the insurance settlement was partially offset by a net foreign currency loss of $1.6 million. Fiscal 2002's gain was partially offset by litigation and claims settlements of $3.7 million and a net foreign currency loss of $1.2 million.
Interest Income and Expenses
Interest income was $20.4 million and $28.6 million for the twelve months ended June 30, 2003 and 2002, respectively. The decrease in income reflected lower prevailing interest rates in the current year.
Interest expense was $19.7 million and $22.1 million for the twelve months ended June 30, 2003 and 2002, respectively. The decrease in expense reflected primarily realized savings from lower variable rate resulting from the interest rate swap transaction with JP Morgan Chase Bank, as well as lower prevailing interest rates in the current year, partially offset by increase in expense from the Lehman Brothers interest rate contract (see Note 3, "Derivative Financial Instruments").
Income Taxes
Our effective tax benefit for the twelve months ended June 30, 2003 was approximately 29 percent, rather than the expected U.S. federal statutory tax benefit of 35 percent, as a result of restructuring charges, state taxes, higher statutory tax rates in certain foreign jurisdictions and certain foreign losses without foreign tax benefit; partially offset by foreign tax credits and research and development credits.
Our effective tax rate for the twelve months ended June 30, 2002 was 26 percent, rather than the U.S. federal statutory tax rate of 35 percent. The lower effective tax rate reflected foreign tax credits and research and development credits, partially offset by higher statutory tax rates in certain foreign jurisdictions and certain foreign losses without foreign tax benefit.
Liquidity and Capital Resources
At June 30, 2004, we had cash and cash equivalent balances of $439.6 million and cash investments in marketable debt securities of $396.6 million. Our cash, cash equivalents, cash investments in marketable debt securities and unused credit facilities of $133.7 million, totaled $969.9 million. Our investment portfolio consists of available-for-sale fixed income, investment-grade securities which we have managed to obtain effective maturities of no longer than 24 months as of June 30, 2004.
During fiscal 2004, operating activities generated cash flow of $163.0 million compared to $129.5 million in the prior year period. Cash flow from operations included $62.5 million of depreciation and amortization and $15.7 million of tax benefit from options exercised for the twelve months ended. Changes in operating assets and liabilities increased cash by $10.5 million for the twelve months ended June 30, 2004. The increase in working capital was primarily attributable to a decrease in inventory resulting from improvements in inventory management and market conditions and the timing of accrued taxes and salaries and wages payable, partially offset by lower accounts payable due to timing and higher accounts receivable as a result of a higher revenue base.
During fiscal 2004, cash used in investing activities totaled $113.3 million. Proceeds from sales or maturities of cash investments were $534.2 million while purchases were $566.0 million. We invested $86.2 million in capital expenditures primarily related to upgrading wafer manufacturing capabilities and increasing assembly capacity. We continue to invest in both personnel and facilities to support our growth, among other areas, in Asia/Pacific, our largest and fastest growing region, including breaking ground on a new assembly and test facility in X'ian, China. Additionally at June 30, 2004, we had purchase commitments for capital expenditures of approximately $11.3 million primarily at our Newport facility. We purchased this facility in fiscal 2002 near the bottom of the last market cycle. At the time of acquisition, one of the two fabrication lines there was idle. In the fourth quarter fiscal 2004, we began recommissioning the idled line and expect first production wafers by July 2005. We intend to fund capital expenditures and working capital requirements through cash and cash equivalents on hand, anticipated cash flow from operations and available credit facilities.
In July 2004 subsequent to fiscal year-end, we acquired the specialty silicon epitaxial services assets from Advanced Technology Materials, Inc. for approximately $41 million in cash, which may be reduced by $3 million, pending the qualification of certain processes transferred as part of the transaction.
Financing activities during fiscal 2004 generated $43.4 million. Proceeds from issuance of common stock and exercise of stock options contributed $44.2 million in cash. As of June 30, 2004, we had revolving, equipment and foreign credit facilities of $166.9 million, against which $33.3 million had been used. As discussed in Note 3, "Derivative Financial Instruments", we are required to obtain irrevocable standby letters of credit in favor of JP Morgan Chase Bank, for $11.5 million plus the collateral requirement for the December 2002 and April 2004 interest rate swap transactions, as determined periodically. At June 30, 2004, $11.5 million in letters of credit were outstanding related to these transactions. The collateral requirement of the transactions may be adversely affected by an increase in the five-year LIBOR curve, a decrease in our stock price, or both. We cannot predict what the collateral requirement of the transactions and the letter of credit requirement will be over time. To illustrate the potential impact, had a 10 percent increase in the five-year LIBOR curve and a 10 percent decrease in our stock price occurred at the close of the fiscal quarter, our letter of credit commitment would have been the minimum amount required of $11.5 million.
We lease certain of our administrative, research and development and manufacturing facilities, regional sales/service offices and certain equipment under non-cancelable operating and capital leases. As of June 30, 2004, the following lists our contractual obligations for the next five years:
We believe that our current cash and cash investment balances, cash flows from operations and borrowing capacity, including unused amounts under the $150 million Credit Facility with BNP Paribas (see Note 4, Bank Loans and Long-Term Debt), will be sufficient to meet our currently foreseeable operating cash requirements and to take advantage of strategic opportunities as they occur in the next twelve months. Although we believe that our current financial resources will be sufficient for normal operating activities, we may also consider the use of funds from other external sources, including, but not limited to, public or private offerings of debt or equity.
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46") which is an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FIN 46 requires a variable interest entity (VIE) to be consolidated by a company that is considered to be the primary beneficiary of that VIE. In December 2003, the FASB issued FIN No. 46 (revised December 2003), "Consolidation of Variable Interest Entities" ("FIN 46-R") to address certain FIN 46 implementation issues. The effective dates and impact of FIN 46 and FIN 46-R for our consolidated financial statements are as follows:
(1)Special purpose entities ("SPEs") created prior to February 1, 2003: We must apply either the provisions of FIN 46 or early adopt the provisions of FIN 46-R at the end of the first interim reporting period ended December 31, 2003.
(2)Non-SPEs created prior to February 1, 2003: We are required to adopt FIN 46-R at the end of the first interim reporting period ended March 31, 2004.
(3)All entities, regardless of whether a SPE, that were created subsequent to January 31, 2003: We are required to apply the provisions of FIN 46 unless we elect to early adopt the provisions of FIN 46-R as of the first interim reporting period ended March 31, 2004. If we do not elect to early adopt FIN 46-R, then we are required to apply FIN 46-R to these entities as of the end of the first interim reporting period ended March 31, 2004. The adoption of FIN 46 and FIN 46-R did not have a material effect on our financial condition, results of operations and cash flows.
Critical Accounting Policies and Estimates
Revenue Recognition
In accordance with Staff Accounting Bulletin No. 101, "Revenue Recognition", we recognize revenue when the evidence of an arrangement exists, pricing is fixed and determinable, collection is reasonably assured, and delivery or performance of service has occurred. We recognize the majority of revenues upon shipment for product sales to all customers, including distributors, with provisions for estimated returns and allowances recorded at the time of shipment. Certain customers have limited rights of returns and price protection programs. We continuously monitor product returns and potential price adjustments and record a provision for these based on notification we receive of pending credits and historical experience. While such credits have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same predictability in estimating returns and allowances. If the historical data and estimates we used to calculate these provisions do not properly reflect future activity, our net sales, gross profit, net income and earnings per share could be impacted.
Certain of our customers' contracts contain substantive acceptance provisions. In such circumstances, we recognize revenue in accordance with specific contract acceptance provisions, in most instances upon customer inspection or upon delivery of proof of conformance to customer specifications. We also maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required.
Inventories
Inventories are stated at the lower of cost (principally first-in, first-out) or market. Inventories are reviewed for excess and obsolescence based upon demand forecasts within a specific time horizon and reserves are established accordingly.
Long-Lived Assets
Long-lived assets are net property, plant and equipment and intangible assets. We test long-lived assets for impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Such events and circumstances include, but are not limited to:
•A significant change in business strategy or in the extent or manner for which the asset is being used or in its physical condition;
•A significant negative change in the business climate, industry conditions, economic conditions or market value of an asset; and
•Current period operating losses or negative cash flow combined with a history of similar losses or a forecast that indicates continuing losses associated with the use of an asset.
We evaluate the recoverability of long-lived assets based on the expected undiscounted cash flows for their asset group as determined in accordance with SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets", without regard to taxes. Impairments, if any, are recognized based upon the fair value of the assets. Fair value is based upon a discounted cash flow analysis. We use the undiscounted cash flows and apply an appropriate discount rate that is representative of the discount rate we use when evaluating potential acquisitions.
In developing our cash flow projections, we use revenue and cost assumptions based on current levels adjusted for anticipated future market conditions. If these market conditions do not materialize, our cash flow forecasts could be materially impacted.
Goodwill and Acquisition-Related Intangible Assets
We classify the difference between the purchase price and the fair value of net assets acquired at the date of acquisition as goodwill. We classify intangible assets apart from goodwill if the assets have contractual or other legal rights or if the assets can be separated and sold, transferred, licensed, rented or exchanged. Depending on the nature of the assets acquired, the amortization period may range from four to twelve years for those acquisition-related intangible assets subject to amortization. We evaluate the carrying value of goodwill and acquisition-related intangible assets, including the related amortization period, in the fourth quarter of each fiscal year. In evaluating goodwill and intangible assets not subject to amortization, we compare the total carrying value of goodwill and intangible assets not subject to amortization to our fair value as determined by our market capitalization. In evaluating intangible assets subject to amortization, we assess the carrying value of each intangible asset in accordance with SFAS No. 144.
Derivative Financial Instruments
Our primary objectives for holding derivative financial instruments are to take advantage of the current low interest rate environment and hedge non-U.S. currency risks. Our derivative instruments are recorded at fair value and are included in other current assets, other long-term assets or long-term debt. Our accounting policies for derivative financial instruments are based on our criteria for designation as hedging transactions, either as cash flow or fair value hedges as defined by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS No. 133" and SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". A cash flow hedge refers to the hedge of the exposure to variability in the cash flows of an asset or a liability, or of a forecasted transaction. A fair value hedge refers to the hedge of the exposure to changes in fair value of an asset or a liability, or of an unrecognized firm commitment. The criteria for designating a derivative as a hedge include the instrument's effectiveness in risk reduction and, in most cases, a one-to-one matching of the derivative instrument to its underlying transaction. We recognize gains and losses on derivatives that are not designated as hedges for accounting purposes currently in earnings. These gains and losses generally offset changes in the values of hedged assets, liabilities or debt.
For currency forward contracts, we measure the effectiveness of the hedge using forward rates to value the forward contract and the forward value of the underlying hedged transaction. For interest rate swaps, we measure the effectiveness using regression analysis, which offsets the change in fair value of the long-term debt with the change in fair value of the interest rate swap.
We recognize in current period's interest and other income and expense, depending on the nature of the underlying asset or liability, the ineffective portions of the hedge, as well as, the amounts not included in the assessment of effectiveness. If we determined that the original hedged transaction probably will not occur as anticipated, and a cash flow hedge is to be discontinued, we would reclassify the unrealized gains or losses into earnings. We would recognize subsequent gains or losses on the
related derivative instrument in income in each period until the instrument matures, is terminated or is sold.
Stock-Based Compensation
We account for stock-based compensation plans using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." In accordance with SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-An Amendment of SFAS No. 123", we disclose the pro forma effects of recording stock-based employee compensation plans at fair value on "net income (loss)" and "net income (loss) per common share-basic and diluted" as if the compensation expense was recorded in the financial statements. Had we recorded the compensation expense, "net income (loss)" and "net income (loss) per common share-basic and diluted", as compared to the actual reported amounts, would approximate the following (in thousand's, except per share data):
The effects of applying SFAS No. 123 in this pro forma disclosure are not indicative of future amounts. SFAS No. 123 does not apply to awards prior to 1996.
Statement of Caution Under the Private Securities Litigation Reform Act of 1995
This Form 10-K Report includes some statements and other information that are not historical facts but are "forward-looking statements" as that term is defined in the Private Securities Litigation Reform Act of 1995. The materials presented can be identified by the use of forward-looking terminology such as "anticipate," "believe," "estimate," "expect," "may," "should," "view," or "will" or the negative or other variations thereof. We caution that such statements are subject to a number of uncertainties, and actual results may differ materially. Factors that could affect our actual results include those set forth below under "Factors that May Affect Future Results" and other uncertainties disclosed in our reports filed from time to time with the Securities and Exchange Commission.
Factors That May Affect Future Results
Downturns in the highly cyclical semiconductor industry or changes in end market demand could affect our operating results and the value of our business.
The semiconductor industry is highly cyclical and the value of our business may decline during the "down" portion of these cycles. We have experienced these conditions in our business in the recent past, while we appear to be at the end of a significant and prolonged downturn, we cannot predict when we may experience such downturns in the future. Future downturns in the semiconductor industry, or any failure of the industry to recover fully from its recent downturns could seriously impact our revenues and harm our business, financial condition and results of operations. Although markets for semiconductors appear to be improving, we cannot assure you that they will continue to improve or
that our markets will not experience renewed, possibly more severe and prolonged, downturns in the future.
In addition, we may experience significant changes in our profitability as a result of variations in sales, seasonality, changes in product mix, price competition for orders and the costs associated with the introduction of new products. The markets for our products depend on continued demand in the communications, consumer electronics, information technology, automotive, industrial and government/space markets, and these end markets may experience changes in demand that could adversely affect our operating results and financial condition.
The failure to implement, as well as the completion and impact of, our restructuring programs and cost reductions could adversely affect our business.
In December 2002, we announced a number of restructuring initiatives. Our goal was to reposition our company to better fit the market conditions, de-emphasize our commodity business and accelerate the move to what we categorize as our proprietary products. The restructuring includes consolidating and closing certain manufacturing sites, upgrading equipment and processes in designated facilities and discontinuing production in a number of others that cannot support more advanced technology platforms or products. The restructuring also includes lowering overhead costs across our support organization. We cannot assure you that these restructuring initiatives will achieve their goals or accomplish the cost reductions planned. Additionally, because our restructuring activities involve changes to many aspects of our business, the costs reductions could adversely affect productivity and sales to an extent we have not anticipated. Even if we fully execute and implement these restructuring activities, and they generate the anticipated cost savings, there may be other unforeseen factors that could adversely impact our profitability and business.
If we are unable to implement our business strategy, our revenues and profitability may be adversely affected.
Our future financial performance and success are largely dependent on our ability to implement our business strategy successfully of transforming our business to one led by our proprietary products. We cannot assure you that we will successfully implement our business strategy or that implementing our strategy will sustain or improve our results of operations.
The semiconductor business is highly competitive and increased competition could reduce the value of an investment in our company.
The semiconductor industry, including the sector in which we do business, is highly competitive. Competition is based on price, product performance, product availability, quality, reliability and customer service. Price pressures may emerge as competitors attempt to gain a greater market share by lowering prices. We compete in various markets with companies of various sizes, many of which are larger and have greater financial and other resources than we have, and thus they may be better able to pursue acquisition candidates and to withstand adverse economic or market conditions. In addition, companies not currently in direct competition with us may introduce competing products in the future.
New technologies could result in the development of new products and a decrease in demand for our products, and we may not be able to develop new products to satisfy changes in demand.
Our failure to develop new technologies or react to changes in existing technologies could materially delay our development of new products, which could result in decreased revenues and a loss of market share to our competitors. Rapidly changing technologies and industry standards, along with frequent new product introductions, characterize the semiconductor industry. As a result, we must devote significant resources to research and development. Our financial performance depends on our ability to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. We cannot assure you that we will successfully identify new product opportunities and develop and bring new products to market in a timely and
cost-effective manner, or that products or technologies developed by others will not render our products or technologies obsolete or noncompetitive. A fundamental shift in technologies in our product markets could have a material adverse effect on our competitive position within the industry. In addition, to remain competitive, we must continue to reduce die sizes and improve manufacturing yields. We cannot assure you that we can accomplish these goals.
Our failure to obtain or maintain the right to use certain technologies may negatively affect our financial results.
Our future success and competitive position may depend in part upon our ability to obtain or maintain certain proprietary technologies used in our principal products, which is achieved in part by defending and maintaining the validity of our patents and defending claims by our competitors of intellectual property infringement. We license certain patents owned by others. We have also been notified that certain of our products may infringe the patents of third parties. Although licenses are generally offered in such situations, we cannot eliminate the risk of litigation alleging patent infringement. We are currently a defendant in intellectual property claims and we could become subject to other lawsuits in which it is alleged that we have infringed upon the intellectual property rights of others.
Our involvement in existing and future intellectual property litigation could result in significant expense, adversely affect sales of the challenged product or technologies and divert the efforts of our technical and management personnel, whether or not such litigation is resolved in our favor. If any such infringements exist, arise or are claimed in the future, we may be exposed to substantial liability for damages and may need to obtain licenses from the patent owners, discontinue or change our processes or products or expend significant resources to develop or acquire non-infringing technologies. We cannot assure you that we would be successful in such efforts or that such licenses would be available under reasonable terms. Our failure to develop or acquire non-infringing technologies or to obtain licenses on acceptable terms or the occurrence of related litigation itself could have a material adverse effect on our operating results and financial condition.
Our ongoing protection and reliance on our intellectual property assets expose us to risks.
We have traditionally relied on our patents and proprietary technologies. Patent litigation settlements and royalty income substantially contribute to our financial results. Enforcement of our intellectual property rights is costly, risky and time-consuming. We cannot assure you that we can successfully continue to protect our intellectual property rights, especially in foreign markets. Our key MOSFET patents expire between 2004 and 2010, although our broadest MOSFET patents expire in 2007 and 2008. Our royalty income is largely dependent on the following factors: the remaining terms of our MOSFET patents; the continuing introduction and acceptance of products that are not covered by our patents; remaining covered under unexpired MOSFET patents; the defensibility and enforceability of our patents; changes in our licensees' unit sales, prices or die sizes; and the terms, if any, upon which expiring license agreements are renegotiated. Market conditions and mix of licensee products, as well as sales of non-infringing devices can significantly affect royalty income. Any decrease in our royalty income could have a material adverse effect on our operating results and financial condition.
Our international operations expose us to material risks.
We expect revenues from foreign markets to continue to represent a significant portion of total revenues. We maintain or contract with significant operations in foreign countries. Among others, the following risks are inherent in doing business internationally: changes in, or impositions of, legislative or regulatory requirements, including tax laws in the United States and in the countries in which we manufacture or sell our products; trade restrictions; transportation delays; work stoppages; economic and political instability; and foreign currency fluctuations.
In addition, it is more difficult in some foreign countries to protect our products or intellectual property rights to the same extent as is possible in the United States. Therefore, the risk of piracy or misuse of our technology and products may be greater in these foreign countries. Although we have not experienced any material adverse effect on our operating results as a result of these and other factors, we cannot assure you that such factors will not have a material adverse effect on our financial condition and operating results in the future.
Delays in initiation of production at new facilities, implementing new production techniques or resolving problems associated with technical equipment malfunctions could adversely affect our manufacturing efficiencies.
Our manufacturing efficiency will be an important factor in our future profitability, and we cannot assure you that we will be able to maintain or increase our manufacturing efficiency to the same extent as our competitors. Our manufacturing processes are highly complex, require advanced and costly equipment and are continuously being modified in an effort to improve yields and product performance. Impurities, defects or other difficulties in the manufacturing process can lower yields.
In addition, as is common in the semiconductor industry, we have from time to time experienced difficulty in beginning production at new facilities or in effecting transitions to new manufacturing processes. As a consequence, we have experienced delays in product deliveries and reduced yields. We may experience manufacturing problems in achieving acceptable yields or experience product delivery delays in the future as a result of, among other things, capacity constraints, construction delays, upgrading or expanding existing facilities or changing our process technologies, any of which could result in a loss of future revenues. Our operating results could also be adversely affected by the increase in fixed costs and operating expenses related to increases in production capacity if revenues do not increase proportionately.
Interruptions, delays or cost increases affecting our materials, parts or equipment may impair our competitive position and our operations.
Our manufacturing operations depend upon obtaining adequate supplies of materials, parts and equipment, including silicon, mold compounds and leadframes, on a timely basis from third parties. Our results of operations could be adversely affected if we were unable to obtain adequate supplies of materials, parts and equipment in a timely manner or if the costs of materials, parts or equipment increase significantly. From time to time, suppliers may extend lead times, limit supplies or increase prices due to capacity constraints or other factors. We have a limited number of suppliers for some materials, parts and equipment, and any interruption could materially impair our operations.
We manufacture a substantial portion of our wafer product at our Temecula, California and Newport, Wales facilities. Any disruption of operations at those facilities could have a material adverse effect on our business, financial condition and results of operations.
Also, some of our products are assembled and tested by third party subcontractors. We do not have any long-term assembly agreements with these subcontractors. As a result, we do not have immediate control over our product delivery schedules or product quality. Due to the amount of time often required to qualify assemblers and testers and the high cost of qualifying multiple parties for the same products, we could experience delays in the shipment of our products if we are forced to find alternative third parties to assemble or test them. Any product delivery delays in the future could have a material adverse effect on our operating results and financial condition. Our operations and ability to satisfy customer obligations could be adversely affected if our relationships with these subcontractors were disrupted or terminated.
We must commit resources to product manufacturing prior to receipt of purchase commitments and could lose some or all of the associated investment.
We sell products primarily pursuant to purchase orders for current delivery or to forecast, rather than pursuant to long-term supply contracts. Many of these purchase orders or forecasts may be revised or canceled without penalty. As a result, we must commit resources to the manufacturing of products without any advance purchase commitments from customers. Our inability to sell products after we devote significant resources to them could have a material adverse effect on our levels of inventory and our business, financial condition and results of operations.
We receive a significant portion of our revenues from a small number of customers and distributors.
Historically, a significant portion of our revenues has come from a relatively small number of customers and distributors. The loss or financial failure of any significant customer or distributor, any reduction in orders by any of our significant customers or distributors, or the cancellation of a significant order, could materially and adversely affect our business.
We may fail to attract or retain the qualified technical, sales, marketing and managerial personnel required to operate our business successfully.
Our future success depends, in part, upon our ability to attract and retain highly qualified technical, sales, marketing and managerial personnel. Personnel with the necessary semiconductor expertise are scarce and competition for personnel with these skills is intense. We cannot assure you that we will be able to retain existing key technical, sales, marketing and managerial employees or that we will be successful in attracting, assimilating or retaining other highly qualified technical, sales, marketing and managerial personnel in the future. If we are unable to retain existing key employees or are unsuccessful in attracting new highly qualified employees, our business, financial condition and results of operations could be materially and adversely affected.
We are acquiring and may continue to acquire other companies and may be unable to successfully integrate such companies with our operations.
We have acquired several companies over the past three years. We may continue to expand and diversify our operations with additional acquisitions. If we are unsuccessful in integrating these companies with our operations, or if integration is more difficult than anticipated, we may experience disruptions that could have a material adverse effect on our business, financial condition and results of operations.
Our products may be found to be defective, claims may be asserted against us and we may not have sufficient insurance.
One or more of our products may be found to be defective after we have already shipped the products in volume, requiring a product replacement or recall. We may also be subject to product returns that could impose substantial costs and have a material and adverse effect on our business, financial condition and results of operations.
Product liability or commercial claims may be asserted with respect to our products. Although we currently have product liability or commercial insurance for certain types of losses, we cannot assure you that we have obtained sufficient insurance coverage for all types of commercial or other losses, that we will have sufficient insurance coverage in the future or that we will have sufficient resources to satisfy any claims.
Large potential environmental liabilities, including those relating to a former operating subsidiary, may adversely impact our financial position.
Federal, state, foreign and local laws and regulations impose various restrictions and controls on the discharge of materials, chemicals and gases used in our semiconductor manufacturing processes. In addition, under some laws and regulations, we could be held financially responsible for remedial
measures if our properties are contaminated or if we send waste to a landfill or recycling facility that becomes contaminated, even if we did not cause the contamination. Also, we may be subject to common law claims if we release substances that damage or harm third parties. Further, we cannot assure you that changes in environmental laws or regulations will not require additional investments in capital equipment or the implementation of additional compliance programs in the future. Any failure to comply with environmental laws or regulations could subject us to serious liabilities and could have a material adverse effect on our operating results and financial condition.
Some of our facilities are located near major earthquake fault lines.
Our corporate headquarters, one of our manufacturing facility, one of our research facility and certain other critical business operations are located near major earthquake fault lines. We could be materially and adversely affected in the event of a major earthquake. Although we maintain earthquake insurance, we can give you no assurance that we have obtained or will maintain sufficient insurance coverage.
There can be no assurance that we will have sufficient capital resources to make necessary investments in manufacturing technology and equipment.
The semiconductor industry is capital intensive. Semiconductor manufacturing requires a constant upgrading of process technology to remain competitive, as new and enhanced semiconductor processes are developed which permit smaller, more efficient and more powerful semiconductor devices. We maintain certain of our own manufacturing, assembly and test facilities, which have required and will continue to require significant investments in manufacturing technology and equipment. There can be no assurance that we will have sufficient capital resources to make necessary investments in manufacturing technology and equipment. Although we believe that anticipated cash flows from operations, existing cash reserves and other equity or debt financings that we may obtain will be sufficient to satisfy our future capital expenditure requirements, there can be no assurance that this will be the case or that alternative sources of capital will be available to us on favorable terms or at all.
Final outcomes from the various tax authorities' audits are difficult to predict and an unfavorable finding may negatively impact the financial results.
We are currently under audit by various taxing authorities. It is often difficult to predict the final outcome or the timing of resolution of any particular tax matter. We have provided certain tax reserves which have been included in the determination of our financial results. However, unpredicted unfavorable settlement may require additional cash and negatively impact our financial position and results of operations.
Terrorist attacks, such as those that took place on September 11, 2001, or threats or occurrences of other terrorist activities whether in the United States or internationally may affect the markets in which our common stock trades, the markets in which we operate and our profitability.
Terrorist attacks, such as those that took place on September 11, 2001, or threats or occurrences of other terrorist or related activities, whether in the United States or internationally, may affect the markets in which our common stock trades, the markets in which we operate and our profitability. Future terrorist or related activities could affect our domestic and international sales, disrupt our supply chains and impair our ability to produce and deliver our products. Such activities could affect our physical facilities or those of our suppliers or customers, and make transportation of our supplies and products more difficult or cost prohibitive. Due to the broad and uncertain effects that terrorist attacks have had on financial and economic markets generally, we cannot provide any estimate of how these activities might affect our future results.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to various risks, including fluctuations in interest and foreign currency rates. In the normal course of business, we also face risks that are either non-financial or non-quantifiable. Such risks principally include country risk, credit risk and legal risk and are not discussed or quantified in the following analyses, as well as risks set forth under the heading "Factors that May Affect Future Results".
Interest Rate Risk
Our financial assets and liabilities subject to interest rate risk are cash investments, convertible debt, credit facilities and interest rate swaps. Our primary objective is to preserve principal while maximizing yield without significantly increasing risk. At June 30, 2004, we evaluated the effect that near-term changes in interest rates would have had on these transactions. A change of as much as ten percent in the London InterBank Offered Rate ("LIBOR") would have had an annualized favorable impact of approximately $0.7 million on net interest income/expense since the interest income on our cash and cash investments would have outweighed additional interest expense on our outstanding debt. For our interest rate contract with Lehman Brothers, an increase of ten percent in interest rates would have had a favorable impact of $0.4 million, and a decrease of ten percent in interest rates would have had an adverse impact of $(0.2) million, on net interest income/expense. These changes would not have had a material impact on our results of operations, financial position or cash flows.
In December 2001, we entered into an interest rate swap transaction (the "Transaction") with JP Morgan Chase Bank (the "Bank"), to modify our effective interest payable with respect to $412.5 million of our $550 million outstanding convertible debt (the "Debt") (see Notes 3, "Derivative Financial Instruments," and 4, "Bank Loans and Long-Term Debt"). At the inception of the Transaction, interest rates were lower than that of the Debt and we believed that interest rates would remain lower for an extended period of time. In April 2004, we entered into an interest rate swap transaction (the "April 2004 Transaction") with the Bank to modify the effective interest payable with respect to the remaining $137.5 million of the Debt. The variable interest rate we have paid since the inception of the swap has averaged 1.91 percent, compared to a coupon of 4.25 percent on the Debt. During the fiscal years ended 2004, 2003 and 2002, these arrangements reduced interest expense by $12.9 million, $10.4 million and $4.6 million, respectively.
Accounted for as fair value hedges under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", the mark-to-market adjustments of the two Transactions were offset by the mark-to-market adjustments on the Debt, resulting in no material impact to earnings. To measure the effectiveness of the hedge relationship, we use a regression analysis. To evaluate the relationship of the fair value of the Transaction and the changes in fair value of the Debt attributable to changes in the benchmark rate, we discount the estimated cash flows by the LIBOR swap rate that corresponds to the Debt's expected maturity date. In addition, our ability to call the Debt was considered in assessing the effectiveness of the hedging relationship. For those years that were projected to include at least a portion of redemption of the convertible debentures, we employed a valuation model known as a Monte Carlo simulation. This simulation allows us to project probability-weighted contractual cash flows discounted at the LIBOR swap rate that corresponded to the Debt's expected maturity date. The market value of the Transaction of $13.1 million and $23.7 million asset position at June 30, 2004 and 2003, respectively, was included in other long-term assets. The market value of the April 2004 Transaction was a $1.3 million liability position and was included in other long-term liabilities.
In April 2002, we entered into an interest rate contract (the "Contract") with an investment bank, Lehman Brothers ("Lehman"), to reduce the variable interest rate risk of the Transaction. The notional amount of the Contract is $412.0 million, representing approximately 75 percent of the Debt. Under the terms of the Contract, we have the option to receive a payout from Lehman covering our exposure
to LIBOR fluctuations between 5.5 percent and 7.5 percent for any four designated quarters. The market value of the Contract at June 30, 2004 and 2003, was $0.9 million and $1.4 million, respectively, and was included in other long-term assets. Interest expense was increased by mark-to-market losses of $0.5 million, $3.1 million and $1.2 million, for the fiscal years ended 2004, 2003 and 2002, respectively.
Foreign Currency Risk
We conduct business on a global basis in several foreign currencies, and at various times, we have currency exposure related to the British Pound Sterling, the Euro and the Japanese Yen. Our risk to the European currencies is partially offset by the natural hedge of manufacturing and selling goods in both U.S. dollars and the European currencies. Considering our specific foreign currency exposures, we have the greatest exposure to the Japanese Yen, since we have significant yen-based revenues without the yen-based manufacturing costs. We have established a foreign-currency hedging program using foreign exchange forward contracts, including the Forward Contract described below, to hedge certain foreign currency transaction exposures. To protect against reductions in value and volatility of future cash flows caused by changes in currency exchange rates, we have established revenue, expense and balance sheet hedging programs. Currency forward contracts and local Yen and Euro borrowings are used in these hedging programs. Our hedging programs reduce, but do not always eliminate, the impact of currency exchange rate movements. We considered an adverse near-term change in exchange rates of ten percent for the British Pound Sterling, the Euro and the Japanese Yen. Such an adverse change, after taking into account our derivative financial instruments and offsetting positions, would have resulted in an annualized adverse impact on income before taxes of less than $1 million for the fiscal years ended June 30, 2004, 2003 and 2002.
In March 2001, we entered into a five-year foreign exchange forward contract (the "Forward Contract") for the purpose of reducing the effect of exchange rate fluctuations on forecasted intercompany purchases by our subsidiary in Japan. We have designated the Forward Contract as a cash flow hedge under which mark-to-market adjustments are recorded in other comprehensive income, a separate component of stockholders' equity, until the forecasted transactions are recorded in earnings. Under the terms of the Forward Contract, we are required to exchange 1.2 billion yen for $11.0 million on a quarterly basis from June 2001 to March 2006. At June 30, 2004, seven quarterly payments of 1.2 billion yen remained to be swapped at a forward exchange rate of 109.32 yen per U.S. dollar. The market value of the Forward Contract was a liability of $2.2 million at June 30, 2004, and an asset of $6.4 million at June 30, 2003. The mark-to-market gains (losses), net of tax, of $(4.0) million, $4.0 million and $1.0 million for the fiscal years ended June 30, 2004, 2003 and 2002, respectively, was included in other comprehensive income. Based on effectiveness tests comparing forecasted transactions through the Forward Contract expiration date to its cash flow requirements, we do not expect to incur a material charge to income during the next twelve months as a result of the Forward Contract.
We had approximately $29.3 million and $22.7 million in notional amounts of forward contracts not designated as accounting hedges under SFAS No. 133 at June 30, 2004 and 2003, respectively. Net realized and unrealized foreign-currency gains (losses) recognized in earnings, excluding any impact from forward contracts, were less than $1 million for the fiscal years ended June 30, 2004, 2003 and 2002.
Item 8.
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements and Financial Statement Schedule
Supporting Financial Statement Schedule:
Schedules other than those listed above have been omitted since they are either not required, are not applicable, or the required information is shown in the Consolidated Financial Statements or related Notes.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors of International Rectifier Corporation
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of International Rectifier Corporation and its subsidiaries at June 30, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Los Angeles, California
August 20, 2004
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(In thousand's except per share amounts)
The accompanying notes are an integral part of this statement.
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(In thousand's except share amounts)
The accompanying notes are an integral part of this statement.
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND
COMPREHENSIVE INCOME (LOSS)
(In thousand's except share amounts)
The accompanying notes are an integral part of this statement.
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(In thousand's)
The accompanying notes are an integral part of this statement.
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Business and Summary of Significant Accounting Policies
Business
International Rectifier Corporation ("IR" or the "Company") is a world leader in power management technology that improves functionality, speed and compactness in electrical applications. The Company's products are used in a range of end markets, including, information technology, consumer electronics, automotive, industrial and government/space. IR's analog ICs, advanced circuit devices, power systems and components enable computer hardware to gain speed and reliability, allow portable electronics to run longer off a single charge, improve automotive fuel efficiency, and cut energy consumption in home appliances and industrial motors. The Company is a market leader in the $6 billion power MOSFET industry. Over 20 companies are licensed under its power MOSFET patents. IR serves customers around the world, and more than half its revenue comes from outside the United States.
IR was founded as a California corporation in 1947 and reincorporated in Delaware in 1979.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and all of its subsidiaries, which are located in North America, Europe and Asia. Intercompany transactions have been eliminated in consolidation.
Fiscal Year
The Company operates on a 52-53 week fiscal year under which fiscal 2004 consisted of 52 weeks ending July 4, 2004, fiscal 2003 consisted of 53 weeks ending July 6, 2003, and fiscal 2002 consisted of 52 weeks ending June 30, 2002. For ease of presenting the accompanying consolidated financial statements, the fiscal year-end for all periods presented is shown as June 30.
Revenue Recognition
In accordance with Staff Accounting Bulletin No. 101, "Revenue Recognition", the Company recognizes revenue when the evidence of an arrangement exists, pricing is fixed and determinable, collection is reasonably assured, and delivery or performance of services has occurred. The Company recognizes the majority of revenues upon shipment for product sales to all customers, including distributors, with provisions for estimated returns and allowances recorded at the time of shipment. Certain customers have limited rights of returns and price protection programs. The Company continuously monitors product returns and potential price adjustments and record a provision for these based on notification received of pending credits and historical experience. While such credits have historically been within the Company's expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same predictability in estimating returns and allowances. If the historical data and estimates used to calculate these provisions do not properly reflect future activity, the Company's net sales, gross profit, net income and earnings per share could be impacted.
Certain of the Company's customers' contracts contain substantive acceptance provisions. In such circumstances, the Company recognizes revenue in accordance with specific contract provisions, in most instances upon customer inspection or upon delivery of proof of conformance to customer specifications. The Company also maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of its
customers was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required.
Research and Development
Research and development costs are expensed as incurred.
Environmental Costs
Costs incurred to investigate and remediate contaminated sites are expensed when such costs are identified and estimable.
Interest Income (Expense)
Interest income (expense) for the fiscal years ended June 30, 2004, 2003 and 2002 are as follows (in thousand's):
Income Taxes
Deferred income taxes are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted rates in effect during the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable for the period and the change during the period in deferred tax assets and liabilities.
U.S. income taxes have not been provided on approximately $216.8 million of undistributed earnings of foreign subsidiaries since management considers these earnings to be invested indefinitely or offset by foreign tax credits. It is not practical to estimate the amount of unrecognized deferred U.S. taxes on these undistributed earnings.
Net Income (Loss) per Common Share
Net income (loss) per common share-basic is computed by dividing net income (loss) available to common stockholders (the numerator) by the weighted average number of common shares outstanding (the denominator) during the period. The computation of net income (loss) per common share-diluted is similar to the computation of net income (loss) per common share-basic except that the denominator is increased to include the number of additional common shares, such as options, that would have been outstanding using the treasury stock method for the exercise of options and the conversion of the Company's convertible subordinated notes using the if-converted method. The Company's use of the treasury stock method also reduces the gross number of dilutive shares by the number of shares purchasable from the proceeds of the options assumed to be exercised. The Company's use of the if-converted method also increases reported net income by the interest expense related to the convertible subordinated notes when computing net income per common share-diluted.
Statement of Cash Flows
Components in the change of operating assets and liabilities, net of effects of acquisitions, for the fiscal years ended June 30, 2004, 2003 and 2002 were comprised of the following (in thousand's):
Supplemental disclosures of cash flow information (in thousand's):
Fair Value of Financial Instruments
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires the disclosure of fair value information about financial instruments. Quoted market prices, when available, are used as the measure of fair value. In cases where quoted market prices are not available, fair values are based on present value estimates or other valuation techniques. These derived fair values are significantly affected by assumptions used, the timing of future cash flows and the discount rate. Considerable judgment and assumptions, which are inherently subjective in nature, are required to interpret market data in developing the estimates of fair value. Accordingly, the estimated fair values may not necessarily be realized in an immediate sale or settlement of the instrument in a current market exchange. The disclosure requirements of SFAS No. 107 exclude certain financial instruments (e.g., leases) and all non-financial instruments (e.g., fixed assets, intangibles). Accordingly, the aggregate amount presented does not reflect the underlying value of the Company. Our financial instruments, including cash, cash equivalents, accounts receivable and accounts payable are carried at cost, which approximates their fair value because of the short-term nature of these investments.
Cash, Cash Equivalents, and Cash Investments
The Company classifies all highly liquid investments purchased with original or remaining maturities of ninety days or less at the date of purchase to be cash equivalents.
The Company invests excess cash in marketable securities consisting primarily of commercial paper, corporate notes and bonds and U.S. government securities. As of June 30, 2004, the Company has managed these investments to obtain effective maturities of no greater than 24 months. At June 30, 2004 and 2003, all of the Company's marketable securities are classified as available-for-sale. In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," unrealized gains and losses on these investments are included as a separate component of stockholders' equity, net of any related tax effect. Realized gains and losses and declines in value judged by management to be other than temporary on these investments are included in interest income and expense.
Cash, cash equivalents and cash investments as of June 30, 2004 and 2003 are summarized as follows (in thousand's):
Inventories
Inventories are stated at the lower of cost (principally first-in, first-out) or market. Inventories are reviewed for excess and obsolescence based upon demand forecasts within a specific time horizon and reserves are established accordingly. Inventories at June 30, 2004 and 2003 were comprised of the following (in thousand's):
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Upon retirement or other disposal, the asset cost and related accumulated depreciation are removed from the accounts and any gain or loss on disposition is included in other income. Depreciation is provided on the straight-line method, based on the estimated useful lives of the assets, ranging from three to 40 years, or the units of production method based upon the estimated output of the equipment. Depreciation expense for the fiscal years ended June 30, 2004, 2003 and 2002 was $51.5 million, $51.7 million and $59.8 million, respectively. Property, plant and equipment at June 30, 2004 and 2003 was comprised of the following (in thousand's):
Property, plant, and equipment at June 30, 2004 and 2003, were adjusted to reflect the $169.0 million asset impairment charges taken in the December 2002 quarter. See Note 6, "Impairment of Assets, Restructuring and Severance Charges".
Depreciation of improvements to leased premises is provided on the straight-line method over the shorter of the remaining term of the lease or estimated useful lives of the improvements. Capital leases included in property, plant and equipment at June 30, 2004 and 2003 were as follows (in thousand's):
Repairs and maintenance costs are charged to expense. In the fiscal years ended June 30, 2004, 2003 and 2002, repairs and maintenance costs were $26.6 million, $23.0 million and $18.9 million, respectively.
Long-Lived Assets
Long-lived assets are net property, plant and equipment and intangible assets. The Company tests long-lived assets for impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Such events and circumstances include, but are not limited to:
•A significant change in business strategy or in the extent or manner for which the asset is being used or in its physical condition;
•A significant negative change in the business climate, industry conditions, economic conditions or market value of an asset; and
•Current period operating losses or negative cash flow combined with a history of similar losses or a forecast that indicates continuing losses associated with the use of an asset.
The Company evaluates the recoverability of long-lived assets based on the expected undiscounted cash flows for their asset group as determined in accordance with SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets", without regard to taxes. Impairments, if any, are recognized based upon the fair value of the assets. Fair value is based upon a discounted cash flow analysis. The Company uses the undiscounted cash flows and applies an appropriate discount rate that is representative of the discount rate used when evaluating potential acquisitions.
In developing the cash flow projections, the Company uses revenue and cost assumptions based on current levels adjusted for anticipated future market conditions. If these market conditions do not materialize, the cash flow forecasts could be materially impacted.
Goodwill and Acquisition-Related Intangible Assets
The Company classifies the difference between the purchase price and the fair value of net assets acquired at the date of acquisition as goodwill. The Company classifies intangible assets apart from goodwill if the assets have contractual or other legal rights or if the assets can be separated and sold, transferred, licensed, rented or exchanged. Depending on the nature of the assets acquired, the amortization period may range from four to twelve years for those acquisition-related intangible assets subject to amortization. The Company evaluates the carrying value of goodwill and acquisition-related intangible assets, including the related amortization period, in the fourth quarter of each fiscal year. In evaluating goodwill and intangible assets not subject to amortization, the Company compares the total carrying value of goodwill and intangible assets not subject to amortization to the Company's fair value as determined by its market capitalization. In evaluating intangible assets subject to amortization, the Company assesses the carrying value of each intangible asset in accordance with SFAS No. 144. At
June 30, 2004 and 2003, goodwill and acquisition-related intangible assets included the following (in thousand's):
The changes in the carrying amount of goodwill for the period ended June 30, 2004 and 2003 are as follows (in '000s):
During fiscal 2003, the purchase price adjustments to goodwill are primarily related to a $26.6 million increase in long-term deferred tax asset for the acquisition of assets of European Semiconductor Manufacturing, Ltd. ("ESM") (see Note 9, "Income Taxes"), partially offset by a $4.8 million increase in severance liability for the acquisition of TechnoFusion GmbH ("TechnoFusion"). The Company reevaluated the recoverability of ESM's deferred tax asset and finalized the severance liability owed to TechnoFusion's employees during fiscal 2003, and reallocated the purchase price accordingly.
As of June 30, 2004, estimated amortization expense for the next five years are as follows (in thousand's): fiscal 2005: $5,330; fiscal 2006: $4,859; fiscal 2007: $4,169; fiscal 2008: $3,425 and fiscal 2009: $3,108.
Derivative Financial Instruments
The Company's primary objectives for holding derivative financial instruments are to take advantage of the current low interest rate environment and hedge non-U.S. currency risks. The Company's derivative instruments are recorded at fair value and are included in other current assets, other long-term assets or other long-term liabilities. The Company's accounting policies for derivative financial instruments are based on its criteria for designation as hedging transactions, either as cash flow or fair value hedges as defined by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS No. 133", and SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". A cash flow hedge refers to the hedge of the exposure to variability in the cash flows of an asset or a liability, or of a forecasted transaction. A fair value hedge refers to the hedge of the exposure to changes in fair value of an asset or a liability, or of
an unrecognized firm commitment. The criteria for designating a derivative as a hedge include the instrument's effectiveness in risk reduction and, in most cases, a one-to-one matching of the derivative instrument to its underlying transaction. The Company recognizes gains and losses on derivatives that are not designated as hedges for accounting purposes currently in earnings. These gains and losses generally offset changes in the values of hedged assets or liabilities.
For currency forward contracts, the Company measures the effectiveness of the hedge using forward rates to value the forward contract and the forward value of the underlying hedged transaction. For interest rate swaps, the Company measures the effectiveness using regression analysis, which offsets the change in fair value of the long-term debt with the change in fair value of the interest rate swap.
The Company recognizes in current period's interest and other income and expense, depending on the nature of the underlying asset or liability, the ineffective portions of the hedge, as well as the amounts not included in the assessment of effectiveness. If the Company determined that the original hedged transaction probably will not occur as anticipated, and a cash flow hedge is to be discontinued, it would reclassify the unrealized gains or losses into earnings. The Company would recognize subsequent gains or losses on the related derivative instrument in income in each period until the instrument matures, is terminated or is sold.
Other Accrued Expenses
Other accrued expenses at June 30, 2004 and 2003 were comprised of the following (in thousands):
Foreign Currency Translations
In general, the functional currency of a foreign operation is deemed to be the local country's currency. Assets and liabilities of operations outside the United States are translated into U.S. dollars using current exchange rates. Income and expense are translated at average exchange rates prevailing during the period. The effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income within stockholders' equity.
Accumulated Other Comprehensive Income
The components of accumulated other comprehensive income as of June 30, 2004 and 2003 were as follows (in thousand's):
Stock-Based Compensation
The Company accounts for stock-based compensation plans using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Had the Company recorded compensation expense using the accounting method recommended by SFAS No. 123, net income (loss) and net income (loss) per common share-basic and diluted would approximate the following (in thousand's, except per share data):
The effects of applying SFAS No. 123 in this pro forma disclosure are not indicative of future amounts. SFAS No. 123 does not apply to awards prior to 1996.
Cost of Start-Up Activities
The Company expenses all start-up and pre-operating costs as they are incurred in accordance with Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities."
Patent Costs
The Company expenses legal costs incurred in developing patent applications. The Company capitalizes legal costs related to the defense and enforcement of issued patents for which success is deemed probable. The related costs are amortized over the remaining useful lives of the patents, which extend from 2007 through 2008 for our key MOSFET patents, using the straight-line method. Such deferred costs are reviewed for impairment and recoverability periodically. Capitalized patent costs, net of accumulated amortization at June 30, 2004 and 2003, were approximately $14.9 million and $15.2 million, respectively.
Concentration of Risk
The Company places its cash in investment-grade vehicles with high credit quality financial institutions. The Company performs periodic credit evaluations of its customers' financial conditions and generally does not require collateral.
Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassification
Certain reclassifications have been made to previously reported amounts to conform to the current year presentation.
2. Investments
Available-for-sale securities as of June 30, 2004 are summarized as follows (in thousand's):
Available-for-sale securities as of June 30, 2003 are summarized as follows (in thousand's):
(1)No investment was in a loss position for greater than one year. The Company holds as strategic investments the common stock of two publicly-traded Japanese companies, one of which is Nihon Inter Electronics Corporation ("Nihon"), a related party as further disclosed in Note 15, "Related Party Transactions". The Company accounts for these available-for-sale investments under SFAS No. 115. These stocks are traded on the Tokyo Stock Exchange. The market values of the equity investments at June 30, 2004 and 2003 were $94.1 million and $43.2 million, respectively, and were included in other long-term assets. Mark-to-market gains, net of tax, for the twelve months ended June 30, 2004 and 2003, were $32.2 million and $8.0 million, respectively, and were included in other comprehensive income, a separate component of equity.
The amortized cost and estimated fair value of cash investments at June 30, 2004, by contractual maturity, are as follows (in thousand's):
In accordance with the Company's investment policy which limits the length of time that cash may be invested, the expected disposal dates may be less than the contractual maturity dates as indicated in the table above.
Gross realized gains and (losses) were $2.6 million and $(0.3) million, respectively, for the year ended June 30, 2004. Gross realized gains and (losses) were $4.8 million and $(1.2) million, respectively, for the year ended June 30, 2003. Gross realized gains and (losses) were $2.4 million and $(0.2) million, respectively, for the year ended June 30, 2002. The cost of marketable securities sold is determined by the weighted average cost method.
3. Derivative Financial Instruments
The Company is exposed to various risks, including fluctuations in interest and foreign currency rates. In the normal course of business, the Company also faces risks that are either non-financial or non-quantifiable. Such risks principally include country risk, credit risk and legal risk and are not discussed or quantified in the following analyses.
Interest Rate Risk
In December 2001, the Company entered into interest rate swap transaction (the "Transaction") with an investment bank, JP Morgan Chase Bank (the "Bank"), to modify the Company's effective interest payable with respect to $412.5 million of its $550 million outstanding convertible debt (the "Debt") (see Note 4). In April 2004, the Company entered into an interest rate swap transaction (the "April 2004 Transaction") with the Bank to modify the effective interest payable with respect to the remaining $137.5 million of the Debt. The Company will receive from the Bank fixed payments equal to 4.25 percent of the notional amount, payable on January 15 and July 15. In exchange, the Company will pay to the Bank floating rate payments based upon the London InterBank Offered Rate ("LIBOR") multiplied by the notional amount. At the inception of the Transaction, interest rates were lower than that of the Debt and the Company believed that interest rates would remain lower for an extended period of time. The variable interest rate paid since the inception of the swaps has averaged 1.91 percent, compared to a coupon of 4.25 percent on the Debt. During the fiscal years ended 2004, 2003 and 2002, these arrangements reduced interest expense by $12.9 million, $10.4 million and $4.6 million, respectively. Accounted for as a fair value hedge under SFAS No. 133, the mark-to-market adjustments of the Transaction and April 2004 Transaction were offset by the mark-to-market adjustments on the Debt, resulting in no material impact to earnings. The market value of the Transaction of $13.1 million and $23.7 million asset position at June 30, 2004 and 2003, respectively, was included in other long-term assets. The market value of the April 2004 Transaction was a $1.3 million liability position and was included in other long-term liabilities.
Both transactions terminate on July 15, 2007 ("Termination Date"), subject to certain early termination provisions. On or after July 18, 2003 and prior to July 14, 2007, if the ten-day average closing price of the Company's common stock equals or exceeds $77.63, the Transaction and the
April 2004 Transaction will terminate. Depending on the timing of the early termination event, the Bank would be obligated to pay the Company an amount equal to the redemption premium called for under the terms of the Debt.
In support of the Company's obligation under the two transactions, the Company is required to obtain irrevocable standby letters of credit in favor of the Bank, totaling $11.5 million plus a collateral requirement for the Transaction and April 2004 Transaction, as determined periodically. At June 30, 2004, $11.5 million in letters of credit were outstanding related to both transactions.
The Transaction and the April 2004 Transaction qualify as fair value hedges under SFAS No. 133. To test effectiveness of the hedge, regression analysis is performed quarterly comparing the change in fair value of the two transactions and the Debt. The fair values of the transactions and the Debt are calculated quarterly as the present value of the contractual cash flows to the expected maturity date, where the expected maturity date is based on probability-weighted analysis of interest rates relating to the five-year LIBOR curve and the Company's stock prices. For the years ended June 30, 2004 and 2003, the hedges were highly effective and therefore, the ineffective portion did not have a material impact on earnings.
In April 2002, the Company entered into an interest rate contract (the "Contract") with an investment bank, Lehman Brothers ("Lehman"), to reduce the variable interest rate risk of the Transaction. The notional amount of the Contract is $412.0 million, representing approximately 75 percent of the Debt. Under the terms of the Contract, the Company has the option to receive a payout from Lehman covering our exposure to LIBOR fluctuations between 5.5 percent and 7.5 percent for any four designated quarters. The market value of the Contract at June 30, 2004 and 2003 was $0.9 million and $1.4 million, respectively, and was included in other long-term assets. Interest expense was increased by mark-to-market losses of $0.5 million, $3.1 million and $1.2 million for the fiscal years ended 2004, 2003 and 2002, respectively.
Foreign Currency Risk
The Company conducts business on a global basis in several foreign currencies, and at various times, it is exposed to fluctuations with the British Pound Sterling, the Euro and the Japanese Yen. The Company's risk to the European currencies is partially offset by the natural hedge of manufacturing and selling goods in both U.S. dollars and the European currencies. Considering its specific foreign currency exposures, the Company has the greatest exposure to the Japanese Yen, since it has significant yen-based revenues without the yen-based manufacturing costs. The Company has established a foreign-currency hedging program using foreign exchange forward contracts, including the Forward Contract described below, to hedge certain foreign currency transaction exposures. To protect against reductions in value and volatility of future cash flows caused by changes in currency exchange rates, it has established revenue, expense and balance sheet hedging programs. Currency forward contracts and local Yen and Euro borrowings are used in these hedging programs. The Company's hedging programs reduce, but do not always eliminate, the impact of currency exchange rate movements.
In March 2001, the Company entered into a five-year foreign exchange forward contract (the "Forward Contract") for the purpose of reducing the effect of exchange rate fluctuations on forecasted intercompany purchases by our subsidiary in Japan. The Company has designated the Forward Contract as a cash flow hedge under which mark-to-market adjustments are recorded in other comprehensive income, a separate component of stockholders' equity, until the forecasted transactions are recorded in earnings. Under the terms of the Forward Contract, the Company is required to exchange 1.2 billion yen for $11.0 million on a quarterly basis from June 2001 to March 2006. At June 30, 2004, seven quarterly payments of 1.2 billion yen remained to be swapped at a forward exchange rate of 109.32 yen per U.S. dollar. The market value of the forward contract was a liability of $2.2 million at June 30, 2004, and an asset of $6.4 million at June 30, 2003. The mark-to-market gains (losses), net of tax, of
$(4.0) million, 4.0 million and $1.0 million for the fiscal years ended June 30, 2004, 2003 and 2002, respectively, were included in other comprehensive income. Based on effectiveness tests comparing forecasted transactions through the Forward Contract expiration date to its cash flow requirements, the Company does not expect to incur a material charge to income during the next twelve months as a result of the Forward Contract.
The Company had approximately $29.3 million and $22.7 million in notional amounts of forward contracts not designated as accounting hedges under SFAS No. 133 at June 30, 2004 and 2003, respectively. Net realized and unrealized foreign-currency gains (losses) recognized in earnings were less than $1 million for the fiscal years ended June 30, 2004, 2003 and 2002.
4. Bank Loans and Long-Term Debt
The following is a summary of the Company's long-term debt and other loans at June 30, 2004 and 2003 (in thousand's):
In July 2000, the Company sold $550 million principal amount of 4.25 percent Convertible Subordinated Notes due 2007. The interest rate is 4.25 percent per year on the principal amount, payable in cash in arrears semi-annually on January 15 and July 15. The notes are convertible into shares of the Company's common stock at any time on or before July 15, 2007, at a conversion price of $73.935 per share, subject to certain adjustments. The notes are subordinated to all of the Company's existing and future debt. The Company may redeem any of the notes, in whole or in part, subject to certain call premiums on or after July 18, 2003, as specified in the notes and related indenture agreement. In December 2001 and April 2004, the Company entered into two transactions with the JP Morgan Chase Bank for $412.5 million and $137.5 million notional, respectively, which had the effect of converting the interest rate to variable and required that convertible notes be marked to market (see Note 3).
The Company entered into a new three-year syndicated multi-currency revolving credit facility expiring in November 2007, which replaced the $150 million facility that expired in November 2003. The new facility, also led by BNP Paribas, provides a credit line of $150 million of which up to $150 million may be used for standby letters of credit. The facility bears interest at (i) local currency rates plus (ii) a margin between 0.75 percent and 2.0 percent for base rate advances and a margin of between 1.75 percent and 3.0 percent for euro-currency rate advances. Other advances bear interest as set forth in the credit agreement. The annual commitment fee for the credit agreement is subject to a leverage ratio as determined by the credit agreement and was 0.375 percent of the unused portion of the credit facility at June 30, 2004. The facility also contains certain financial and other covenants, with which the Company was in compliance at June 30, 2004. The Company pledged as collateral shares of certain of its subsidiaries. At June 30, 2004, under the new credit agreement, the Company had $17.2 million borrowings and $14.4 million letters of credit outstanding. At June 30, 2003, under the previous credit agreement, the Company had $16.3 million borrowings and $13.4 million letters of credit outstanding. Of the letters of credit outstanding, $11.5 million were related to the interest rate
swap transactions (see Note 3) at June 30, 2004 and 2003. At June 30, 2004, the Company had $166.9 million in total revolving lines of credit, of which $33.3 million had been utilized, consisting of $14.4 million in letters of credit and $18.9 million in foreign revolving bank loans, which is included in the table above.
At June 30, 2004 and 2003, under the $150 million credit agreement, the Company had $17.2 million and $16.3 million, respectively, borrowings outstanding, and $14.4 million and $13.4 million, respectively, in letters of credit outstanding. Of the letters of credit outstanding, $11.5 million were related to the swap transactions at June 30, 2004 and 2003.
As of June 30, 2004, scheduled principal payments on long-term debt are as follows: fiscal 2005: $0.1 million; fiscal 2006: $0.1 million; fiscal 2007: $0.1 million; fiscal 2008: $550.0 million; and fiscal 2009 and thereafter: $0.6 million.
5. Capital Stock
Employee Stock Purchase Plan
The Company has a compensatory employee stock purchase plan ("ESPP"). Under this plan employees are allowed to designate between two and ten percent of their base compensation to purchase shares of the Company's common stock at 85 percent of fair market value at a designated date. During fiscal 2004, 2003 and 2002, 296,481; 252,724 and 158,563 shares were purchased at weighted average per share exercise prices of $18.82, $19.26 and $27.32, respectively. Shares authorized under this plan that remained unissued were 32,902; 329,383 and 582,107 at June 30, 2004, 2003 and 2002, respectively. The weighted average per share fair value of ESPP options granted, using the Black-Scholes option pricing model, in 2004, 2003 and 2002 was $13.06, $8.50 and $12.70 per share, respectively. In November 2003, the stockholders of the Company approved an amendment to the ESPP, which increased the number of shares available for issuance by 1,000,000 shares and extended the expiration date to 2013. These additional shares were registered with the Securities and Exchange Commission subsequent to fiscal year-end in July 2004.
The fair value of ESPP options at date of grant indicated above was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:
Stock Option Plans
The Company has three stock option plans, as follows: the Amended and Restated Stock Incentive Plan of 1992 ("1992 Plan"), the 1997 Employee Stock Incentive Plan ("1997 Plan") and the 2000 Incentive Plan ("2000 Plan"). Under the 1992 Plan, options to purchase shares of the Company's common stock may be granted to the Company's employees, including executive officers, and to members of the Company's Board of Directors. Under the 1997 Plan, options to purchase shares of the Company's common stock may be granted to the Company's employees and consultants, but not to executive officers of the Company or members of its Board of Directors. No options may be granted under the 1992 Plan after December 31, 2002. Under the 2000 Plan, options to purchase shares of the Company's common stock and other stock-based awards may be granted to the Company's employees, officers, directors, and consultants and advisors. Options have been issued with an exercise price at least equal to the fair value of the Company's common stock at the date of grant ("at market"). Option grants made prior to and on January 1, 2002 generally become exercisable in annual installments of
20 percent beginning on the first anniversary date, and expire after ten years. Option grants after January 1, 2002 generally become exercisable in annual installments of 25 percent beginning on the first anniversary date, and expire after seven years.
In November 1996, the stockholders of the Company approved an amendment to the 1992 Plan. The amendment broadened the types of options and other stock-based awards (e.g., restricted stock, SARs and performance shares) that may be granted (prior to the amendment, only non-qualified options could be granted), extended the term of the 1992 Plan for three years to December 31, 2002, retained the provision for the annual increase in shares of the Company's common stock available for grant of 1.5 percent of outstanding shares, increased the maximum number of shares that may be granted to non-employee directors from 100,000 to 120,000 (including an annual grant of 5,000 shares to each such director), reduced the holding period for full vesting of certain non-employee director options from one year to six months, and generally provided the committee of the Board of Directors that administers the 1992 Plan with substantial powers and discretion with respect to awards. On January 1, 2002 and 2001, 949,703 and 930,803 shares, respectively, were added to the 1992 Plan. As noted previously, the 1992 Plan expired on December 31, 2002.
The Board of Directors adopted the 1997 Plan in November 1997, which authorized 6,935,000 shares to be granted. The terms of the options authorized and granted under the 1997 Plan are substantially similar to those under the amended 1992 Plan. Executive officers and directors are not eligible for grants under the 1997 Plan. On October 1, 2001 the 1997 Plan expiration date was amended from December 31, 2001 to December 31, 2009. As of June 30, 2004, there were 220,135 shares available for future grants to eligible employees. During fiscal 2004, 2003 and 2002, only non-qualified options were issued under the 1997 Plan.
In November 1999, the stockholders of the Company approved the 2000 Plan, which authorized 7,500,000 shares to be granted. The 2000 Plan is effective as of January 1, 2000. No awards may be granted under the 2000 Plan after December 31, 2009. As of June 30, 2004, there were 1,042,045 shares available for future grants to eligible persons.
A summary of the status of options under the 2000, 1997 and 1992 Plans are as follows:
The following table summarizes significant option groups outstanding at June 30, 2004 and related weighted average price and life information:
Additional information relating to the 1992, 1997 and 2000 Plans at June 30, 2004, 2003 and 2002 is as follows:
The fair value of options at date of grant indicated for the summary of the status of options table above was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:
Shareholder Rights Plan
On August 2, 1996, the Company's Board of Directors adopted a Shareholder Rights Plan (the "Plan") under which preferred stock purchase rights (the "Rights") have been and will continue to be granted for each outstanding share of the Company's common stock held at the close of business on August 14, 1996. The Plan is intended to ensure fair and equitable treatment for all shareholders in the event of unsolicited attempts to acquire the Company.
The Rights will become exercisable ten days after a person or group (the "Acquirer") has acquired beneficial ownership of 20 percent or more of the Company's common stock other than pursuant to a qualified offer, or announces or commences a tender offer or exchange offer that could result in the acquisition of beneficial ownership of 20 percent or more. Once exercisable, each Right entitles the holder to purchase one one-thousandth of a share of a new series of preferred stock at an exercise price of $135, subject to adjustment to prevent dilution. If the Acquirer acquires 20 percent or more of the Company's common stock, each Right (except those held by the Acquirer) entitles the holder to purchase either the Company's stock or stock in the merged entity at half of market value. The Rights have no voting power, expire on August 14, 2006, and may be redeemed at a price of $0.01 per Right up to and including the tenth business day after a public announcement that the Acquirer has acquired 20 percent or more of the Company's shares.
The Company amended and restated its Rights Agreement to remove the requirement that continuing directors vote in board approvals of certain corporate transactions as of December 15, 1998.
6. Impairment of Assets, Restructuring and Severance Charges
During fiscal 2003 second quarter ended December 31, 2002, the Company announced its restructuring initiatives. Under these initiatives, the goal was to reposition the Company to better fit the market conditions, de-emphasize its commodity business and accelerate the Company's move to what it categorizes as proprietary products. The Company's restructuring plan included consolidating and closing certain manufacturing sites, upgrading equipment and processes in designated facilities and discontinuing production in a number of others that cannot support more advanced technology platforms or products. The Company also planned to lower overhead costs across its support organizations. During fiscal 2004 second quarter ended December 31, 2003, the Company announced the divestiture or discontinuation of certain of its commodity products totaling approximately $100 million of annual revenues, to further focus its resources on value-added opportunities.
The Company estimates that charges associated with the above restructuring will be approximately $234 million. These charges will consist of approximately $189 million for asset impairment, plant closure and other charges, $6 million of raw material and work-in-process inventory, and approximately $39 million for severance-related costs.
For the fiscal year ended June 30, 2004, the Company recorded $33.5 million in total restructuring-related charges, consisting of: $15.2 million for asset impairment, plant closure costs and other charges, and $18.3 million for severance-related costs. For the fiscal year ended June 30, 2003, the Company recorded $193.9 million in total restructuring-related charges, consisting of: $169.7 million for asset impairment, plant closure costs and other charges, $6.0 million for raw material and work-in-process inventory charges, and $18.2 million for severance-related costs. Restructuring-related costs were charged as incurred in accordance with SFAS No. 146, "Accounting for the Costs Associated with Exit or Disposal Activities". Asset impairments were calculated in accordance with SFAS No. 144. In determining the asset groups, the Company grouped assets at the lowest level for which independent identifiable cash flows were available. In determining whether an asset was impaired the Company evaluated undiscounted future cash flows and other factors such as changes in strategy and technology. The undiscounted cash flows from the Company's initial analyses were less than the carrying amount for certain of the asset groups, indicating impairment losses. Based on this, the Company determined the fair value of these asset groups using the present value technique, by applying a discount rate to the estimated future cash flows that is consistent with the rate used when analyzing potential acquisitions.
As of June 30, 2004, the Company had recorded $227.4 million in total charges, consisting of: $184.8 million for asset impairment, plant closure costs and other charges, $6.0 million for raw material and work-in-process inventory charges, and $36.6 million for severance-related costs. Components of the $184.8 million asset impairment, plant closure and other charges included the following items:
•As the Company emphasizes more advanced generation planar products, it expects the future revenue stream from its less advanced facilities in Temecula, California to decrease significantly. These facilities had a net book value of $138.3 million and were written down by $77.7 million. It is expected that these facilities will continue in use until approximately December 2007 and the remaining basis is being depreciated over units of production during this period. It is assumed that salvage value will equal disposition costs.
•As the Company emphasizes more advanced generation trench products, it expects the future revenue stream from its less advanced facility in El Segundo, California to decrease significantly. This facility had a net book value of $59.5 million and was written down by $57.2 million. This
facility had significantly reduced production as of fiscal year-end June 30, 2003 and 2004 and is used primarily for research and development activities.
•As the Company emphasizes more advanced generation Schottky products, it expects the future revenue stream from its less advanced facility in Borgaro, Italy to decrease significantly. This facility had a net book value of $20.5 million and was written down by $13.5 million. It is expected that this facility will continue in use until approximately December 2007 and the remaining basis is being depreciated over units of production during this period. It is assumed that salvage value will equal disposition costs.
The Company is in the process of restructuring its manufacturing activities in Europe, which included a review of its Swansea, Wales facility, a general-purpose module facility. Based on a review, the Company determined that this facility would be better suited to focus only on automotive applications. The general-purpose module assets at this facility, with a net book value of $13.6 million, were written down by $8.2 million. In addition, the Company is moving most manufacturing activities from its recently acquired automotive facility in Krefeld, Germany to its Swansea, Wales and Tijuana, Mexico facilities. The Company expects the move to be completed by fiscal second quarter 2005.
The Company has also moved the majority of the production from its Venaria, Italy facility to its Mumbai, India facility, which was completed as of December 31, 2003. The Company stopped manufacturing products at its Oxted, England facility as of September 30, 2003, and the remaining inventory was transferred to the Tijuana, Mexico assembly facility.
•The Company has eliminated the manufacturing of its non-space military products in its Santa Clara, California facility as of July 31, 2004. Going forward, subcontractors will handle the Company's non-space qualified products previously manufactured in this facility. The Company is also transitioning certain assembly of government and space products from its Leominster, Massachusetts facility to its Tijuana, Mexico facility. Associated with these reductions in manufacturing activities, certain assets with a net book value of $4.0 million were written down by $2.0 million.
•$26.2 million in other miscellaneous items were charged, including $19.3 million in relocation costs and other impaired asset charges and $6.9 million in contract termination and settlement costs.
As a result of the restructuring initiatives, certain raw material and work-in-process inventories were impaired, including products that could not be completed in other facilities, materials that were not compatible with the processes used in the alternative facilities, and materials such as gases and chemicals that could not readily be transferred. Based on these factors the Company wrote down these inventories, with a carrying value of $98.2 million, by $6.0 million. As of June 30, 2004 and 2003, the Company had disposed of $3.0 million and $2.6 million, respectively, of these inventories, which did not have a material impact on gross margin for the fiscal years then ended.
As of June 30, 2004, the Company has recorded $36.6 million in severance-related charges: $31.5 million in severance termination costs related to approximately 1,054 administrative, operating and manufacturing positions, and $5.1 million in pension termination costs at our manufacturing facility in Oxted, England. For the years ended June 30, 2004 and 2003, the Company recorded $15.5 million and $15.9 million, respectively, in severance termination costs, and $2.8 million and $2.3 million, respectively, in pension termination costs. The severance charges associated with the elimination of positions, which included the persons notified to date, had been and will continue to be recognized ratably over the future service period, as applicable, in accordance with SFAS No. 146, "Accounting for the Costs Associated with Exit or Disposal Activities". The Company measured the total termination benefits at the communication date based on the fair value of the liability as of the termination date. A
change resulting from a revision to either the timing or the amount of estimated cash over the future service period will be measured using the credit-adjusted risk-free rate that was used to initially measure the liability. The cumulative effect of the change will be recognized as an adjustment to the liability in the period of the change.
In June 2003, the Company had recorded an estimated $5.1 million in severance costs associated with the acquisition of TechnoFusion GmbH in Krefeld, Germany. In fiscal 2004, the Company finalized its plan and determined that total severance would be approximately $10 million, and accordingly, the Company adjusted purchased goodwill by $4.8 million. The Company communicated the plan and the elimination of approximately 250 positions primarily in manufacturing to its affected employees at that time. The associated severance is expected be paid by fiscal second quarter 2005.
The following summarizes the Company's severance accrual related to the TechnoFusion acquisition and the December 2002 restructuring plan for the periods ended June 30, 2004 and 2003. Severance activity related to the elimination of 29 administrative and operating personnel as part of the previously reported restructuring in the fiscal quarter ended June 30, 2001, is also disclosed. The remaining June 2001 severance relates primarily to certain legal accruals associated with that restructuring, which will be paid or released as the outcome is determined (in thousand's):
7. Insurance Claim
In June 2000, some equipment in one of the Company's wafer fabrication lines was damaged by exposure to hazardous materials. Remediation and repairs to the fabrication line continued throughout fiscal 2003. The Company carried insurance, underwritten by Zurich Financial Services Group ("Zurich"), for both property losses and business interruption.
During fiscal 2002, the Company reached a final settlement with Zurich for $42 million. During fiscal 2002 and 2001, the Company received $18.0 million and $15.0 million, respectively, and the remaining $9.0 million was recorded as a receivable at June 30, 2002 and collected in July 2002.
During fiscal 2003, 2002 and 2001, the Company recorded manufacturing cost reimbursements of $1.4 million, $11.4 million and $4.0 million, respectively, within cost of sales. During fiscal 2001, an additional, $3.5 million was recorded as revenue relating to amounts reimbursed for sales lost as a result of the interruption. The Company had cash outlays of $15.9 million for equipment purchases and repairs and restorations. During fiscal 2002, as a result of the settlement, the Company recorded a non-recurring $4.0 million gain on involuntary conversion of equipment in other income and expense. This gain primarily represents the excess of the proceeds received and used to replace the damaged equipment over the net book value of the replaced equipment. During fiscal 2002, the Company determined the net gain on the settlement of the claim to be $3.4 million, which was recorded within other income and expense for the year ended June 30, 2002. The remaining balance of the insurance settlement of $3.8 million was included in accrued liabilities at June 30, 2002. The accrued balance was deferred for additional subcontractor costs and equipment repairs and restorations to be made. During fiscal 2003, the Company determined that no material costs or restorations remained beyond the $1.4 million made on the damaged equipment, and therefore, recognized the $2.4 million balance of settlement gains in other income and expense.
8. Geographic Information and Foreign Operations
The Company operates in one business segment. Revenues from unaffiliated customers are based on the location in which the sale originated. The Company includes in long-lived assets, all long-term assets excluding long-term cash investments, long-term deferred income taxes, goodwill and acquisition-related intangibles. Geographic information for the fiscal years ended June 30, 2004, 2003 and 2002 is presented below (in thousand's):
No customer accounted for more than ten percent of the Company's consolidated net revenues in fiscal 2004, 2003 or 2002. No customer accounted for more than 10 percent of the Company's accounts receivable at June 30, 2004 and 2003.
9. Income Taxes
Income (loss) before income taxes for the fiscal years ended June 30, 2004, 2003 and 2002 is as follows (in thousand's):
The provision (benefit) for income taxes for the fiscal years ended June 30, 2004, 2003 and 2002 is as follows (in thousand's):
The tax benefit from options exercised reduced current income taxes payable for 2004, 2003 and 2002 by $15.7 million, $0.5 million and $3.9 million, respectively.
The Company's effective tax rate on pretax income differs from the U.S. federal statutory tax rate for the fiscal years ended June 30, 2004, 2003 and 2002, as follows:
In connection with the acquisition of TechnoFusion GmbH, the Company acquired certain net deferred tax liabilities of approximately $0.1 million. In connection with the acquisition of European Semiconductor Manufacturing, Ltd. ("ESM"), the Company acquired deferred tax assets generated from ESM's capital allowances and net operating loss ("NOL") carryforwards of $49.9 million. At fiscal year-end 2002, a full valuation allowance was placed on ESM's deferred tax assets. During fiscal 2003, the Company determined that expected manufacturing volumes and profits at the ESM foundry would recover a portion of the deferred tax asset. As such, the Company reduced the valuation allowance on ESM's net deferred tax assets by $26.6 million, which reduced purchased goodwill to zero accordingly. Acquired deferred tax assets and liabilities at the date of purchase are based on the Company's best estimate of the ultimate realization of such assets and liabilities. The Company continually evaluates
the acquired entity's valuation allowance. If a valuation allowance on an acquired entity's deferred tax assets established at the acquisition date is subsequently deemed not necessary, the tax benefits for those items are applied first to reduce any goodwill related to the acquisition, then to reduce other non-current intangible assets related to the acquisition, and then to reduce income tax provision.
The major components of the net deferred tax asset (liability) as of June 30, 2004 and 2003 are as follows (in thousand's):
The Company has approximately $17.7 million and $46.6 million of U.S. federal foreign tax credits and U.S. federal research and development tax credit carryforwards, respectively, before valuation allowance, available to reduce income taxes otherwise payable, which expire from 2005 to 2023. The Company has approximately $3.2 million of alternative minimum tax credits, which can be carried over indefinitely to offset regular tax liabilities to the extent of the alternative minimum tax. Before valuation allowances, the Company has $28.8 million in state research and development tax credits that carry forward indefinitely.
The Company has NOL carryforwards for U.S. federal, United Kingdom and Italy purposes of approximately $36.4 million, $48.1 million and $13.2 million, respectively. The U.S. federal, United Kingdom and Italy NOLs begin to expire in 2022, indefinitely, and 2007, respectively, with certain limitations.
Pursuant to Sections 382 and 383 of the Internal Revenue Code, the utilization of NOLs and other tax attributes may be subject to substantial limitations if certain ownership changes occur during a three-year testing period (as defined). The Company does not believe an ownership change has occurred as of June 30, 2004, that would limit the Company's utilization of its NOL or credit carryovers.
Realization of deferred tax assets is dependent upon generating sufficient taxable income. The Company believes that there is a risk that certain deferred tax assets may result in no benefit and, accordingly, has established a valuation allowance of $53.5 million against them. During fiscal 2003, the valuation allowance against ESM's deferred tax asset generated from its NOLs was reduced from $49.9 million to $16.2 million, which reduced purchased goodwill to $0 as of June 30, 2003. Although realization is not assured for the remaining deferred tax assets, management believes it is more likely than not that they will be realized through future taxable earnings or alternative tax strategies.
The Company is currently under audit by various tax authorities. Unfavorable settlement of any particular issue would require use of cash. Favorable resolution would be recognized as a reduction to the effective tax rate in the year of resolution or a reduction of goodwill if it relates to purchased tax liabilities. The Company's tax reserves are included in income taxes payable. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, the Company believes the results of these audits are not expected to have a material impact on its financial position or results of operations.
10. Net Income (Loss) per Common Share
The reconciliation of the numerator and denominator of the net income (loss) per common share-basic and diluted determined in accordance with SFAS No. 128, "Earnings per Share," is as follows for the years ended June 30, 2004, 2003 and 2002 (in thousand's, except per share amounts):
The conversion effect of the Convertible Subordinated Notes into 7,439,000 shares of common stock were excluded from the computation of "net income (loss) per share-diluted", since such effect would be anti-dilutive for all periods presented. Additionally, 859,000 shares of the Company's stock options for the year ended June 30, 2003, were excluded from the "net loss per common share-diluted" calculation, since including those shares would be anti-dilutive.
11. Environmental Matters
Federal, state and local laws and regulations impose various restrictions and controls on the storage, use and discharge of certain materials, chemicals and gases used in semiconductor manufacturing processes. The Company does not believe that compliance with such laws and regulations as now in effect will have a material adverse effect on the Company's results of operations, financial position or cash flows.
However, under some of these laws and regulations, the Company could be held financially responsible for remedial measures if properties are contaminated or if waste is sent to a landfill or recycling facility that becomes contaminated. Also, the Company may be subject to common law claims if it releases substances that damage or harm third parties. The Company cannot make assurances that changes in environmental laws and regulations will not require additional investments in capital equipment and the implementation of additional compliance programs in the future, which could have a material adverse effect on the Company's results of operations, financial position or cash flows, as could any failure by the Company to comply with environmental laws and regulations.
International Rectifier Corporation and Rachelle Laboratories, Inc. ("Rachelle"), a former operating subsidiary of the Company that discontinued operations in 1986, were each named a potentially responsible party ("PRP") in connection with the investigation by the United States Environmental Protection Agency ("EPA") of the disposal of allegedly hazardous substances at a major superfund site in Monterey Park, California ("OII Site"). Certain PRPs who settled certain claims with the EPA under consent decrees filed suit in Federal Court in May 1992 against a number of other PRPs, including the Company, for cost recovery and contribution under the provisions of the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"). IR has settled all outstanding claims that have arisen against it out of the OII Site. No claims against Rachelle have been settled. The Company has taken the position that none of the wastes generated by Rachelle were hazardous.
Counsel for Rachelle received a letter dated August 2001 from the U.S. Department of Justice, directed to all or substantially all PRPs for the OII Site, offering to settle claims against such parties for all work performed through and including the final remedy for the OII Site. The offer required a payment from Rachelle in the amount of approximately $9.3 million in order to take advantage of the settlement. Rachelle did not accept the offer.
In as much as Rachelle has not accepted the settlement, the Company cannot predict whether the EPA or others would attempt to assert an action for contribution or reimbursement for monies expended to perform remedial actions at the OII Site. The Company cannot predict the likelihood that the EPA or such others would prevail against Rachelle in any such action. It remains the position of Rachelle that its wastes were not hazardous. The Company's insurer has not accepted liability, although it has made payments for defense costs for the lawsuit against the Company. The Company has made no accrual for potential loss, if any; however, an adverse outcome could have a material adverse effect on the Company's results of operations or cash flows.
The Company received a letter in June 2001 from a law firm representing UDT Sensors, Inc. relating to environmental contamination (chlorinated solvents such as trichlorethene) assertedly found in UDT's properties in Hawthorne, California. The letter alleges that the Company operated a manufacturing business at that location in the 1970's and/or 1980's and that it may have liability in connection with the claimed contamination. The Company has made no accrual for any potential losses since there has been no assertion of specific facts on which to form the basis for determination of liability.
12. Commitments
The future minimum lease commitments under non-cancelable capital and operating leases of equipment and real property at June 30, 2004 are as follows (in thousand's):
Total rental expense on all operating leases charged to income was $11.6 million, $10.3 million and $10.0 million in fiscal 2004, 2003 and 2002, respectively. The Company had outstanding purchase commitments for capital expenditures of approximately $11.3 million at June 30, 2004.
13. Litigation
In June 2000, the Company filed suit in Federal District Court in Los Angeles, California against IXYS Corporation, alleging infringement of its key U.S. patents 4,959,699; 5,008,725 and 5,130,767. The suit sought damages and other relief customary in such matters. The Federal District Court entered a permanent injunction, effective on June 5, 2003, barring IXYS from making, using, offering to sell or selling in, or importing into the United States, MOSFETs (including IGBTs) covered by the Company's U.S. patents 4,959,699; 5,008,725 and/or 5,130,767. In August 2003, the Court of Appeals for the Federal Circuit stayed that injunction, pending appeal on the merits. In that same year, following trial on damages issues, a Federal District Court jury awarded the Company $9.1 million in compensatory damages. The Federal District Court subsequently trebled the damages, increasing the award from $9.1 million to approximately $27.2 million, and ruled that the Company is entitled to an additional award of reasonable attorney's fees for a total monetary judgment of about $29.5 million. In March 2004, the U.S. Court of Appeals for the Federal Circuit reversed the summary judgment granted the Company by the Federal District Court in Los Angeles of infringement by IXYS of the Company's U.S. patents 4,959,699; 5,008,725 and 5,130,767. The case was remanded for further proceedings and reexamination of a number of issues before the Los Angeles District Court where it originated. The Federal Circuit reversed in part and vacated in part infringement findings of the District Court, granted IXYS the right to present certain affirmative defenses, and vacated the injunction against IXYS entered by the District Court. The ruling by the Federal Circuit will also have the effect of vacating the damages judgment obtained against IXYS. The Federal Circuit affirmed the District Court's rulings in the Company's favor regarding the validity and enforceability of the three Company patents. The Company plans to continue to vigorously pursue its claims for damages and other relief based on IXYS' infringement of the asserted patents.
Additionally in a related case, in July 2003, the District Court awarded the Company sanctions against Samsung Semiconductor, Inc., in an amount including attorney's fees of about $7.3 million, subject to certain credits of up to $4.5 million. In March 2004, the Court of Appeals for the Federal Circuit determined that Samsung did not violate the injunction, vacating the previous sanctions award.
In January 2002, the Company filed suit in the Federal District Court in Los Angeles, California against Hitachi, Ltd. ("Hitachi") and affiliated companies alleging infringement of certain of its U.S. patents. The Company later brought additional claims alleging infringement of certain other of IR's patents. Hitachi denied infringement and validity of the patents and entered a counterclaim of patent misuse. During fiscal 2004, the Company added Renesas Technology Corp ("Renesas") and its U.S. affiliate to such suit as additional parties defendant. Renesas is a joint venture comprised of Hitachi (55 percent) and Mitsubishi Electric Corporation (45 percent). In January 2004, the Company, Hitachi and Renesas entered into a patent cross-license agreement. The agreement also settled the previously pending litigation among the parties. In the March quarter, the Company reported a one-time pretax gain, net of legal expenses and related costs, of approximately $5.9 million related to this matter. The agreement also provides for Hitachi and Renesas paying an on-going royalty on worldwide sales covered by certain Company power MOSFET/IGBT patents. The Company will pay an on-going royalty to Hitachi on Company sales in Japan of certain power MOSFETs and to Renesas on the Company's sales in Japan of certain other products. The agreement takes effect for payment of ongoing royalties on April 1, 2004 and will continue through the expiration of the applicable licensed patents.
14. Acquisitions
In July 2004 subsequent to fiscal year-end 2004, the Company acquired the specialty silicon epitaxial services assets from Advanced Technology Materials, Inc. for approximately $41 million in cash, which may be reduced by $3 million, pending the qualification of certain processes transferred as part of the transaction. We estimate goodwill to be approximately $16 million based on preliminary independent valuations of the fixed assets.
15. Related Party Transactions
As discussed in Note 2, the Company holds as a strategic investment common stock of Nihon, a related party. At June 30, 2004 and 2003, the Company owned 17.5 percent of the outstanding shares of Nihon. The Company's Chief Financial Officer is the Chairman of the Board of Nihon. In addition, the general manager of the Company's Japan subsidiary is a director of Nihon. Although the Company has representation on the Board of Directors of Nihon, it does not exercise significant influence, and accordingly, the Company records its interest in Nihon based on readily determinable market values in accordance with SFAS No. 115 (see Note 2).
In June 2002, the Company entered into agreements to license certain technology to Nihon and to contract Nihon to manufacture certain products. The estimated value of the licensing and manufacturing agreements are $5.4 million and $2.0 million, respectively, of which $3.3 million and $2.5 million was recognized as revenue for the fiscal years ended June 30, 2004 and 2003, respectively. No revenue was recognized under these agreements for the fiscal year ended June 30, 2002.
16. Quarterly Financial Data (Unaudited)
Summarized quarterly financial data is as follows (in thousand's, except per share amounts):
(1)Fiscal first quarter 2003 through fiscal fourth quarter 2004 included pretax impairment of assets, restructuring and severance-related charges, including the pension termination costs at the Oxted, England facility of $2.8 million and $2.3 million in fiscal 2004 and 2003, respectively, as follows (in thousand's, except per share amounts):
(2)Fiscal fourth quarter 2004 included a $0.01 dilutive effect from the conversion of the Company's outstanding convertible subordinated notes into 7,439,000 shares of common stock. The conversion effect was not included in previous quarters, since such effect would have been anti-dilutive.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
(a)Evaluation of disclosure controls and procedures The term "disclosure controls and procedures" refers to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files under the Securities Exchange Act of 1934 ("Exchange Act") is recorded, processed, summarized and reported, within required time periods. The Company's management, with the participation of the Company's Chief Executive Officer, Alexander Lidow, and Chief Financial Officer, Michael P. McGee, carried out an evaluation of the effectiveness of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer believe that, as of the end of the period covered by this report, such controls and procedures are effective in making known to them material information related to the Company (including its consolidated subsidiaries) required to be included in this report.
Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving an entity's disclosure objectives. The likelihood of achieving such objectives is affected by limitations inherent in disclosure controls and procedures. These include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures such as simple errors, mistakes or intentional circumvention of the established processes.
(b)Changes in internal controls There was no significant change in our internal controls during the fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting.
Item 9B.
Item 9B. Other Information
None
PART III
For information called for by Items 10, 11, 12, 13, and 14 reference is made to the items under "Election of Directors", "General Information-Security Ownership of Principal Stockholders and Management", and "Ratification of Auditors-Independent Auditors" in the Registrant's definitive proxy statement for its annual meeting of stockholders, to be held November 22, 2004, which will be filed with the Securities and Exchange Commission within 120 days after July 4, 2004, and which is incorporated herein by reference. Certain information concerning the executive officers of the Company is included in Part I. See "Additional Item" on page 13.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
a.Financial Statements and Financial Statement Schedule being filed as part of this report are listed in the index on page 39.
b.Reports on Form 8-K: None.
c.Exhibits filed as part of this report are listed on the Exhibit Index on page 73.
EXHIBIT INDEX
Incorporated By Reference:
Submitted Herewith:
See page 39 for an index of Financial Statements and Financial Statement Schedule being filed as part of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
INTERNATIONAL RECTIFIER CORPORATION
(Registrant)
By:
/s/ MICHAEL P. MCGEE Michael P. McGee
Executive Vice President and
(Principal Financial and Accounting Officer)
Date: September 17, 2004
Each person whose signature appears below hereby authorizes Michael P. McGee, as attorney-in-fact and agent, with full powers of substitution, to sign on his behalf, individually and in the capacities stated below, and to file any and all amendments to this Form 10-K, and other documents in connection therewith, with the Securities and Exchange Commission, granting to said attorney-in-fact and agent full power and authority to perform any other act on behalf of the undersigned required to be done in the premises.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signatures
Title
Date
/s/ ERIC LIDOW Eric Lidow
Chairman of the Board
September 17, 2004
/s/ ALEXANDER LIDOW Alexander Lidow
Director, Chief Executive Officer
(Principal Executive Officer)
September 17, 2004
/s/ JACK O. VANCE Jack O. Vance
Director
September 17, 2004
/s/ ROCHUS E. VOGT Rochus E. Vogt
Director
September 17, 2004
/s/ JAMES D. PLUMMER James D. Plummer
Director
September 17, 2004
/s/ MINORU MATSUDA Minoru Matsuda
Director
September 17, 2004
/s/ ROBERT ATTIYEH Robert Attiyeh
Director
September 17, 2004
SCHEDULE II
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
For the Fiscal Years Ended June 30, 2004, 2003 and 2002
(In thousand's)
(1)Deductions include the write-off of uncollectible trade receivable and obsolete and scrap inventory, revaluation of federal, state and foreign valuation allowance, and the effect of SFAS No. 52, "Foreign Currency Transactions".
(2)The ($13,535) Deductions include a $26,593 reduction in valuation allowance on European Semiconductor Manufacturing, Ltd.'s ("ESM") deferred tax assets, which was established at the acquisition date as noted at (3) below. In fiscal 2003, the Company determined that expected manufacturing volumes and profits at ESM would recover a portion these deferred tax assets. The reduction to valuation allowance was partially offset by $13,058 increases in valuation allowance on deferred tax assets related to certain foreign subsidiaries' capital allowances and net operating loss carryforwards.
(3)The $49,862 Charged to Other represents a full valuation allowance placed on deferred tax assets related to ESM's capital allowances and net operating loss carryforwards acquired in connection with the acquisition of ESM in the fourth quarter of fiscal year 2002. At the acquisition date, the Company placed a full allowance on these deferred tax asset pending further evaluation of their recoverability.
(4)The $38,187 Deductions principally relate to the disposal of inventory reserved as part of the June 30, 2001 restructuring charge. The disposal of this inventory did not materially impact gross margin for fiscal 2002.
PART I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
PART II
Item 5. Market for the Registrants' Common Equity-Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements and Financial Statement Schedule
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In thousand's except per share amounts)
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In thousand's except share amounts)
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS) (In thousand's except share amounts)
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In thousand's)
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
PART III
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
EXHIBIT INDEX
SIGNATURES
SCHEDULE II
INTERNATIONAL RECTIFIER CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES For the Fiscal Years Ended June 30, 2004, 2003 and 2002 (In thousand's)